Then he makes his first mistake; he asks his family or friends for advice. Of course the typical responses range from ‘Well, so and so tells me …’ or ‘I heard it is best to …’ From here, the entrepreneur almost always seeks out legal counsel. The problem with asking lawyers is that their answer is always one of pure risk elimination and not one to allow maximum business flexibility. As an entrepreneur, you must remember what being in business is all about – making a profit. Often one form of business ownership is more beneficial in maximizing profit over another form and can still provide risk reduction.
To understand this profit and risk management relationship, this article first explains the eight different forms of business ownership. Next, risk assessment is evaluated to help the entrepreneur understand why one form of entity status may be superior to another. From there, tax consequences are explained. Finally, some general guidelines are presented to help the entrepreneur make an informed decision.
So to start, let’s look at the eight different forms of business ownership.
- 1 Eight Different Forms of Business Ownership
- 2 Risk Management
- 3 Selection Process
- 4 Tax Consequences
- 5 Insights to the Decision Model
- 6 Summary – Forms of Business Ownership
Eight Different Forms of Business Ownership
There are eight different forms of legal status for a business. The eight are divided into two distinct categories. One category is driven by profit. The other category is customer oriented. In business, there are generally three goals.
- Make a profit
- Provide for the long-term security of employees
- Serve the consumer by providing the customer with a product or service that is in demand.
Six of the eight entity forms are designed to maximize the number one goal – profit. The second category focuses on the third goal of business. So two of the eight forms place this goal as the priority in its legal structure. The following is a table of the two categories and the corresponding entity forms customarily found:
The following sections explain each of the eight entity forms of business ownership in more detail.
This is the easiest and simplest of all entity forms to create. There is literally one form to fill out and that is an SS-4 Application for a Federal Identification Number. There is no application to the secretary of your respective state. The sole proprietorship form of business status is ideal for micro-businesses and for home businesses especially those selling general consumer products either over the internet or at weekend events. The risk factor to others is generally none existent or extremely low and there are no employees. The tax impact is comparable to the other five remaining profit driven entity forms. The benefits are numerous and include:
When two or more individuals get together for a business endeavor they automatically form a partnership. Most partnerships have a single goal in mind and are short lived. They are often family arrangements to complete a single task. An example would be heirs selling some inherited property or two brothers agreeing to work together on a single project over a weekend to make a few extra dollars. The primary goal is profit just as with the sole proprietorship. The secondary goal of rendering service or providing a product is short term. So, most partnerships are undocumented relationships. This is where the problems begin.
When two or more individuals get together for a long-term relationship a formal agreement is necessary to prevent future conflicts. A partnership agreement spells out the specific duties and responsibilities each partner has in the relationship. The agreement covers compensation and how profits are calculated for each partner. Better agreements cover time commitments, financial obligations, business protocols, termination procedures and liability exposure. A well drafted document is often more than 50 pages long.
Partnerships are uniquely the most flexible of all business forms of ownership as it is simple to negotiate changes to the agreement. In addition, a well drafted financial compensation and earnings allocation clause can minimize the overall tax burden borne by all partners.
There are few drawbacks. One is that any partner may encumber the business by asserting authority to a third party. Secondly, it is difficult to raise additional capital as new partners tend to misunderstand or distrust this form of business ownership. The legal community has tainted this legal status as an unworthy business ownership model mostly out a lack of knowledge of how it works. Finally, there is the personal wealth defense, a shield per se, to protect the partners. It is non-existent in partnerships. This doesn’t mean it is a poor ownership model it merely requires the partners to use other tools to protect their personal wealth.
Overall, partnerships are the most flexible and effective business form of ownership.
Limited partnerships are almost identical to partnerships. Limited partnerships solve the problem of raising more capital that often hamper traditional partnerships.
With small businesses, no matter the form of ownership all lenders require personal guarantees of the owners in case of default with debt. In a limited partnership, the limited partners are exempt from this requirement. Limited partners are at risk to the value of their investment just like shareholders in a corporation. The drawback for a limited partner is the highly restrictive management role. Limited partners can only vote their share of ownership as it pertains to changing the partnership agreement. Limited partners are not allowed management input.
Overall, the drawback for a limited partnership is a significantly reduced ability to change the partnership agreement. In effect, there is a trade off for additional investment by third parties by a decrease in flexibility a traditional partnership offers.
One last note about limited partnerships. It is a wonderful tool to use with retiring partners. Basically in lieu of paying a retiring general partner his share of value upon retirement, the general partner converts to limited partner status and is paid his capital account balance over time via installments from annual earnings.
Your average investor or business entrepreneur subscribes to the belief that everyone is out to get your wealth. This is especially valid given our litigious society. Zero credence is given to the fact that many of these cases in civil court are valid claims. The reality is that if your business is grossly negligent then it deserves to be sued. To protect personal wealth many owners resort to the corporation form of ownership. Lawyers have convinced many small business entrepreneurs that it is difficult for the claimant in a civil case to pierce the corporate veil. This may be true in some cases but not in many cases especially where professional licenses are the underlying foundation of the business. This means engineers, doctors, lawyers and many others with professional licenses can easily lose their livelihood and personal net worth due to the personal nature of their service. The reality is that the corporate form of ownership provides some degree of protection but it is thin and easily penetrable when gross negligence exists.
There are other more beneficial reasons to consider corporate status as the form of ownership. First is the ability to raise additional capital. In the partnership format, any new partners must sign the partnership agreement. That signature serves as title to ownership. In the corporation form, the stock certificate serves as title to ownership. Furthermore, a shareholder position does not entitle the bearer to a role in management. It only allows the holder the right to vote for directors that in turn appoint officers to manage the company. The average layman understands this exchange of financial investment for very restrictive rights in regards to corporate structure.
A second benefit of corporate business status is recognition as a true and wholly separate business entity. Third party vendors and customers understand that the business is itself an entity whereas partnerships are understood to be a group of individuals. In court a corporation is allowed to represent itself whereas partnerships are sometimes not allowed as an entity and therefore the partners must provide their own representation. This is a matter of how states recognize corporations as legally separate entities.
The best and often compelling reason to not exist in the corporate form is the legal separate entity status. Although beneficial for a layer of protection and recognition as a separate entity, it is also now taxable as a separate entity. With this taxable position there is the possibility of double taxation. Fortunately Congress provides an out to this known as S-Corporation status.
S-Corporations are corporations with special tax status. In effect, an S-Corporation is exactly like a partnership whereby taxation is at the individual level. This is referred to as pass-through taxation. All tax items are transferred to the individual shareholders per their respective percentage of ownership. Tax items include:
All these tax items are reported via Form K-1. The form is turned in to the IRS and a copy is forwarded to the shareholders.
Although there are tax savings, this status has many restrictions including disallowance of certain employee benefits for owners, greater scrutiny over certain deductions and a responsibility to track tax for each shareholder. In addition, the S-Corporation status is designed for small business including limits on revenue and the number of shareholders. The status requires the agreement of all shareholders and acceptance by these shareholders of their respective share of any trust issues related to taxation. Basically, the IRS expects each shareholder to do their share of due diligence in regards to the company’s tax issues.
In general, S-Corporations provide dual benefits. First it is viewed as a corporation in the eyes of the state and the legal system. Secondly it has special tax treatment similar to partnerships eliminating double taxation customarily assigned to regular corporations (also known as C-Corporations).
The drawback to this form of entity status is the lack of ownership flexibility as provided via the partnership agreement. So a relatively new form of business ownership (about 60 years old now) provides both flexibility and corporate protection.
Limited Liability Corporation (Company)
Limited liability companies or limited liability corporations are basically partnerships with corporate protection granted by the state. Just like a partnership limited liability corporations (LLC’s) must have a well documented membership agreement. The term ‘member’ is used instead of partner with this form of ownership status. As identified with the partnership agreement, the membership agreement should also have clauses covering:
… and so forth.
In the eyes of all third parties including customers, LLC’s are seen as corporations; but for internal purposes, they are just like partnerships. As for tax purposes, the IRS allows the owners (members) to select their respective tax status. LLC’s can elect to be taxed as a sole proprietorship (single member operation), partnership or as an S-Corporation.
There are several drawbacks to this form of ownership. The first is inherent in a partnership relationship as the underlying form of ownership. Many LLC’s do not have or have a poorly written membership agreement. Furthermore, many entrepreneurs using this form of ownership fail to take advantage of the tax benefits especially those operations that are capital intensive. Finally, novice entrepreneurs fail to properly document their business accounting affairs and often mix personal and business expenses thus exposing the corporate protection to civil claims.
With the above six different business forms of ownership profit is the primary motive. In addition to profit, businesses seek out the desire to provide a product or service solely for the community, a select group or for a few individuals.
The non-profit designation is actually a misnomer. All organizations seek out positive income over expenses (net income) in order to continue operations. The key is that these organizations are actually tax exempt. Congress allows these organizations that serve society or exist to promote social awareness or further science the right to retain all of their excess earnings as capital investment for the future. Some non-profits are allowed the status as charitable organizations whereby donations from individuals and corporations are deductible by these individuals and corporations on their respective tax returns. Examples include religious organizations, educational institutions and tax recognized groups receiving the coveted 501(c)(3) designation.
Common non-profit or tax exempt organizations include:
Again, just because they are tax exempt does not mean donors or membership dues are deductible on individual tax returns; it merely means the organization is allowed to retain excess receipts over expenses without taxation as long as these excesses are used in the future to promote community good. Profit is not the principle purpose of this businesses’ existence. Service is the primary purpose.
Trusts are set up to benefit one or a few individuals. There are two types of trusts – revocable and irrevocable. Revocable trusts can be modified and therefore are not recognized as a legally separate entity. Only irrevocable trusts are recognized as a separate form of business ownership. Often trusts are immediately created upon the death of an individual as a function of closing the estate. Other trusts are created to deposit assets including ownership rights to businesses. The donor of the assets is called the grantor (trustor) and the person running or managing the trust is the trustee. Unlike other forms of ownership, the trust can be taxed in whole on its profits or taxed partially. Any untaxed income is assigned via Form K-1 to the beneficiary. The beneficiary is the third party the trust is designed to take care of in accordance with the trust document.
In general, there are no tax benefits related to a trust; its primary purpose is to provide financially for the beneficiary(ies). Everything is spelled out in the trust document. Very few businesses start out in the trust form but over time the owner or primary key person deposits the business into the trust for the long term benefit of his/her family and for legacy purposes.
With business assets in the trust, the trust is configured to benefit/individuals, the business is managed to make a profit to fund the benefit. In the legal section of this site are several articles explaining trusts. The Internal Revenue Code has several different types of trusts allowed from the very simple to highly complex real estate investment conduits.
The trust form of ownership is a very sophisticated form of ownership and requires extensive legal and accounting assistance. Small law firms and accounting practices will not have the knowledge depth to assist the trustee. Only large firms have the resources to assist in creating trusts and complying with the tax code. This form of ownership is not recommended for microbusinesses.
The above eight forms of ownership are the legally acceptable tools used in the business world. To assist the reader in evaluating the best form of ownership for their individual situation, the entrepreneur must first assess risk and how to manage risk.
Risk is inherent in any business activity. There are some things in life that are certain including death, the proverbial taxation and risk. In business, the greater the risk the greater the reward sought for the risk taken. Risk is divided into two broad categories – pure and market risk.
Pure risk is described as controllable. It includes acts of God and accidental errors by human beings. Examples include property accidents, automobile accidents, loss from fire or flooding and automotive incidents. Insurance is the most common loss protection instrument. For example, all states require worker’s compensation insurance for employee injuries. Typical small business insurance includes:
- General Liability – covers customers for injury on premises
- Property – protects the company for losses incurred associated with assets and facilities from fire and flooding
- Professional – reimburses customers for losses incurred due to lack of professional due diligence
- Health – covers employees and their families for general health
- Product Liability – protects customers over long terms from any effects of product use or failure of the product
- Life Insurance – loss of life and provides something to the employee’s family
- Key Man Policy – similar to life insurance except it is designed to reimburse the business for the loss of a key individual
- Bonds – covers employee dishonesty
- Disability – covers claims for long term non employment related health issues
Insurance is the primary tool to reduce the cost of losses associated with pure risk. Other tools to reduce pure risk include training, risk assessments and the corporate culture. However, some risks are uncontrollable.
At the macro level of economics no single person can control or manipulate the market. It takes vast numbers of investment dollars to change the market. This includes everything from interest rates to inflation to government debt. Uncertainty exists in the market. With any investment decision, there is a possibility of losing it all. The key is defining what ‘all’ means.
The market risk is generally uncontrollable but the legal profession believes that it is controllable to some degree with the use of the proper form of ownership. Most attorneys default to the corporate shield to separate business assets from personal assets. They cite lawsuits as the primary reason to use this form of ownership. These types of lawsuits are rare and typically exist due to gross negligence (obvious misconduct) of the business. Even so, buying proper insurance mitigates these claims as often the insurance underwriter engages high profile law firms to defend against such claims.
In reality, the form of ownership selection is a tool to enhance profitability and control to some extent market risk. Insurance is the tool to control pure risk which includes these so called litigious pseudo claims.
One last note about pure risk claims. Experienced business owners purchase an umbrella policy. A typical $1 Million additional coverage is less than $1,000 per year. Each additional $1 Million of coverage is marginal (in the $250 to $400 range) in cost. So a $3 Million umbrella policy is less than $2,000 per year. If your operation has a high interaction rate with customers and the customer is exposed to injury, umbrella policies are the perfect tool to significantly reduce pure risk.
The key lesson here related to risk is that the form of ownership is designed to reduce market risk and not pure risk issues. As the small business grows, it will naturally convert to the corporate shield to protect against customer claims and other business lawsuits. In the small business world select the form of ownership that will best maximize profits.
With small business the key is to keep the eye on the prize. The selection of the proper form of ownership makes this task easier. Since most small businesses are not community service driven or designed to benefit a select few individuals, the non-profit and trust forms of ownership are not a part the selection group.
Historically most small businesses simply followed the pattern of development via maturation from sole proprietorship to a full corporation. Most likely your small business will follow this same pattern. As a mircobusiness (revenue of less than $500,000 per year), the sole proprietorship is quite advantageous. The focus is on earning profit as there is no annual requirement to file an application or articles to the state. It is simple and geared around the owner’s identity. Most risks are pure in nature and insurance is the true shield to protect the owner from claims. The more important issues begin as the business grows and requires more management than just the owner. Others get involved.
Now the emphasis shifts from one person to a relationship management between two or more primary and responsible parties. Profit is not as important in comparison to the need to create a manageable relationship between the parties. This is the underlying objective of a partnership agreement. Even if this partnership level is skipped to go directly into the corporate form, the owners must still draft a management agreement between them to reduce friction and misunderstandings. So no matter what, anytime more than one owner is involved; some form of formal arrangement is required between the parties. The beauty of the partnership agreement is the ease of implementing amendments and addressing not only compensation but control of the business operations.
Sometimes new parties or old retiring partners do not want or are interested in managing or being actively involved in the business. They are there purely for financial gain. In effect, they are passive. With partnerships the partners simply modify the form of business to a limited partnership. In this situation, the general partner(s) is the only exposed party to any legal claim including market based risk claims. The limited party can only lose their respective investment.
As the business continues to grow and prosper there may begin some wealth accumulation; I’m referring to more than $1 Million in net worth for the business. Now the owners may seek to cash this wealth by selling ownership rights to other parties. The easiest and simplest form of ownership transfer is via stock. Stock is the ownership instrument used with corporations. Corporations will add an additional layer of protection as wealth retention becomes an essential concern of investors. Even with corporation status, the shareholders still need to agree to by-laws, a shareholder agreement, cross-purchase agreements and employment arrangements in order to be truly successful.
If the corporation is well capitalized and has adequate working capital it may seek out preferred tax status for the shareholders. This involves getting permission from the IRS for S-Corporation status. This step transfers the tax obligation (the actual tax payments) to the shareholders. This is why the IRS requires each shareholder to sign a document acknowledging this financial responsibility.
At some point in the small business maturation process, the owner(s) may want the additional corporate protection and the flexibility partnership agreements bring and simply become a limited liability company (LLC). As stated earlier this format can provide the corporate shield protection in case of a lawsuit gone wild. The drawback is the requirement to have a well documented membership agreement. This agreement can cost upwards of $10,000 for a multi-member small business. Without this document, the inner turmoil will doom the business to failure and a lawsuit will pale in comparison. Again, pure risk items are customarily managed with insurance including umbrella policies.
MARKET RISK IN SMALL BUSINESS IS MANAGED WITH A WELL WRITTEN PARTNERSHIP, MEMBERSHIP OR SHAREHOLDER’S AGREEMENT. PURE RISK ISSUES RESULTING IN LAWSUITS ARE MANAGED WITH INSURANCE AND PREVENTION PROGRAMS.
So what is the best decision model to select the appropriate form of ownership? The following is a general guideline.
Is your goal profit driven or service focused?
If you seek out to serve the community or a select few individuals then the non-profit status or trust form of ownership is best. Go to non-profit organizations page or the legal page for trusts for further help. If profit is the motive, go to question number two.
What is your personal net worth?
If your personal net worth is less than $250,000, then continue to question three. If your net worth is more than $250,000, then the corporate form of ownership will serve you well in the long run. The other option is the limited liability corporation. Go to questions five and six for more guidance.
Will you be involved with others?
If ‘no’ then the sole proprietorship is adequate for you. Remember to purchase more than enough insurance to reduce overall pure risk. If you hire staff, create a culture of awareness, training and safety to prevent employees suing over frivolous issues. Get guidance from the human resources page on this website.
If ‘yes’ you must create an agreement between the parties for control and ownership. The agreement must address not only the financial investment but the time commitment by all partners. Create a partnership agreement and force all parties to sign the notes created during discussions related to the respective sections of the agreement. A partnership is a good form of ownership especially if the other partner is only putting up a little financial risk. The agreement is designed to award the partner with more invested capital and time commitment. However, some partners are only interested in financial reward and desire to be silent. If so, go to question four. If any of the partners are going to be actively involved and if any partner has a net worth of more than $250,000 then the corporation or limited liability company form of ownership is more appropriate. Go to question five.
Will any owners have a passive position related to the business?
If ‘yes’ then the limited partnership is an ideal tool. In general, the partnership agreement grants rights to the limited (Ltd) partner for two critical aspects of business. First it grants a right to vote on changes to the partnership agreement and secondly it outlines the method of profit allocation and distribution.
If ‘no’ make sure the partnership agreement has a well defined responsibility assignment to each of the general partners. The partner with the highest net worth has the most to lose concerning market risk. Again, if any partner’s net worth exceeds $250,000 net of the business value, go to question five.
Do any general partners have a net worth of $250,000 or more net of the business?
If ‘no’ go back to question three.
If ‘yes’ then the general partner with the greatest net worth may want to opt for either the corporate form of existence or the limited liability corporation status. The corporate form is generally more restrictive and penalizes wealth distribution when dividends are paid. The restrictions of a shareholder’s agreement make it difficult to reward the owners with the most to lose or the hardest worker a greater share of the profits. Therefore it behooves the management team to consider the limited liability corporation form of business ownership. Go to question six.
Does one partner have more knowledge, certification or experience over other partners?
If ‘no’ then the corporate form of ownership is more appropriate because the restrictive covenants of the shareholder’s agreement and employment arrangement make it nearly impossible for one owner to dominate financially over other owners.
If ‘yes’ then the traditional partnership or limited liability corporation is best. The partnership/membership agreement allows for maximum latitude of compensation for a key man. In addition, all partners/members are equally compensated in a passive method for their respective financial position. The partner/member that generates the highest gross margins is compensated in a superior manner over other partners/members. The only key question to separate traditional partnership from limited liability status is risk. Go to question seven.
Can the product or service rendered permanently injure or disable the customer?
If ‘no’, a traditional partnership is warranted. A corporate shield is not necessary nor cost effective. Pure risk items are easily managed with insurance.
If ‘yes’, a corporate shield is necessary if any partner’s/member’s net worth exceeds $250,000 net of the business. The corporate shield is acquired via corporation status or using the LLC form of ownership.
Notice with the above questions that tax consequences are not the decision driver for the form of ownership? This next section will cover this in more detail.
The reason tax consequences are not the primary driver in the decision model for the form of business is that practically speaking all of the models are taxed at the investor/owner level. Look at the following table:
Notice that the only business entity format that is taxed as a business is the corporation. The company pays a tax and if it pays out profits to owners (shareholders) known as dividends; the dividends are taxed at the individual level. This is known as double taxation and is commonly found in the top 2,000 companies worldwide. In small business, double taxation is not an issue for several reasons. Number one, wealth earned by the company can be easily transferred to owners as additional compensation or using different stock instruments such as preferred stock or via capital gains. Secondly, the goal of a business is to build it up in value which is normally done by retaining earnings.
Most small businesses that decide to incorporate use the S-Corporation status which assigns net profit to shareholders per percentage of ownership. Distributions are common to pay the tax on behalf of the shareholder. This information is reported using Form K-1 for the tax return 1120-S.
There are some tax restrictions for certain industries; so the entity format selection process is modified to comply with the Internal Revenue Code. First off, S-Corporations may not exist as pure passive income generators. Examples include real estate rentals or any capital investment rental company. It may not be used to act as an investment vehicle like a lending company or a bank.
Some industries are restricted to their tax format by the very nature of the business. For example, any form of finance is customarily incorporated because the market risk for failure is very high. To limit the losses, incorporation is functionally the most appropriate option. Furthermore, the IRS regulations are so overwhelming for the finance industry the corporate form of ownership is the only one that makes sense.
Often tax consequences are the guiding thought in selecting the form of ownership. In reality, most forms of ownership tax at the individual level or have no real impact at the small business stage of the business life cycle. Unless the net profits exceed $500,000 per year, income taxation is the least of the concerns in the decision model. Other concerns are more important.
Insights to the Decision Model
The Internal Revenue Service reports that over 70% of all new businesses start out as sole proprietorships. Why? It is simply the most cost effective form of ownership at the small business level. Most of these businesses are home based and have very low if any pure risk. Furthermore, many do not even get to the level of a microbusiness (profits less than $100,000/yr).
Odds are that your business will start out as a sole proprietorship.
Some businesses are fortunate and grow rapidly requiring continuous reinvestment of profits back into the business. In effect the owner’s personal wealth is the business. Once this wealth surpasses several hundred thousand dollars the owner should consider incorporation and using the S-Corporation status to control taxation. Let your CPA guide you as this wealth accumulates.
Throughout this article market risk is the real risk issue to consider when selecting the business form of ownership. None of the entity forms will protect you from the personal guarantee. This single tool slices a huge hole in the corporate veil of protection. Even leases require personal guarantees.
The real market risk is adding key individuals to the management team. Thoughtful, principled and hard working team members will drive the success of the business. The best tool is prevention of risk and this means a well drafted document whether a partnership, membership or shareholder’s agreement.
Summary – Forms of Business Ownership
There is a profit and risk relationship that affects the form of business ownership. The goal of the particular form of ownership is to reduce market risk and not pure risk. Pure risk which is often a lawyer’s primary concern is managed with insurance and with enforced policies (including corresponding procedures) to prevent accidents.
Market risk refers to investment loss. The form of ownership can help to reduce market risk but not eliminate the potential loss. The reality is that the consumer will cast the ultimate vote of approval.
There are eight forms of small business ownership. Two of the forms (non-profit and trusts) are driven by the product or service rendered. Most small businesses select one of the six profit driven forms of ownership. The most common is the sole proprietorship which accommodates the owner until either partners are needed or wealth accumulates.
When partners are needed the owner may elect the partnership, limited partnership or corporation form of ownership. No matter the choice, a well drafted working relationship agreement must accompany the arrangement. The real market risk is in the working relationship of the principles.
As the business prospers, capital infusion from silent partners becomes essential; so often the business form of ownership matures into the limited partnership or the corporate form of existence. To minimize taxation, the owners may elect S-Corporation status.
The limited liability company (LLC) is appropriate for not only corporate protection but the ability to easily amend the membership agreement. This form of ownership is very common in the professionally licensed industries (law, accounting, engineering, architecture, medical and surveying). Act on Knowledge.