BA243:
Lesson 1: Business Forms
Introduction to Business Forms
A business form is the type of business you choose to create. Forms include sole proprietorships, partnerships, limited liability companies, and corporations. You will learn more about these in the course commentary and in the Chapter readings in your textbook.
Lesson Objectives
- Describe the various business forms.
- Identify when you would use a particular business form.
Lesson Readings & Activities
By the end of this lesson, make sure you have completed the readings and activities found in the Lesson 1 Course Schedule.
Business Forms
A business starts with an idea, a desire, or a plan from an individual or a group working together. Often, thoughts about what form the business should take are not high on the list of priorities. They may not need to be right away, but, at some point in the early stages of planning, the business form will need to become a priority.
The form a business takes is determined by many factors, but the two most important ones are liability protection and taxes. Each business form provides varying benefits in both areas. In this lesson, we will discuss the various types of business forms and when you would choose one over the other.
There are generally four types of business forms (with some variations). The four basic types are
- sole proprietorships,
- partnerships,
- limited liability companies, and
- corporations.
Sole Proprietorships
A sole proprietorship is formed when one person starts a business in his or her name (or in a fictitious name). Although multiple people might work for a sole proprietorship, only one person will own the business.
The owner of a sole proprietorship will often open a separate bank account to track information about the revenues and expenses of the business, but there is no separate tax return prepared for the business. Business income is reported on the owner’s personal tax return, and the owner’s Social Security number is used as the business's tax identification number. The low cost of launching a sole proprietorship makes it a popular option for start-up businesses; you can go out and cultivate business for yourself.
Sole proprietorships do not provide liability protection. Should there be an accident, a problem with the product you are selling, or a lawsuit filed against you by a customer, your personal assets would be at risk. Liability protection limits the amount that a person or entity with a claim against you can collect from you personally. This amount is typically based upon whether or not you have purchased enough business insurance to cover the claim.
Partnerships
A partnership is similar to a sole proprietorship, but more than one person forms the business. A partnership is made up of two or more individuals or business entities that come together to form a business. The most basic form of partnership is a general partnership, in which ownership of the business is divided between the individuals or business entities equally. Often, a partnership agreement is prepared to determine how the business will be run, how decisions will be made, how profits and losses will be shared, and how a partner could be removed from the business (either voluntarily or involuntarily).
A partnership is taxed similarly to a sole proprietorship; there is no separate return filed for the partnership. Rather, the partners receive a Schedule K-1 form. The form identifies each partner's portion of the business profits, which is then reflected on each partner's personal tax return. Because it is made up of more than one member, a partnership obtains a separate tax identification number (known as the employer identification number), which is used for employment purposes. However, because business income is reported on personal tax returns, personal Social Security numbers are used for some tax purposes.
Partners’ personal assets are subject to liability, but each partner shares in that liability for the business. Business insurance is key for protecting the partners’ individual assets. Forming a limited partnership can limit liability. In a limited partnership, there is at least one general partner and one or more limited partners. The limited partners' liability (personal exposure) is limited to their investment (the cash or assets they contributed to the business). In turn, these partners have limited say in how the business is run and how decisions are made. In a limited partnership, the general partner (or partners) accepts the personal liability associated with the business. Some states require partners to file formal documents with the state in order to form a limited partnership.
Limited Liability Companies
A limited liability company (LLC) has a more formal business structure. An LLC is formed by filing a document with the Department of State in the state where the business is located. This document is sometimes called a certificate of organization, but its name can vary from state to state. The document identifies the name of the business, its address, its purpose, and the person or persons forming the business.
The individual or individuals that form an LLC are called members. The LLC is then either managed by the members collectively or a managing member is selected to run the day-to-day operations of the business. This form of business also includes the preparation of an operating agreement, which is similar to a partnership agreement in that it describes how the business will be run, how decisions will be made, how profits and losses will be shared, and how a member could be removed from the business.
An LLC provides the liability protection of a corporation and the tax benefits of a partnership. Members’ liabilities are limited to the assets of the LLC; their personal assets are not at risk unless they act inappropriately (for example, by defrauding a customer). An LLC would still want to have business liability insurance to protect and defend itself against lawsuits.
For tax purposes, an LLC can be treated the same as a sole proprietorship if it is made up of one member; the individual's Social Security number would be used as the business's tax identification number, and tax would be passed through to the individual's tax return. An LLC can be treated the same as a partnership if there is more than one member; it would be taxed in same manner as a partnership and use a K-1. An LLC can also elect to be taxed as a corporation. When an LLC elects to be taxed as corporation, a separate tax identification number is obtained, as in a partnership; however, unlike a partnership's number, the tax identification number is used to file a separate tax return for the corporation. The income for a corporation is not passed through to its owners as in a sole proprietorship, single-member LLC, or partnership.
LLCs provide a lot of flexibility, making them the most popular business form.
Corporations
A corporation also requires a formal business structure. A corporation is formed by filing articles of incorporation with the Department of State in the state where the business is located. The form identifies the name of the business, its address, its purpose, and the person or persons forming the business.
The individual or individuals that form a corporation are called shareholders; they own stock in the business. A corporation is required to have bylaws, which describe how the business will be run, how decisions will be made, how profits and losses will be shared, and how shareholders could be removed from the business.
A corporation provides the most liability protection; shareholders’ liability is limited to the assets of the corporation. Their personal assets are not at risk unless they act inappropriately (for example, by intentionally deceiving a customer). A corporation will still want to have business liability insurance to defend itself and pay claims—if the assets of the corporation are needed to settle a claim, the business may not be able to continue, and, while the personal assets are protected, the business (and, thus, the shareholders’ livelihood) would no longer exist.
A corporation is subject to a two-tier tax structure, which occasionally makes it an unpopular business option. The corporation itself files a tax return and is taxed on its profits. Then, when the profits are passed on to the shareholders as income, they are again taxed (this time personally to each shareholder).
The kind of corporation we have described so far is known as a C corporation. An S corporation results from a corporation electing to be taxed under Subchapter S of Chapter 1 of the Internal Revenue Code. An S corporation works in a similar manner as a C corporation, but an S corporation must meet the following requirements:
- It must either be a domestic corporation or limited liability company.
- It must have only one class of stock (whereas a C corporation can have more than one).
- It must not have more than 100 shareholders.
- Profits and losses must be allocated to shareholders proportionately to their interest in the business.
S corporations bypass the double taxation of C corporations by reporting the entire corporation income on the shareholders' personal tax returns. Thus, like a partnership, an S corporation issues Schedule K-1 forms to the shareholders to report profits or losses.
The level of danger inherent in a business's purpose would determine which form it should take. For example, a dress maker may not need a lot of liability protection because the most likely issue he or she would face is a customer unhappy with the dress; the dress maker can remake the garment or offer a discount and likely work out the issue. However, if you were in the construction business and building homes, there would be greater liability if the structure were bad or you used low-quality materials. There could be large losses or larger claims made against your business, so you would want to choose a form that offers the most liability protection. C corporations are less popular because of their double taxation, but if your business grew to a point where you could go public and issue stock, you might register as a C corporation so that you could issue different classes of stock for the general public and for those who started the business. (This would affect each group's right to have a say in how the business is run.)
Business Formation Video
Video 1.1 discusses the various business types that we have covered in this lesson. It elaborates on how the businesses are formed, the number of owners or persons that can be involved, some of the documentation that is needed, and the liability and taxes that affect each type of business.
PETER C. BRONSTEIN: The next topic that we're going to discuss is business formation. What does that include? Well, there are many different ways that a business can be formed and operated.
We have the sole proprietorship. Sole proprietorship is where one party owns the business exclusively. There are no partners. There's no shareholders. There's no one else involved in the company. It's basically you own the company 100% exclusively.
The next concept is partnership. Partnership generally includes more than one person. So you generally will have at least two people-- could be three, five, could be an unlimited amount of partners. In a partnership, the partnership is typically governed by what's called a partnership agreement. Why do you need governance? Because now you have more than one party involved in the transaction.
Partnerships have been around for hundreds of years. Partnerships allow parties to expend more sums of money in raising capital. Why? Because instead of having one person put all the money into the business to start and operate and begin the business, you can have multiple parties putting money in.
You also have multiple decisions. You also have multiple issues that have to be dealt with, which is why you need a partnership agreement. The partnership agreement itself will govern how things are determined and what happens when there are deadlocks among the partners.
A third form of business ownership is incorporation. Incorporation is basically not necessarily the big corporations out there on the S&P 500 and the Dow. We're talking about usually small corporations, closely-held corporations by two or three people. But it can be thousands and even millions of shareholders.
Basically, the way a corporation is done-- that requires you to file a copy of articles of incorporation with the Secretary of State of your state. Once the articles of incorporation are filed, you now have a valid corporation. When you have a valid corporation, that is a shell. You have nothing in your corporation. Once a corporation is formed, you need to obtain various information, like a taxpayer ID number.
You have to then prepare minutes. What are minutes? Minutes are basically determining who shall be the directors of the corporation, who should be the officers of that corporation that actually run the corporation, where your bank account is going to be, who your accountant is going to be-- there are many, many different types of matters that can come up in minutes. And minutes need to be documented. Failure to document your minutes can make you an invalid corporation.
Now, one of the big advantages for corporations, in addition to raising much more capital than even a partnership can typically do-- and certainly, more than a sole proprietor can do, unless you're an actual billionaire-- the reality is that you get what's called limited liability protection. What does that mean?
Limited liability protection means that if somebody were to come after the corporation or a creditor were to come after the corporation, that creditor can only come after the maximum value that's within the corporation, the assets. If a corporation has $100,000 or $10,000-- if those are all the assets that the corporation has, then that is all that a party can seek and collect.
However, when you're dealing with a partnership, there are two issues there, one of which is unlimited liability. A creditor or somebody that was coming after the partnership can come after all the partners-- not only that they can come after all the partners to collect monies and go after your personal assets, like your home and your bank accounts and your stock portfolios, but in addition to that, a creditor can actually go after one partner and collect all of the debt.
What does this mean? Well, if there was a creditor out there that was owed $300,000 and there are two partners that have nothing and one partner has $300,000, the creditor can go after solely the party that has the $300,000. There is no requirement after receiving a judgment or going after a judgment to collect. It's called joint and several liability. It's a very, very important factor-- many, many reasons why partnerships or partners decide to become shareholders and form a corporation.
A newer form of ownership which has only been around, believe it or not, since 1979 is the limited liability company. It is now very, very common, and nearly every state has a limited liability company. A limited liability company actually, in the state of California, did not come about until 1995-- again, a relatively new concept.
What is a limited liability company? A limited liability company is a hybrid between a partnership and a corporation. It has the aspects of limited liability protection that the corporation holds, OK? So in that respect, it is like a corporation.
However, it is governed by what's called an operating agreement, which is similar but not exactly the same as a partnership. Therefore, that agreement will govern the rights and duties and responsibilities of the parties in the entity. You don't have to prepare annual minutes if you form an LLC, although you have the ability to do so.
Limited liability companies is very well known, and many, many people like the LLC route because you don't have to keep up the corporate formalities. However, it is still a relatively new concept, having in California only been around since 1995. And in the United States, the first LLC act was actually committed in 1979.
Now, in the state of California, one of the aspects of limited liability companies is they do have a tax based on gross receipts. You do not have a gross receipts tax based on corporations. However, limited liability companies are a lot easier to run, a lot easier to manage, and many, many people select that option.
That is our segment on business formation.