Under United States law, a firm has the option of various legal forms under which it operates. This depends on the company size and area of operations, but also often remains the choice of the executives as each legal form requires a different approach to profitability, liability, and firm structure. Legal and tax considerations are considered in selecting the business structure. The most common legal forms of business structures include sole proprietorships, partnerships, corporations, and limited liability companies (LLC) which are discussed in this paper.
A sole proprietorship is a business model where ownership belongs to one person. Legally, the firm and the individual are considered to be the same entity. This approach has the benefits of ensuring all profits go to the owner, but at the same time, the individual is personally responsible for losses and debts of the firm. Liability in this form is the sole responsibility of the owner. Therefore, if faced with debt or legal action, the court can forfeit the personal assets of the owners. A sole proprietorship is considered a high-risk form of business, largely used by self-employed individuals or extremely small firms that have no official employees (Open Textbook Library).
In a sole proprietorship, business income and losses are reported on the personal income tax return of the owner. A specialized form, Schedule C (profit or loss from a business) is filed alongside the traditional Form 1040. The firm itself does file separately, known by the IRS as “pass-through” taxation due to business profits passing through personal filings. The owner is taxed fully on the profits of the business regardless if they personally benefited or withdrew money from the company (“Business Structures”). Raising capital in sole proprietorships can take on the forms of the owner contributing personal funds or taking out a loan (credit score and liability will remain on the individual, not the business). Owners can seek equity investments for interest in the company in exchange for capital. However, giving up equity, even a small percentage of the firm dilutes the ownership. Sole proprietorships can legally only have one owner, so any equity investment will force the firm to change its legal form to a partnership (Masters).
In partnerships, two or more individuals share equity ownership of a firm. Partnerships are often formed when persons’ expertise or funding capabilities complement each other to run operations of the firm together. However, similar to sole-proprietorship, the individuals are the sole beneficiaries of the profits but are also fully responsible for losses and debts. Partnership agreements commonly lay out in writing what each partner contributed to the firm in terms of assets and outline their share in the firm, upon which their profits are based. However, partnerships have the risk of joint liability, so if one partner faces a lawsuit or debt collection related to the business, the other owners are fully responsible, including their personal assets being at risk (Open Textbook Library).
Taxation in partnerships is similar to sole proprietorships, using the pass-through system. Partners individually file income taxes, paying tax based on their share of the partnership’s income. Partnerships can raise capital in a variety of ways. Partners can contribute personal funds in exchange for greater equity in the firm that is negotiated internally (“Business Structures”). Partnerships can apply for business loans from banks or other financial institutions, but the liability lies with all partners. Partnerships can explore options of attracting external investment or venture capital funding in exchange for equity. The investor becomes a partner in the firm and there are no changes in terms of legal business form since the partnership structure can have multiple stakeholders.
Many large firms have the legal structure of a corporation, which is notably different from other forms due to the separation of ownership and management. Corporation ownership is commonly split in many different ways between founders, major investors, and stockholders who have bought shares on publicly traded stock markets. Meanwhile, the leadership and day-to-day management of the company are run by executives who are hired into the position and are not legally required to have owned shares of the company. Unlike other forms, profits and losses of the company remain solely in the business, in a manner that all employees (including executives) receive set salaries. Shareholders do not receive a direct portion of the firm’s profits. Instead, shareholders benefit from a firm’s success due to rising stock prices that they can sell for profit on the stock exchange, or in some cases, large corporations choose to pay cash dividends to stockholders in a successful year (Open Textbook Library).
Corporate taxation is relatively complex and differs from other business structures. Corporations are the only legal form that must pay income taxes on profits as a business entity. Taxable profits include the money kept in the company after deduction of business expenses and money distributed to shareholders as dividends. At the same time, all owners/shareholders are required to file individual income taxes independently from the company, where they indicate any profits received from dividends or stock sales. This taxation of both the corporation and its shareholders is known as double taxation. A specialized form of corporation, known as the S corporation legal form can avoid double taxation and operates much like partnerships where taxation is pass-through to the owners. However, that is impractical for most major corporations since the ownership cap remains at approximately 100 people, while large companies commonly have tens of thousands of shareholders. Raising capital in corporations is done through equity investment and the offering of shares on the stock market or through corporate loans through financial institutions (Laurence).
Limited Liability Company (LLC)
The LLC form is one of the most popular legal business structures, yet it is only recognized at the state level, not the federal. The LLC combines positive features from all forms of business structures. LLC is essentially a more formal partnership structure, requiring the filing of articles of organization with the state. However, it is significantly easier to establish than a corporation while offering more flexibility. The articles of organization outline the ownership, rights, powers, duties, and liabilities of all members. Both individuals and corporations can form an LLC. The benefit of the LLC is that similar to a partnership, profits from the firm go directly to the members. However, the liabilities of the firm and individual owners are separated. Therefore, owners are not personally liable for the debts or liabilities against the company. However, LLCs face numerous other regulations that differ between states, and can be dissolved in the case of bankruptcy or death of a member, whilst corporations can exist in perpetuity (Open Textbook Library).
In terms of federal taxes, since LLCs are not recognized at the federal level, the firm must choose a designation of either a corporation or a partnership, following the above-discussed tax structures. Therefore, it is possible for LLCs, despite being relatively large firms, to not pay federal taxes and follow the “pass-through” scheme where individual owners pay taxes on income based on their shares. Raising capital for LLCs is similar to partnerships in terms of personal investments, loans, or outside equity investments since members can be added or subtracted throughout the lifetime of the LLC. However, an LLC cannot issue stock since this type of business structure does not have shareholders but members show to share the profits of the business (“Business Structures”).
There are various legal business structures that firms can choose based on their economic and legal interests. It is evident that business size and operations also have an influence on selecting the most practical structure. When creating a business, many entrepreneurs consider the most optimal structure for them to make a profit, pay fewer taxes, and protect themselves from liability. This evaluation and consideration of legal business forms provide clear distinctions in making that important choice.
“Business Structures.” IRS, 2020.
Laurence, Bethany K. “How Corporations Are Taxed.” NOLO. Web.
Masters, Terry. “Attracting Capital in a Sole Proprietorship.”.
Open Textbook Library. Mastering Strategic Management. University of Minnesota Libraries Publishing, 2016.