BUS 311 Choosing A Business Entity Assignment Instructions
If you were to start your own business, which business entity structure would you choose? Justify why your chosen structure is the best organizational form.
Explain the following business structures: sole proprietorship, partnership, LLC, and a corporation. In your analysis address the following for each business structure:
- Steps to form
- Personal liability for owners
- Advantages and disadvantages
Choosing A Business Entity – Sole Proprietorship, Partnership, Limited Liability Company (LLC) or a Corporation
If a person were to start a business, that person would need to select the business entity structure that would best meet its needs. The choices are sole proprietorship, partnership, a limited liability company (LLC) or a corporation. The business owner needs to properly analyze each structure to have a good understanding of how to form the business, what the personal liability for owners is, taxation, and the advantages and disadvantages of each are so that the business can be most successful.
Sole Proprietorship Business Entity
Most likely, small businesses will consider the business entity of sole propriety as the choice to start their business in. This is a simple way of starting a business. The owner owns and manages his or her own business. All the responsibilities fall on the owner as well as all the profits that the business generates. This business owner is also personally responsible for the debts, liabilities and torts.
A sole proprietorship is the simplest of the business structures to form. If you are mowing lawns during your summer break from school, you are a sole proprietor. Licenses and permits can be obtained at the state and local levels (Sole Proprietorship, n.d.). Business owners may use their own name for their business or choose an assumed name that is original. Careful thought should be given to the name to prevent any torts.
Unlimited personal liability exists in a sole proprietorship. The owner is personally liable for all debts incurred by the business as well as any other obligation that the business may be held too. For example, the student mowing lawns can be held responsible if he accidently uses a grass killer on a lawn instead of lawn fertilizer and kills the entire lawn. If business owners are not responsible in the business practices they can risk losing their entire life savings with the possibility of having to file for bankruptcy.
With a sole proprietorship, taxes are passed onto the owner and not the business. The owner will have to report his earnings using the IRS form 1040 (Hopson and Hopson, 2014). Schedule C of the IRS forms is what would be used to annotate the businesses expenses and income, then the filer would transfer the “bottom-line amount” onto the IRS Form 1040 (Sole Proprietorship, n.d., para. 5). Owners can basically file on their own with very little to no help required from a professional tax consultant.
The advantages and disadvantages of a sole proprietorship should be reviewed in order to make a clear determination if this business entity is the best fit for a business. Advantages are that it is easy to start up a business, owners have total control of the business, and preparing taxes at the end of the year is simple. Disadvantages to this business entity is that personal liability is unlimited, to include those liabilities gained from employees (Sole Proprietorship, n.d.). Being the owner and manager of a business can be very tiring leaving very little time for personal matters. Upon learning of the advantages and disadvantages, a business owner may consider a partnership.
At times, businesses may already be in a partnership without realizing it. Partnerships are entered upon by two people that can act as a principal and an agent simultaneously (Rogers, 2012). In the partnership, it is important to understand what each partner will be responsible for. Things to consider are “how future business decisions will be made, including how the partners will divide profits, resolve disputes, change ownership and how to dissolve the partnership” (Partnership, n.d., para. 2). Partnerships can be either a general partnership or a limited partnership. In a general partnership, it is most likely that all partners will have equal shares of profits, losses and liability. In a limited partnership, certain partners may be limited to their participation in the business, decision making, and even profits.
Forming a partnership requires the registration of the business with the state in which your business is located in. This can be done through the Secretary of State’s office according to the U.S. Small Business Administration website (Partnership, n.d.). A unique business name is required. Normally, the legal name is what appears on the partnership agreement and can also be the last names of each partner. Should the partners decide to operate the business under a fictitious name, then they would have to file that with the state as well. After registering with the state, the business will need to obtain the proper licenses and permits at the state or local levels.
Personal liability for owners in a partnership are identical to sole proprietorships. In this business entity, “Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners” (Partnerships, n.d., para. 16). This means that partners can be sued together or individually. Because of this situation, the partnership may want to take up business insurance that may help alleviate some of the liabilities associated with this business entity (Rogers, 2012).
Taxes are still a responsibility of the partners in a partnership. The business is not held responsible for taxes. The partnership will report income, deductions, gains, and losses from the business’s operations by filing an “annual information return” (Partnership, n.d., para. 9). Profits and losses are “passed through” to the partners by the business. The partners will be responsible to claim their corresponding share of the partnership’s profits or losses on their own personal returns. They can do this by using the information provided to them on their copy of the Schedule K-1.
Reviewing the advantages and disadvantages of a partnership can clarify if this is the business entity of choice for an organization. One advantage is that the partnership is simple to form. Partners just have to agree on the extent of their roles and responsibilities. Partners bring in their skills and form a pool in which the skills of each partner can be taken advantage of. The disadvantage is clear when it comes to liabilities. “Partners are not only liable for their own actions, but also for the business debts and decisions made by other partners” (Partnerships, n.d., para. 16). The real disadvantage is that partners may have to utilize their personal assets to satisfy the partnership’s debt. If a partnership is not the best option for a business, then the flexible limited liability company may be the choice.
Limited Liability Company
The limited liability company is new. All members can manage the business or they may opt out in the articles of organization. According to Hopson, “An LLC takes the advantages of a corporation and combines them with the flexibility and pass-through tax treatment of a partnership, has relatively inexpensive startup costs, and is easy to manage” (P. 43). This business entity protects the members and the managers from liabilities.
Forming an LLC varies in each state. In general, owners will have to choose a business name that is unique, state that it is an LLC, and cannot use restricted words that the state puts out. There is also the requirement to file the “articles of organization” that includes the name of the business, the address, and who the members are (Limited Liability Company, n.d., para. 6). If the LLC includes multiple members, then it is recommended to file an “operating agreement” that states the “percentage of interests, allocation of profits and losses, member’s rights and responsibilities and other provisions” (para 17). Registering the business, obtaining licenses, and permits are also required at the state and local levels.
Personal liability for owners remains, for the most part, with the limited liability company (LLC). “Members are protected from personal liability for business decisions or actions of the LLC” (Limited Liability Company, n.d., para. 18). What this means is that the members of the LLC cannot be held personally liable and therefore their personal assets are protected. The LLC will have to settle its debts as well as any torts against the company.
A limited liability company is not a separate tax entity. All federal taxes are reported by each member. “Each partner receives a K-1 from the partnership detailing the individual partner’s pro rata share of each particular type of income or deduction, and the partners report each item on their individual tax return” (Hopson and Hopson, 2014, p. 46).
Even though the LLC is a relatively new business entity it has its advantages and disadvantages. The advantage of limited liability offers protections to the members of the LLC and safeguards their personal assets for the most part, except from “wrongful acts” (Limited Liability Company, n.d., para. 18). There is less paperwork and the start-up costs are not so expensive compared to an S-Corporation. A disadvantage of an LLC is that it has limited life. This means that if a member leaves, then the company is dissolved but the members must continue to close out any business obligations. Through a special provision in the operating agreement, the life of the LLC can continue in the event of a member leaving the organization. If an LLC is not the choice, then business owners can look at the corporation.
A corporation is treated like a person. It pays taxes, it can own property, and it is “subject to civil and some criminal penalties for acts it performs through its agents” (Rogers, 2012, p. 274). The corporation is regulated by the statutes of the state that provided for its existence. This business entity is a legal person. This structure is well suited for companies that are large in size and possess multiple employees.
Forming a corporation requires a unique business name and if operating under a fictitious name that it be filed with the state. Registering the business will require articles of incorporation to be filed with the Secretary of State. The establishment of directors and issuance of stock certificates to the initial shareholders is a requirement in some states. There may be other specific filing requirements that each state may request and business owners must not neglect these additional requirements. Registering the business, obtaining licenses, and permits will also be required at the state and local levels.
A corporation offers limited liability to its shareholders. The corporation will take responsibility for business debts and actions. This can only occur if the corporation operates according the statutes of the state that provided for its existence. According to Rogers (2012), “If the corporate form of business organization is used to defraud creditors, stockholders will lose the protection of limited liability and will be held personally liable for all debts of the corporation” (p. 275). It is wise for the corporation to operate ethically so that it can afford the limited liability to its stockholders.
A corporation must pay federal, state and local taxes. They must register with the IRS and obtain a tax ID number. According to Rogers (2012), “The corporation itself is taxed on its earnings, and the shareholders are also taxed when they receive dividends or sell shares at a profit” (p. 276). Exception to the double taxation occurs in the subchapter S corporation that contains “pass through” taxation. The shareholders are the ones taxed on the earnings.
The corporation has its advantages and disadvantages as well. The advantage of the corporation is the limited liability of the shareholders. Here, the corporation is responsible for debts and the shareholders personal assets are free of risk. “Perpetual existence” is another advantage of the corporation (Rogers, 2012, p. 275). Corporations can live for as long as the current shareholders want it to live. The corporate can also raise capital through the sale of stocks. The disadvantages of a corporation are that it takes a lot of time and money to start and operate. The double taxation may not be beneficial to shareholders. Finally, the recordkeeping that is required of a corporation makes it unappealing.
The Best Business Entity
After analyzing the various business entities, it appear as though the limited liability company (LLC) is the best option for a business owner to take up. Every business owner wants his business to succeed and in order for a business to succeed it must have a plan to grow itself accordingly. The sole proprietorship is a wonderful option if the business is small and has little to no plans of expanding. An example of this would be a business man with a local corner market that wants to earn enough income to satisfy his personal finances and no more. The partnership entity is a very risky business format that allows two or more partners to come together and share their ideas. If one of the partners has a slight disagreement with the other partner as to how to tackle a certain task, the partnership may dissolve quickly. The Corporation offers the best limited liability, but the cost of running such an entity is big. Not to mention the double taxation imposed on the earnings at the corporation and shareholder level. Plus who would want to go through so much paperwork in today’s times. The LLC offers the limited liability that protects the owner’s personal assets, requires less recordkeeping, and offers the ability of decide who earned a certain percentage of the profits and losses.
Business owners must analyze each business entity to have a good understanding of how to structure their business, they must consider the personal liability, taxation, the advantages and disadvantages that come with each entity so that the business can be most successful. A sole proprietorship is good for an owner that want to have total control of operations. A partnership allows two partners to share their ideas and become successful if they manage to stay together for the long haul. An LLC, seems to be the best option that offers a business the opportunity to be successful even after long after the original founders have left. A corporation is good for those organizations that are large in size and have many employees, but it requires a lot of maintenance. Business owners must take proper steps to strategically analyze each business entity to understand what the best option is.