If you are considering starting your own business, it is important to choose the optimal form of business organization. Often, the biggest factors in this decision are liability and taxation. In short, a business ought to limit as much liability and be as tax-efficient as possible.
If you do not have any formal business organization and operate by yourself, you will probably be classified as a sole proprietorship. There are no formal steps required to establish a sole proprietorship. As a sole proprietorship, you are personally responsible for the liability of your business. However, as a sole proprietorship, you also benefit from “pass through,” also known as “single” taxation.
If you do not have any formal business organization and operate with one or more other persons, you will probably be classified as a partnership. Importantly, a court may find a partnership to exist even if a writing does not exist explicitly forming a partnership. Thus, it is important for any “association of two or more persons carrying on as co-owners a business for profit” to create a partnership agreement. As with a sole proprietorship, members of a partnership are personally responsible for the liability of the business. Additionally, it is important to note that each partner is jointly and severally liable for the business. A partnership also benefits from “pass through” taxation.
A limited liability company is a relatively new form of business organization that has increased in popularity over the last few decades (Missouri first recognized limited liability companies in 1993). A limited liability company is formed by submitting articles of incorporation to the Secretary of State. Typically, the owner of a limited liability company is not personally responsible for the liability of the business. Importantly, limited liability companies also benefit from “pass through” taxation. The limited liability company is unique in its combination of limited liability and pass-through taxation, which is largely the reason behind the popularity of the limited liability company.
A corporation is typically the most complex form of business organization. A corporation is also formed by submitting articles of incorporation to the Secretary of State. Typically, the owner of a corporation is not personally liable for the corporation. However, the owner of a corporation can face “double taxation” in that the corporation’s earnings are taxed, and the owner’s income from the corporation is taxed as well. It is possible to avoid “double taxation” by electing to have the corporation taxed as a subchapter S corporation, which carries additional requirements.
The bottom line: the limited liability company’s combination of limited liability and pass-through taxation is hard to beat for most businesses. Especially when weighed against the exposure of personal liability in a sole proprietorship or partnership, it is easy and inexpensive to form and operate a business as a limited liability company.
If you have additional questions about business organizations or are ready to form a business, call or come visit the business law attorneys at the Paul Law Firm. Consultations are always free!
The Missouri Bar has put together a fantastic introductory publication titled “Business Law Resource Guide.” Here is the excerpt regarding business organizations:
Missouri presently allows individuals to operate a business under four forms of organizations:
- Sole Proprietorships
- Partnerships
- Corporations
- Limited Liability Companies
Sole Proprietorships
A sole proprietorship is really not an organization but rather ownership and corporation by one individual. Any one person who begins a business without deliberately creating another form automatically begins as a sole proprietorship. No formal creation is necessary.
Partnerships
A partnership is a combination of individuals, called partners, who operate a business. Although no formal creation is necessary, individuals who wish to form a partnership should enter into a written agreement, called a Partnership Agreement or Articles of Partnership, which sets out all the terms of the relationship. Generally, the partners collectively make decisions concerning the partnership. A limited partnership is a special type of partnership. In a limited partnership, the limited partners share in the profits, but they generally do not participate in the management of the limited partnership. Missouri law also allows for the creation of a limited liability partnership, which permits one partner to be shielded from individual joint liability for partnership obligations created by another partner’s or person’s misconduct. A partner’s liability is not limited, however, when the misconduct took place under the supervision or control of the partner. Only liability arising from the misconduct of other partners or persons is covered by this law; the partnership is not relieved from liability for other partnership obligations and individual partners are liable for their own misconduct.
Corporations
A corporation is a more complex arrangement allowing for multiple owners but with centralized management. The owners, called stockholders, elect directors, who in turn elect officers to manage the affairs of the corporation. The individuals who wish to form a corporation, called incorporators, must prepare a formal written document called Articles of Incorporation. This document is then submitted to the Secretary of State for approval. Once approved, the Secretary of State issues a Certificate of Incorporation which authorizes the corporation to act. A corporation is then considered to act as a separate person. There are two types of special corporations. A subchapter S corporation is a regular corporation but is recognized by the Internal Revenue Service as a special corporation afforded a different income tax treatment. The Internal Revenue Service has technical and complex rules concerning subchapter S corporations. Missouri also recognizes non-profit corporations. Missouri treats non-profit corporations somewhat differently and the Internal Revenue Service provides for a different income tax treatment for non-profit corporations.
Limited Liability Companies
A limited liability company is a new form of business organization in Missouri. A limited liability company operates much like a partnership but with some of the advantages of a corporation. A formal written document called Articles of Organization must be prepared and submitted to the Secretary of State for approval. The owners, called members, manage the limited liability company unless the members provide in the Articles of Organization for centralized management by a manager.
Selection of a Business Organization
Although the choice of the type of business organization depends upon many factors, in addition to those previously discussed, most selections are made for three reasons:
- Liability
- Income Taxes
- Funding
Liability
Liability concerns the extent to which an owner is responsible for the debts and charges against the organization. If an owner has “personal liability,” she is totally responsible, and creditors may reach all personal funds of the owner — even if the funds are not invested in or part of the business. If an owner has “limited liability,” his responsibility is limited to only the funds that he has invested in the organization. An evaluation of the risks and possible liabilities to be incurred in the operation of the business leads to the selection of the appropriate form of business organization. A sole proprietor is personally liable for all debts of the business. Generally, a partner is also personally liable for all the debts of the partnership. However, the liability of a limited partner in a limited partnership is generally limited solely to that person’s investment or contribution to the limited partnership. Unless special circumstances apply, a stockholder’s liability is limited solely by the stockholder’s investment in the corporation. Generally, the liability of a member in a limited liability company is limited solely to the member’s investment in the limited liability company.
Income Taxes
All income of a sole proprietorship is taxed on the sole proprietor’s own personal income tax return at the appropriate individual tax rates. A partnership must prepare an income tax return but the partnership pays no income taxes itself. The partnership income tax return acts as a conduit of income to the individual partners. The partnership return apportions the income (or loss) among the partners or limited partners. Each partner or limited partner then includes his or her portion of the income (or loss) on his or her personal income tax return. Since a corporation is considered a separate person, the corporation prepares its own income tax return and pays income tax on its income. Any distribution of income as dividends to the stockholders is also taxed on a stockholder’s individual personal income tax return. The income tax rate for the corporation may be very different from the individual personal rate. A subchapter S corporation is treated similarly to a partnership for income tax purposes. The income taxation of a nonprofit corporation is separate and very complicated. If a limited liability company complies with technical and complex income tax rules, the income earned by the limited liability company is taxed as the income from a partnership.
Funding
When obtaining funds from third parties, a sole proprietorship is generally limited to borrowing money, usually from a bank. A partnership can seek additional investment from loans or it can solicit additional partners (or limited liability partners) who may contribute additional funds. A corporation has more opportunities for seeking investment. It can borrow money, seek additional investors to purchase either common or preferred stock or issue other corporate securities such as corporate bonds. A limited liability company can obtain additional funds similar to a partnership.
Check out the rest of the Missouri Bar’s Business Law Resource Guide. We also recommend the Missouri Secretary of State’s Missouri Small Business Startup Guide.