An entrepreneur starts a new business every eleven seconds in the United States and one in twelve Americans attempts to start a new business annually. Business organizations can be legal entities through which investors and entrepreneurs provide goods and services and collaborate with one another to achieve commercial goals. Other business organizations, called nonprofits, further charitable purposes.
Unfortunately, 63 percent of new businesses fail within six years and one possible explanation for this high failure rate is that an entrepreneur has selected a business form that doesn’t meet her needs. Selecting the optimal choice can feel like a daunting task because there are rewards and pitfalls with any entity selection.
This module’s goal is to address the basic questions regarding business organizations: What factors impact the decision to form one type of organization as opposed to another? What are the most frequently formed business entities? Which laws regulate business organization activities?
A business entity can assume many different forms. The types of business entities that we will introduce and discuss in-depth in this program include:
- Sole proprietorships
- General partnerships
- Limited partnerships
- Limited liability partnerships
- Professional corporations
- S corporations
- C corporations
- Limited Liability Companies
Factors to Consider When Choosing a Business Entity
Once she decides to start a business, the entrepreneur will decide what type of business entity to form.
According to Entrepreneur Magazine’s Ameen Khwaja “Of all the choices [a business owner] make(s) when starting a business, one of the most important is the type of legal structure you select for your company. Not only will this decision have an impact on how much you pay in taxes, it will affect the amount of paperwork your business is required to do, the personal liability you face and your ability to raise money.”
The entrepreneur should select the most appropriate business entity after analyzing six factors in a pre-business formation analysis. Should she create a business that doesn’t protect her needs and goals, she can open herself and her business to unlimited liability and her personal assets may be seized to satisfy a judgment or debt. If she selects a business form that is too complex for her needs, she can get swept up in a tide of red tape as she spends money and resources adhering to state and federal regulations that she may have avoided.
All six of these factors are interrelated and impact one another, so none of them should be considered in a vacuum. In addition to analyzing these six factors during the analysis, an entrepreneur should consult an attorney and accountant for guidance on choosing the best entity that aligns with the goals she seeks to accomplish with her business.
- Ownership and Control
The first important factor an entrepreneur should not overlook is the level and degree of control she wants to exercise. One entrepreneur may want to manage and oversee a business herself and operate it without assistance from others because she attaches a lot of value to her own leadership. If that’s the case, then the sole proprietorship may be the most appropriate entity. Another owner, however, may seek a more passive role and may want to merely invest in a business while allowing others to direct daily operations. In that case, she will likely incorporate her business.
Deciding how to control a business will have ramifications on the other factors to consider when choosing a business form, such as taxation, liability, and capitalization.
- Liability and Financial Risk
The second factor is the entrepreneur’s willingness to expose himself to liability, so he should weigh the potential for legal and financial liabilities for his business’s obligations. An owner of some business entities has unlimited liability for all business obligations. In other types, the owner has unlimited liability for some, but not all, of the entity’s obligations. Finally, an owner’s liability may be limited to the extent of her capital contribution.
For example, assume an entrepreneur wants to start a construction firm. The nature of the construction industry is inherently risky because of the costs of materials, a high rate of on-site employee accidents, and high costs of compliance with government regulations. He may therefore seek separation between himself and his business to avoid personal liability in case of an accident or job gone bad.
In this case, he may form a complex legal structure or multi-layered business entity, such as a C Corporation, S Corporation, or limited liability corporation to prevent his personal assets from being seized for any debts and losses incurred.
- Business Formation Costs
Tina is a recent college graduate who wants to start a business selling gourmet coffee. Eventually, she’d like to open a chain of cafes, but as of right now, she doesn’t have a lot of money to fund her startup. Young entrepreneurs frequently find themselves facing these circumstances, which lead to the third consideration: business formation costs.
An entrepreneur like Tina doesn’t have the time, patience, and most importantly, money, to form a business entity that will require her to pay thousands of dollars in legal fees and costs for complex recordkeeping. If she did have the financial resources, she still might be hesitant to devote the time to register with the secretary of state where her business operates and engage in various other corporate formalities. She may instead pursue an inexpensive and easy-to-set -up entity with minimal annual filing and formation requirements. To avoid the headache and hassle of exorbitant startup costs, Tina could form a sole proprietorship, or, if she goes into business with other people, a partnership.
Taxation plays a major role in selecting the form of business. Every business entity has a different basis of taxation. Some businesses are taxed more heavily than others and a more complex business entity like a corporation is subject to double taxation, meaning a business owner can be taxed at both the personal and corporate rates. With others, there is no double taxation, but the owner may have to pay more in Social Security and Medicare taxes and can’t claim life or health insurance income tax deductions. For example, the tax bill passed in December of 2017 allows a deduction of up to 20% for self-employment income while LLCs allow flexibility to choose how to be treated as a taxpaying entity from year to year. Corporations, on the other hand, have the unique advantages of low tax rates (a maximum of 21% under the 2017 tax reform bill, as compared to a 37% maximum tax rate for individuals) and of not requiring the shareholders to report the corporation’s income on their personal tax returns.
An entrepreneur should compare the tax regulations and obligations of each type of business entity. Tax regulations are constantly evolving because states and municipalities frequently amend their tax codes, so an entrepreneur will want to consider current, and potential future, tax liabilities during the pre-business formation analysis.
The fifth consideration in the pre-business formation analysis is how the business owner wants, and expects, to get money for her business to operate and grow. Creating a successful business depends on whether the entity is adequately capitalized, for expenses quickly add up and the entrepreneur’s business won’t survive if she can’t manage its cash flow.
Some forms of ownership differ in their ability to raise capital. For example, an entrepreneur forming a corporation may have an easier time raising capital than if he forms a sole proprietorship because he can issue shares for the corporation to others and foster financial contributions. Getting contributions from others often enables a business to grow in the future.
Capitalization is not a task a business owner will usually undertake solo. She may confer with accountants, bankers and other professionals to understand how much capital is necessary, how she can raise it, and how she can budget capital for the business’s operations.
- Transferability and Liquidity
Finally, the entrepreneur will want to choose an entity only after determining how her choice impacts her ability to transfer her ownership interest. To illustrate this, let’s return to the example of Tina, the gourmet coffee connoisseur, and add some more facts. In her first year of selling coffee, Tina is very successful, but she soon gets tired of the industry and wants to sell her company. If, for example, she formed a C or S corporation, transferring her ownership interest won’t be difficult because all she’ll have to do is sell her stock to a new owner on the open market.
However, another business entity choice will not offer Tina the same degree of business transfer flexibility. If she had formed her business as a partnership, she couldn’t easily hand over her business interest without the consent of all her other partners.
Federal Laws Applicable to Business Organizations
Businesses are also subject to extensive regulation under federal securities and tax laws. Federal tax laws affect all business organizations because they all must pay taxes or file information with the federal government concerning income and payouts so that it can follow the money.
Depending on its form, a business entity could be subject to federal securities laws. A security is an investment interest in the business entity that can be exchanged for value. It’s a catch-all term that covers many kinds of investments, such as stocks, bonds, and mutual funds. The governing law is the Securities Act of 1933, known as the “truth in securities” law. It requires that investors receive financial and other information concerning securities prior to public sale. It also prohibits deceit, misrepresentations, and other fraud in securities sales. A company that sells securities must register them and provide a description of the company’s business; a description of the security to be offered for sale; provide information about the company’s management and offer financial statements certified by independent accountants.
A business owner may also have to comply with federal employment and labor laws. Some laws are the Fair Labor Standards Act, which sets minimum wage, overtime and minimum age requirements for employers and employees, and the Americans with Disabilities Act, which prevents an employer with 15 or more employees from discriminating against employees with disabilities and impairments.
Depending on the business entity, it may have to abide by federal financial regulations. The owners of a large, multinational corporation traded on a U.S. stock market, must comply with the Sarbanes-Oxley Act, which mandates several reforms to enhance corporate responsibility, enhance financial disclosures and combats corporate and accounting fraud.
Knowledge of all these federal laws and their numerous requirements undoubtedly impacts an entrepreneur before he decides what type of business to form. Compliance with these requirements is costly and takes time. A cost-conscious business owner, or one with limited financial resources, will choose an entity like a sole proprietorship or partnership to avoid spending the resources necessary to comply with the law.
State Laws Applicable to Business Organizations
State laws affect businesses most immediately and directly. Since each state offers different tax benefits and have different requirements and definitions for partnerships, corporations, and other entities, an entrepreneur will select to form a business in a state that gives him benefits he wants the most. Again, this ties in to the six factors in the business formation analysis. One entrepreneur may want low taxes, while another will want to form a business in a state that doesn’t have a great deal of formation regulations and startup costs.
Each state has laws regarding partnerships, corporations, and other entities, but many states’ laws on the formation and governance of business entities are based on model or uniform acts. A few of these codes are:
- The Uniform Partnership Act;
- The Uniform Limited Partnership Act;
- Model Business Corporation Act;
- Revised Uniform Limited Liability Company Act
Once a state adopts a statute, an entrepreneur can easily access the laws in state codes. Each law provides general provisions, definitions, information on the nature of the business entity, the relations of partners or members, dissociation, and dissolution and how a business owner can cease operations.
For the entrepreneurs who choose to incorporate, many do so in Delaware. Delaware has far and away more public company incorporations than any other. This is mainly because Delaware has an established body of corporate law that is favorable to businesses and has created special courts to handle corporate law issues to provide corporations with judicial predictability should issues arise.