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Businesses produce goods and services in many different organizational forms.
In this lesson, you will examine the fundamental concepts, advantages,
disadvantages, and tax implications of four organizational forms.
Sole proprietorship, partnership, corporation, and
limited liability company, or LLC.
While other alternative forms do exist, these four are incredibly common.
You will then consider how tax and non-tax features strategically influence
the organizational form chosen to conduct business.
An understanding of these issues is a necessary step before delving deeper into
the taxation of business entities.
Let's begin by discussing each of the four organizational forms.
For now, we can keep the taxation details fairly broad.
A sole proprietorship is a business owned and operated by one individual.
It is not a separate legal entity apart from the individual owner.
An advantage of this organizational form is that it is simple to initiate
and terminate.
In addition, only one individual, the owner, is ultimately responsible for
every business decision, eliminating most, if not all, conflicts.
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Naturally, there are some disadvantages to this form.
For instance, a sole proprietorship has limited life, that of the owner.
It can be challenging to raise capital for business operations, on account of there
being no ownership interests to transfer, such as through shares of stock.
And the owner has unlimited personal liability.
As far as taxes go, the owner reports all business income and
expenses on Schedule C of Form 1040, his or her personal tax return.
These amounts are reported regardless of whether the owner withdrew assets
personally.
The net profit or loss from the business is ultimately netted against the owner's
other taxable income.
Because this organizational form is the primary focus of most introductory tax
courses, it will primarily service a benchmark case for
this course about separate legal entities.
A partnership is formally defined as a association of two or
more persons to carry on as co-owners a business for profit.
A related concept is that of a joint venture,
which occurs when partnerships are formed for specific projects and transactions,
while retaining their individual identities.
For example, in December 2011, Microsoft Corporation and
General Electric formed a joint venture called Caradigm,
to produce a healthcare data and intelligence system.
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The primary advantages of a partnership include the sharing of management
responsibilities and risks with partners, who can be individuals and
most other types of business entities.
But a key shortcoming is that partnerships limited life,
meaning that if one partner leaves the business, the partnership terminates, and
a new entity must be formed.
In addition, general partners are jointly and severally liable for
the obligations of the business.
However, limited partners in a partnership are not liable for debts, but
cannot actively manage the business.
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From a tax perspective, partners report their rateable share
of partnership net income on their own tax returns.
That is, net income and other items flow through to the owners of the entity.
A partnership files Form 1065, but pays no entity-level income tax.
You will learn a lot about the taxation of partnerships in Taxation
of Business Entities 2.
A corporation is a separate legal entity formed under state law.
A corporation has most of the same rights and responsibilities as individuals
in that it can enter into contacts, own assets, incur debts, and litigate.
The management responsibilities of a corporation
are vested in the Board of Directors.
Nearly all publicly-traded firms are organized as corporations.
Some well-known advantages of the corporate form include limited liability,
perpetual life, and ease of ownership and
capital acquisition through transfers of stock.
The downsides include centralized management, and in some cases,
the double-taxation of income.
Let's discuss the tax issue a little more.
Corporate taxation is governed by either Subchapter C or
Subchapter S of the Internal Revenue Code.
Under Subchapter C, regular corporations, called C corporations,
are subject to an entity-level income tax.
In other words, C corporations compute tax on taxable income
using the corporate tax rate schedule.
However, when income from a C corporation is distributed to shareholders,
such dividend payments are not deducible by the corporation.
Instead, shareholders report the dividend income on their own tax returns.
Therefore, income that has already been taxed at the corporate level
is taxed again at the shareholder level.
This structure results in the double taxation of income.
C corporations file Form 1120.
You will learn a lot about the taxation of C corporations in other modules.
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Under Subchapter S,
so-called S corporations are taxed like pass-through entities.
That is, the entity has all the advantages of the corporate form,
such as limited liability, but does not pay an entity-level income tax.
Instead, stockholders, which are limited in number and
type, report their pro rata share of net income from the business on their personal
tax returns, just as if they were partners in a partnership.
You will learn about the taxation of S corporations in Taxation of
Business Entities 2.
The fourth and final organizational form is the limited liability company, or LLC.
An LLC is a hybrid business entity that, pursuant to state law,
is neither a corporation nor a partnership.
It is instead an unincorporated entity with member owners that is governed by
an operating agreement and relevant state law.
All 50 states and the District of Columbia have passed LLC laws.
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The key advantage of an LLC is that its members have limited liability, like
a corporation, but are primarily treated like a partnership for tax purposes.
In other words,
members obtain corporate benefits without the double taxation of income.
The drawbacks of an LLC often depend on the governing state law.
For example, some states do not allow free transferability of interest in an LLC, or
provide for continuity of life.
You'll learn more about LLCs in the Taxation of Business Entities 2.
Michael P Donohoe, PhD, CPAAssociate Professor of Accountancy and PwC Faculty Fellow
