In order to sign contracts and conduct commerce in the modern world, a business must be established as a legal entity. There are several types of legal entities to choose from. Each type has benefits and weaknesses and the choice of the type of business entity depends on the owners, their motivations, and often their tax status. The main reasons for adopting one type of legal status over another is to manage the liability that can be associated with various business activities, and to avoid personal harm in the event of a lawsuit.
1) Sole Proprietorship
A sole proprietorship is a business that is owned by one person, like Joey’s Lemonade Stand. Joey is the sole proprietor, or owner, of his business. In most cases, a sole proprietorship is the same as the person who runs the business. So if Joey wants to buy a new table for his business, he would buy it using his own money and the ownership of the table would probably be in Joey’s own name. The benefit of this type of legal entity is that it is the simplest to manage (often no paperwork or lawyers are required). The drawback of this type of business entity is that there is no difference between Joey’s personal assets (such as his train set, his bike, or his piggy bank) and the assets of the business (Joey’s lemonade stand table). So if Joey gets sued by someone who claims he got sick from drinking Joey’s lemonade, Joey’s train set might be used to compensate the person who got sick.
4) Limited Liability Company (LLC)
A limited liability company (LLC) is sort of a cross between a corporation and a sole proprietorship or partnership. It is a relatively recent invention in the United States, and is patterned after its older German cousin, the GmbH (Gesellschaft mit beschränkter Haftung). Most LLCs are formed by professionals, such as accountants, doctors, lawyers, interior designers, and so forth.
The main benefits are that there is much less paperwork to establish and maintain an LLC, and like a corporation, the liability of the owners is limited to the amount of capital put into the LLC (which is often very low in the case of professionals) and the owners avoid double taxation since the profits are taxed on the owners’ personal tax returns. Another benefit of the LLC is that it can choose how it wants to operate for U.S. tax purposes. In the early years, when it has more losses than profits, it can be a sole proprietorship and the losses will go against the owner’s personal income statement. In later years, the LLC can choose to operate and report its profit as a corporation so that the owner avoids self-employment taxes.
The disadvantages of an LLC are that some states levy high fees or franchise taxes on these entities, the LLC can end up with a short lifespan due to the death of one of the owners, it can be difficult to raise money from investors, and the accounting requirements of an LLC are greater than those for sole proprietorships and partnerships.
5) Nonprofit Organization
A nonprofit organization or not-for-profit corporation (nonprofit) is a company that is organized under the jurisdiction of a government authority and has no shareholders. It does not issue stock. A nonprofit organization usually engages in some sort of societal good, such as charity work, a homeowners’ association, a foundation to explore research, and so on. Sometimes nonprofits are incorporated, but they are exempt from taxation by government law. The idea of a nonprofit organization is that its goal is not to make a profit, but to pour any and all money into the primary purpose of the organization (funding cancer research, operating a boy scout troop, providing wheelchairs for the physically challenged, building a clean water supply for a Malaysian village, etc.). Most nonprofits are funded by donations from individuals and/or corporations or by grants from governments.
The benefit of a nonprofit is that it does not pay income or sales taxes, and it may qualify for reduced rates on goods and services that it purchases. The drawback is that it must comply with strict rules and reporting requirements on how it generates and disposes of its income. Some nonprofits have financing restrictions as well (that is, they cannot borrow money). The largest nonprofit in the world is the Bill and Melinda Gates Foundation, which has an endowment, or pile of cash, of $61 billion. (Bill Gates is one of the founders of Microsoft.)