The three primary forms of business organization in the United States are the sole proprietorship, the partnership, and the corporation. The principal differences among them lie in the ownership structure, the legal status of the business and how the company's profits are taxed.
A sole proprietorship is a business owned by one person. Legally, there is no distinction between the business and the owner -- the owner is the company, and the company is the owner. The owner is personally liable for all of the company's debts. All profit is considered to be the owner's personal income and must be reported on the owner's individual income tax return. The advantage of this form of business organization is simplicity: no partnership agreements to be signed, no corporate formalities to perform.
A partnership is a business with two or more owners. There are two basic types of partnerships: general and limited. In a general partnership, each partner is personally liable for all of the debts of the business. In a limited partnership, some partners have limited liability -- they can lose what they've put into the business, but no more -- while others have full liability. Partnerships don't pay income taxes; instead, the owners report the company's profits as personal income according to their share of ownership in the company. A partnership involves more paperwork than a sole proprietorship, including a formal partnership agreement.
A corporation is a "person," legally speaking. It is a distinct entity separate from its owners -- the shareholders.The company itself is responsible for all of its debts. The shareholders can lose the money they've invested in the company, but no more. A corporation directly pays income taxes on its profits, just like individuals do. Shareholders pay taxes on corporate profits only if those profits are distributed to them as dividends. The advantages of corporate organization include limited liability for shareholders and the ability to raise money by selling stock. Drawbacks include greater state and federal regulation and the fact that corporate profits can be taxed twice: once as income to the company and a second time when distributed as dividends.
States have created an additional form of business organization -- the limited liability company, or LLC -- that combines features of a partnership and a corporation. The company owners receive corporate-style liability protection, but the company can opt to be be taxed like a partnership, with profits reported on the owners' personal income taxes. Certain corporations, meanwhile, can claim "Subchapter S" status with the Internal Revenue Service. An "S corp" doesn't pay corporate income taxes; instead, its profits pass to the owners' income taxes like in a partnership or LLC.
Profits vs. Cash
When choosing a form of organization for a business, entrepreneurs commonly give great weight to how profits will be taxed. But it's critical to understand just how those taxes are applied. When company profits are taxed as personal income -- as with a sole proprietorship, partnership, LLC or S corp -- the business owners pay taxes on their share of the profits regardless of whether they actually receive any money from the company. If the company reinvests its profit in, say, new equipment, the owners still have to pay taxes on that profit.