CHOOSING A BUSINESS ENTITY
Choosing a Business Entity
An important, but often misunderstood, decision in the life of a business is the entrepreneur’s or existing business owner’s choice among the different forms of legal entities under which the business can operate. The decision is determinative regarding the tax treatment and legal liability of both the business and its owners. This Legal Update addresses the basic characteristics, advantages, and disadvantages of the various business entity options.
The Sole Proprietorship
The Sole Proprietorship is the simplest to form of all the business entities. It consists of one person who owns all of the assets of the business and is created by default whenever one person forms a business without selecting a different form of entity. There is no distinction between the business owner and the business itself for legal liability, tax and other purposes. On the plus side, a Sole Proprietorship can be formed with little formality or expense. Owners of Sole Proprietorships do not have to file separate tax returns for their businesses; all business income and expenses are reported directly on the owner’s personal income tax return. Thus, the Sole Proprietorship is, in some cases, an attractive option for start-up businesses and for businesses without employees. This form, however, provides its owner with unlimited personal liability for the debts and risks of the business and less tax flexibility than any other entity. For tax purposes, all business profits and losses are personal to the business owner. For liability purposes, creditors of the business can collect on unpaid debts and liabilities of the business from the owner’s personal assets. Additionally, an individual’s ownership interest in a Sole Proprietorship is non-transferable except upon liquidation of the business. Most states require individuals who conduct or transact a business under any name other than the real names of the owners to file an “assumed name” notice with the County Clerk in the county in which the business is located.
The General Partnership
The General Partnership is conceptually similar to the Sole Proprietorship with one major distinction: a General Partnership is formed whenever two or more people co-own a business and share in its profits and losses. Like a Sole Proprietorship, a General Partnership requires little formality to get started, and it is formed by default whenever two or more people form a business together without selecting another form of entity. Business partners should, however, create ground rules to govern their business relationship through a partnership agreement. Absent such an agreement, decision-making authority is shared by all partners, and the business entity will not survive beyond the lives of its owners.
A General Partnership is taxed in a manner similar to a Sole Proprietorship, with profits and losses flowing through directly to the owners. The most significant concern in operating a
General Partnership is that each co-owner is liable for the debts incurred by other co-owners acting in furtherance of the business. A co-owner’s personal assets are at risk for the wrongful acts of all other co-owners in connection with the business, making the General Partnership potentially the riskiest of all business entities. For this reason and a variety of others, when a General Partnership or other kind of partnership is formed, it is advisable to have a written agreement among the partners.
The Limited Partnership
Because of the potential exposure created by shared liability of co-owners in a General Partnership, the Limited Partnership is an attractive alternative. In a Limited Partnership, certain co-owners are designated as “limited partners.” Limited partners are often passive investors who do not participate in the management of the business. Limited partners are liable for business debts only to the extent of their capital investment; however, they can lose their insulation from liability by involving themselves in management or through their own improper conduct. A Limited Partnership must be owned by at least one “general” (managing) partner. The general partner(s) retains personal liability for partnership debts. Like General Partnerships and Sole Proprietorships, profits and losses of the business flow through directly to the owners for tax purposes. Limited Partnerships can only be formed through compliance with certain formalities, which vary from state-to-state.
The Limited Liability Partnership
A Limited Liability Partnership (“LLP”) requires the filing of a “statement of qualification” or similar application with a state office in the state in which it is formed. The basic difference between an LLP and a General Partnership is the allocation of liability among co-owners. In an LLP, all partners are liable for business debts only to the extent of their capital investment, but each partner remains liable for his or her own improper conduct. Unlike Limited Partnerships, there is no distinction between “general” and “limited” partners in an LLP. In most other respects, LLPs are treated similarly to Limited Partnerships and share many of the same advantages and disadvantages.
The C Corporation
The C Corporation derives its name from subchapter C of the Internal Revenue Code. The C Corporation (as well as the S Corporation discussed below) is a legal entity distinct from its owners. In general, the corporation, and not its shareholders, is responsible for business debts and obligations. Provided that, among other things, requisite corporate formalities are followed, the owners’ liability for business debts is limited to their capital contributions. Generally, a corporation is managed by its officers and directors. Corporate officers and directors can be held liable for business debts only in limited circumstances. Additionally, one’s ownership interest in a C Corporation is freely transferable unless specifically precluded by agreement.
The C Corporation is a separate U.S. taxpayer. The shareholders/owners do not pay any income taxes on corporate profits until the profits are distributed to them. This form of entity can be advantageous for investors in businesses that will reinvest profits rather than pay dividends because the corporate tax rate is generally lower than the personal income tax rate. A major drawback of this form, however, is that distributed profits are subject to double taxation – once at the corporate level when the profits are earned, and again at the shareholder level, when (and to the extent that) profits are distributed. In contrast to other forms, such as Sole Proprietorships and Partnerships, C Corporations can deduct 100% of the health insurance and other employee benefit costs paid for employees who are also shareholders of the corporation. These advantages make a C Corporation an attractive option for some small business owners whose compensation as employees of the business may result in little or no excess profit, and therefore little or no double-taxation. Owners of existing C Corporations should be forewarned that conversion to an S Corporation or an LLC will subject the business to limited corporate level taxation. For this reason, it is often imprudent to convert.
The S Corporation
In order to avoid the double taxation applicable to distributed profits of C Corporations, certain corporations may elect to be taxed under Subchapter S of the Internal Revenue Code (so called “S Corporations”). The S Corporation is taxed similarly to a partnership – profits and losses flow directly through to the owners – but the S Corporation retains the advantages of limited liability for its owners. For start-up businesses expecting business losses during the first few years of operation, the tax characteristics of an S Corporation are quite appealing because owners can freely offset business losses against their personal incomes, so long as they are active in the business.
Because of statutory restrictions, the S Corporation form is not an option for all businesses. For example, in order to qualify for S Corporation status in Illinois, corporate stock can be held by no more than 35 persons; generally shareholders must be individuals; and there can only be one class of stock issued. The failure to maintain compliance with these eligibility requirements can cause termination of the entity’s status (and resulting tax complications). Both S Corporations and C Corporations are formed through application to the Secretary of State of the state of incorporation and compliance with various statutory provisions, including various requirements and restrictions with respect to the structure, management and documentation of the entity.
The Limited Liability Company (“LLC”)
The LLC is a flexible business form designed to combine the limited liability benefits of a corporation with the flow-through tax advantages and reduced structural formalities and restrictions available through Partnership forms. An LLC is formed through application to the appropriate office of the state of organization and compliance with various statutory provisions. LLC owners, however, have much more flexibility than shareholders of corporations to define
and control various aspects of their businesses’ structure, management and ownership rights – through an operating agreement. Ordinarily, the LLC operating agreement will determine whether the business will be managed by specially designated managers or else the members themselves. Like a corporation, an LLC is a distinct entity from its owners and holds property in its own name.
An LLC can be a more attractive business form than an S Corporation because it does not require as many formalities. The most obvious advantage of the LLC over the Limited Partnership is that every member (not just limited partners) may limit his or her personal liability without sacrificing the ability to participate in management. LLC owners, however, generally do not enjoy some of the tax-favored fringe benefits available to C Corporations such as group term life insurance, disability insurance, medical expense reimbursement plans, and cafeteria plans. These benefits are often similarly unavailable to owners of S Corporations. Additionally, one hundred percent of LLC business income is subject to Medicare tax. An existing LLC can usually convert to the C Corporation form without paying any taxes.
Determining the most appropriate form of entity for your business is an intensely individualized process, taking into account, among other things, the entrepreneur’s/owner’s specific interests and goals, the nature of the business, and the number and identities of the present and potential future investors in the business. Because choosing among the different types of business entities is a fundamental decision with important and lasting consequences, entrepreneurs and owners need to make careful and informed choices up front with the advice of experienced legal counsel.
To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or tax-related matter[s].