Choice of Entity
When an entrepreneur or a group of entrepreneurs decide to begin a business, an important decision is the form in which to conduct the business. This decision will involve a determination as to the basic relationship the group has with each other, the liabilities entailed in the business, and a number of other tax driven and non-tax factors.
There are a minimum of five basic forms a business could operate under. In order to determine which form fits the particular business being contemplated, we suggest you seek a professional business attorney and a certified public accountant. The outline below will give you general information on the differences between these entities and the advantages and disadvantages applicable to each.
Sole Proprietorship
The simplest form for a "one-man" or "one-woman" business is to run the business as a sole proprietorship. There is no set-up requirement. By definition, this form does not involve any partners. The most glaring disadvantage for this form is that the sole proprietor is personally liable for all the debts of the business. When the sole proprietor dies, the business automatically is included in the estate of the owner.
Partnership
A partnership is an association of two or more persons running the business as co-owners. Although strongly advisable, there is no writing requirement. However, the two or more persons must have shown intent to join together as partners. Each partner is jointly and severally liable for all the debts of the business. "Jointly and Severally" does not mean that each partner is liable for his or her share of the business debts. It means that each partner could be held liable for the entire debt of the business if the other partners are not able to pay the debts of the business. Therefore, if one partner of the business has a lot more assets than the other partners, then this form may not be favorable for the partner with the assets.
The management and control of the business is vested in each general partner. Each partner has the right to bind the partnership with other parties. This means that each partner may go out and contract or otherwise obligate the business without specific approval from the other partners. Furthermore unless otherwise specifically agreed upon, each partner has "equal say" in the partnership's management. Each partner has one vote regardless of how much interest the partners hold. For example, if A, B, and C are partners, A owns 50%, B owns 25%, and C owns 25%, they each have one vote in decision making. A's vote is not twice the power of B's and C's.
The advantages of a partnership lie in the simplicity in its creation and the ease of its dissolution. Partners merely need to agree to create the partnership and agree to dissolve when they see fit. Another aspect of a partnership which may or may not be an advantage is that because a partnership is a consensual relationship, a general partner must obtain the consent of all partners to transfer a partnership interest to a third party.
One of the tax advantages of a partnership is that the contribution of property to a partnership in exchange for an interest in the partnership is usually without tax to the partner making the contribution under Internal Revenue Code Section 721. Another important advantage which is shared by other forms such as Limited Liability Company is that the income and loss of the business pass through the entity to the partners. This means that the income of the business is not taxed at the business level first before distribution to the partners; there is no "double tax" which is the taxing of the business income at the business level and again when the profit is distributed to the owners of the business, which is the case for a C corporation, as discussed below. This pass-through treatment also allows a partner to offset the losses of a business against other income of the partners. A partnership, unlike a sole proprietorship, requires the filing of a separate partnership tax return.
Limited Partnership
A limited liability partnership is a general partnership which limits the liability of those who have limited control and management of the partnership. The general partners of a limited partnership have control and management of the business and are personally liable for the debts of the partnership. The set-up of a limited partnership requires more formality than the other two forms discussed above. The limited partnership requires the filing of a certificate with the state and a written partnership agreement is essentially required for protection of the limited partners. Most other characteristics of a partnership discussed above apply to a limited partnership as well.
Corporation
A corporation is an organization created under state law which is considered a separate legal entity. The owners of the corporation (shareholders) generally receive shares of common stock of the corporation constituting their ownership interests. A corporation may issue more than one class of stock with different rights and preferences. A corporation is required to obtain a separate tax identification number from the Internal Revenue Service by filing an Employer's Identification Number, which is to be used as the social security number of the corporation for purposes of banking and taxation.
The most recognized advantage of a corporation is that the shareholders of the corporation are generally not liable for the debts or obligations of the corporation. There are some exceptions to this general rule where a court can "pierce the corporate veil" of the corporation and reach into the assets of the shareholders. One example is that if the court finds that the corporation is the "alter ego" of the shareholders, meaning that the shareholders disregard the entity of the corporation and do not follow corporate formalities and/or mingle funds of the corporation with personal assets of the shareholders. Other exceptions to the limited liability of the shareholders include the statutory imposition of tax liability and certain environmental liability on the shareholders of a corporation.
The set up of a corporation requires formal filing of Articles of Incorporation with the Secretary of State's office, the preparation and adoption of bylaws, and at a minimum an initial organization meeting of the directors of the corporation. The corporation is managed by a Board of Directors who may or may not be the shareholders of the corporation. In most cases, unless otherwise required by law, the directors make the decisions for the corporation and the officers of the corporation execute the actions of the corporation. Officers include Chief Executive Officer, President, Vice-President, Secretary and Treasurer. Shareholders and directors must meet at least annually and minutes of board meetings must be recorded and kept by the corporate secretary.
Unless elected to be a Subchapter S corporation, as discussed below, a corporation is regulated under Subchapter C of the Internal Revenue Code. Income to a C corporation is taxed both at the corporation level and when dividend is distributed to the corporation's shareholders. Furthermore, the losses of a C corporation are not passed through to the shareholders. The losses are retained in the corporation as loss carryovers which can be used to offset future income of the corporation.
The double-tax aspect of a C corporation generally causes many closely-held corporations to elect to be an S corporation. However, there are restrictions in S-corporations that limit its use.
S-Corporation
Within a set time limit from the date of incorporation, a corporation may file a form with the Internal Revenue Services to elect to be subject to Subchapter S of the Internal Revenue Code. S corporations have the benefit of the pass-through of income and loss to the shareholders of a corporation similar to a partnership. Set-up requirements, management and control of S corporations are the same as C corporations. The same formalities of regular meetings and directorship also apply to S corporations.
Under the requirements of the Internal Revenue Code, S corporations are restricted to have no more than 75 shareholders who must be residents of the United States. The shareholders may not be other corporations or non-qualifying trusts. The corporation may only have one class of stock and may not own more than 80% or more of another corporation.
Limited Liability Company
A limited liability company is created with the filing of a certificate of formation with the Secretary of State's office. The owners of the limited liability company are called "members" and the management and control of the company are held by the "manager(s)." The cost of setting up a limited liability company is generally the same as a corporation. The members of the limited liability company enjoy full limited liability of corporations but may elect to be taxed as a partnership with the pass-through benefits. There are also no restrictions similar to the S corporations on the type of shareholders. There is no limit on the number of members and they are not required to be citizens of the United States. There is also no restriction against corporate members.
Another advantage of a limited liability company is that it is able to allocate losses and income to its members other than a pro-rata distribution according to the ownership interests of the company, unlike a corporation (both S and C corporations) where the dividends must be distributed according to the ownership interests.
Another unique advantage of a limited liability company is that in January 1, 1997, the Internal Revenue code was amended to permit a limited liability company to "check-the box" to be taxed as either a corporation or a partnership.
The disadvantages of a limited liability company as compared to a corporation include the ability of a corporation to use stock as compensation to its employees and the self-employment tax imposed on the managing members of a limited liability company.
The above information is provided as an introduction to the different entities commonly used by entrepreneurs to conduct business.
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Disclaimer: Chang Law Group PC only provides legal advice after having entered into an attorney client relationship, which our website specifically does not create. Unless otherwise stated by a representative of Chang Law Group PC, only after having entered into a written, signed agreement with Chang Law Group PC will an attorney-client relationship have been created. It is imperative that any action taken be done on specific advice of counsel. Because every case is different, the general information provided herein may not be applicable to everyone and the law could have been changed at any time prior to an update of the website.
