One of the first steps in organizing any new business is to determine which type of business entity should be formed. While this analysis may seem simple and straight forward, there are often a number of complex issues that must be considered. To determine which entity best suits our client’s situation, we evaluate the relationship among the owners, the owners’ obligations at formation and in the future, how the business will raise working capital when it is formed and as it grows, what type of management organization will be effective for the business, and which income tax treatment will be most efficient, as part of the analysis.
Sole Proprietorship
What is it?
A sole proprietorship is the simplest form of conducting business. The individual “proprietor” is the company for legal and tax purposes, and the proprietor is liable for the debts and obligations of the business.
How is it formed?
Most state business statutes do not require the proprietor to file a formation statement for a sole proprietorship, but county and/or local government ordinances may require the proprietor to register the business name and to obtain a local business license.
How is it taxed?
For income tax purposes, the proprietor includes the business’s revenue and expenses on his or her individual income tax return (generally Schedule C of Form 1040). In addition, the proprietor may be required to register with the state department of revenue for the collection and remittance of sales and use taxes, payroll taxes, or any other applicable state or local taxes.
Who uses it?
Many small businesses are started as a sole proprietorship by their owners and are later converted into another entity to protect the owner from being personally liable to future business creditors.
General Partnership
What is it?
A general partnership is formed when two or more partners (who can be individuals, other partnerships, LLCs, or corporations) join together to conduct a business for profit. The general partnership is a legal entity that is separate from its partners, but the partners are personally liable for partnership debts and obligations.
How is it formed?
Most states do not require that the partners file a formation statement to form a general partnership, but in many states the partners may elect to file a statement identifying who has been authorized to execute contracts on behalf of the partnership. A partnership agreement may also be prepared to describe the economic, voting, and management rights and obligations of the partners.
How is it taxed?
General partnerships are “flow through” entities for income tax purposes. This means that the general partnership does not pay income taxes directly to the IRS, rather the partnership’s revenue and expenses are included by the partners on their income tax returns. However, a general partnership may be required to remit income tax deposits to a state on behalf of one or more partners under certain circumstances. Partnerships also are generally required to register with the state department of revenue for the collection and remittance of sales and use taxes, payroll taxes, or any other applicable state or local taxes. Some states also impose a “replacement” tax or property tax on the partnership’s income or property, which is paid by the partnership, in addition to any income tax paid by the partners.
Who uses it?
General partnerships may be formed by two or more individuals when they create a business or purchase income producing property together without forming another type of entity. General partnerships may be converted into another entity to limit each partner’s personal liability to future creditors of the partnership.
Limited Partnership
What is it?
A limited partnership is an arrangement between one or more general partners and one or more limited partners for the conduct of a business. A limited partnership is similar in operation to a general partnership, but the limited partners are generally not personally liable for the partnership’s debts and obligations in excess of their capital contributions. The general partner of a limited partnership remains personally liable for the partnership’s debts and obligations.
How is it formed?
Most states require the filing of a formation statement for a limited partnership, and the filing of annual or biennial registration statements in future years. In addition, a Partnership Agreement is also commonly prepared for a limited partnership to describe the economic obligations and voting rights of the partners, and the management procedures and responsibilities of the general partner.
How is it taxed?
The taxation of a limited partnership is the same as a general partnership. However, the “passive activity” provisions of the tax code may apply to the limited partner(s) to limit their ability to deduct losses, and the “self-employment” tax provisions may apply to the general partner(s) increasing their annual tax liability. Accordingly, these tax issues should be considered when determining if a limited partnership should be formed.
Who uses it?
Limited partnerships are commonly used to form “joint ventures” between existing businesses, to own and operate real estate, and for businesses that plan on raising capital from “silent” partners.
Limited Liability Company (LLC)
What is it?
LLCs are one of the most recent forms for a business entity that combine many of the advantages of corporations and partnerships. LLC owners (members) generally are not liable for the debts and obligations of the LLC above their initial capital contribution. LLC statutes provide flexibility in organizing the management structure for the LLC, and there can be multiple classes of members having different economic interests and voting rights. An LLC can be designed to have a management and ownership structure that is similar to a sole proprietorship, limited partnership, or corporation. Some states now allow “Series LLCs” that provide owners with the flexibility of organizing one entity with separate operating “series,” and each series is treated like a separate company.
How is it formed?
A formation statement is generally required to be filed with the state, and an Operating Agreement describing the ownership and management of the LLC is generally required to be prepared and signed by the Members. Annual registration statements are also generally required for an LLC.
How is it taxed?
An LLC with one member is taxed like a sole proprietorship, with its income and expenses being reported by the sole member on his or her individual income tax return. For a multi-member LLC, current tax law allows the members of the LLC to “check the box” to choose whether the LLC is taxed as either a partnership or corporation. If the members elect corporate taxation for the LLC, then an election statement must be filed with the IRS.
Who uses it?
LLCs have become the entity of choice and are commonly used by sole proprietors wanting protection from the debts and obligations of the business, real estate owners, and business owners wanting flexibility in designing a management structure and/or choosing the manner of taxation.
Business Corporation (often called a "C-Corporation")
What is it?
A C-corporation is the oldest form of entity offering liability protection for its owners. C-corporations are owned by shareholders and managed by a board of directors. The shareholders generally elect the directors and they vote on significant events. The directors oversee the management of the company and hire officers who report to the board. In addition, a C-corporation can have multiple “classes” of stock, with each class having different voting and/or distribution rights for shareholders.
How is it formed?
Articles of Incorporation are required to be filed with the state, and By-laws describing voting and management procedures must be prepared and approved by the shareholders and directors. Corporations are generally required to file an annual report with the state. The shareholders and directors are generally required to hold meetings for elections and approval of key decisions.
How is it taxed?
A C-Corporation is a separate taxable entity. Profits of a C-corporation are subject to double taxation, first at the corporate level and again when they are received by the shareholders as dividend distributions. Also, in many states the “Paid-in-Capital” of a C-corporation is subject to an annual “franchise tax” in addition to the state income taxes.
Who uses it?
C-corporations are one of the most common forms of conducting business and are commonly used by businesses planning on offering stock to the public, manufacturing, commercial and retail businesses with operations in many geographic locations, businesses wanting to compensate employees with stock, and businesses wanting a clear separation between ownership and management. For some professionals (e.g., accountants, doctors, and lawyers), the professional regulations limit the type of entity that may be used by the professionals and corporations are often a form of business that has been approved for use under the state regulations. Not-for-profit entities also generally conduct their operations as a corporation.
Small Business Corporation (often called an "S-Corporation")
What is it?
An S-corporation is a business corporation that has filed an election with the IRS to be treated as a “flow through” entity for income tax purposes. An S-corporation must meet certain requirements, including limits on the number and type of shareholders, before it can elect “S” status. Unlike a C-corporation, an S-corporation may only have one “class” of stock with the same distribution rights for all shareholders, although both voting and non-voting shares of stock may be issued.
How is it formed?
An S-corporation is formed in the same manner as a C-corporation.
How is it taxed?
Once “S” status is elected, the corporation avoids double taxation. Taxable items “flow through” to the shareholders and are taxed only once at the shareholder level. The “flow through” of income for an S-corporation is similar to a partnership, but several tax rules (e.g., the “passive” activity and “self-employment” tax rules) may treat S-corporations and partnerships differently. For this reason, it is important to analyze the owners’ income tax treatment before determining which “flow through” entity type should be formed for a new business.
Who uses it?
Private businesses that are “closely held” by a small number of individuals that want to avoid the double taxation of a C-corporation, such as family owned businesses in manufacturing, retail sales, or other high risk industries where the corporate form of ownership is preferred for liability protection.
