One of the first issues that an entrepreneur or business owner faces is choosing the most effective form of legal business entity. This decision can be confusing–here are a few points regarding business formation and the different types of business entities.
THE SOLE PROPRIETORSHIP:
The Sole Proprietorship is the most basic form of business entities. This form often occurs by default when one person takes their business idea to market. Many times, the entrepreneur does not have any employees when the business is started–so the ease of use makes it a go-to choice for individual business owners. An important point–by not selecting any other business form available to the business owner, the owner takes on the Sole Proprietorship (and all its benefits and liabilities) by default.
The business owner and the business itself merge; and there is no practical distinction between the business owner and the business itself for legal liability, taxation and other purposes. The Sole Proprietorship offers the advantage of little formality and expense in formation. Generally, all business income and expenses are reported on the owner’s personal income tax return.
For liability purposes, the owners personal assets become available to creditors for debts and liabilities. In many states, individuals who conduct business under a different name than their legal name (for example, John Doe operates a business called Mobile Software Solutions) are required to file an “assumed name” with the County Clerk’s office for the county in which the business is located.
THE GENERAL PARTNERSHIP:
The General Partnership is closely related to the Sole Proprietorship. Here, we have two or more people engaging in business for profit and usually determining how the losses will be shared. The General Partnership also requires little formality to get started. Again, like a Sole Proprietorship, it is formed by default when two or more people forgo selecting any other form of business entity.
One of the main issues that arises is governing the business and selecting rules that the partners will utilize. Usually, this is taken care of with a partnership agreement. Without this agreement, all partners share in the decision making process and the partnership will not extend past the lives of its owners.
A General Partnership is taxed similarly to a Sole Proprietorship. Profits and losses flow through the General Partnership owners. The most striking point about a General Partnership is that each co-owner is liable for the debts incurred by the other co-owners for the business– including wrongful conduct. This makes the General Partnership the front-runner for the riskiest type of business form as co-owners personal assets are at risk for the conduct of others.
QUICK SHOT: As a related side note to entertainment law, bands often are unaware that they are forming a General Partnership when the jamming starts and the shows begin.
THE LIMITED PARTNERSHIP:
The Limited Partnership is a derivative of the General Partnership that allows co-owners to “limit” their exposure in certain cirumstances. A Limited Partnership has at least one “General Partner” who retains personal liability for partnership debts. “Limited Partners” are usually partners that have solely contributed a capital investment–an they are liable for the debts of the partnership up to the amount of that investment.
Again, the profits and losses flow through the owners for tax purposes. Limited Partnerships are subject to formation guidelines that vary from state-to-state.
THE LIMITED LIABILITY PARTNERSHIP:
In a Limited Liability Partnership, all partners are liable for business debts up to their capital investment and each partner is liable for their own wrongful conduct. Limited Liability Partnerships are similar to General Partnerships and generally have the same advantages and disadvantages.
THE C CORPORATION:
The C Corporation (from subchapter C of the IRS code) is a separate and distinct legal entity. Shareholders are owners; Officers and Directors run the corporation. The corporation is responsible for business debts and other obligations. The owners liabilities are limited to their capital contributions. Officers, Directors and employees of the corporation can be held liable for business debts only in limited circumstances. Ownership in a corporation is transferable and alienable.
The major distinction in this type of business entity is what is referred to as double-taxation.Â Distributed profits are subject to taxation at the corporate level when the profits are earned and at the shareholder level when (and if) profits are distributed. Again, the C Corporation is a separate taxpayer and the shareholders do not pay income taxes on corporate profits until they are distributed. However, the advantages of the C Corporation become apparent in tax benefits like the ability to deduct employee health insurance and benefits.
THE S CORPORATION:
The S Corporation is similar to the C Corporation–but, the S Corporation can avoid double taxation. The S Corporation is taxed similarly to a partnership in that the profits and losses flow through the owners. The advantage is the limited liability for owners. However, there are limitations in the number of shareholders for formation. Failure to abide by these standards can cause the loss of status and resulting tax and legal complications.
THE LIMITED LIABILITY COMPANY:
The Limited Liability Company (“LLC”) is a relatively new construct. It combines the benefits of the corporation in limiting liability with the flow through tax advantages of the Sole Proprietorship and Partnership. The application for an LLC is usually filed with the Office of the Secretary of State. An “Operating Agreement” or “Membership Agreement” determines whether the business will be managed by the members themselves or dedicated managers. Just like a C Corporation, an LLC is also a distinct legal entity. LLC’s are very attractive because members can limit personal liability while participating in theÂ management of the business.
Choosing a type of business entity is an important decision that can have long-term consequences. Accordingly, entrepreneurs and owners should make good choices on the front-end with the help of experienced legal counsel.
*Disclaimer: The information contained in this article is not legal or tax advice. In order to ensure compliance with the IRS, any U.S. federal tax information in this communication is not intended or posted for the purposes of being used to: (i) avoid penalties under the Internal Revenue Code; or (ii) promote, market or recommend to another party any transaction(s) or tax-related matter(s).