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If you are about to start a business, then a key consideration is what business form your entrepreneurial entity should take. In most states, you typically choose between a Limited Liability Company (LLC), Corporation, Limited Partnership, sole proprietor (if you have a single owner), or a general partnership (if you have more than one owner).
It should be noted that there is no ‘right’ or ‘wrong’ business entity. Each has its own advantages and disadvantages in terms of financing, growth, flexibility, legal protections, income tax consequences, costs and formalities. Incorporating involves a filing fee with the Secretary of State and record keeping during the course of your company’s lifetime. The ultimate entity choice depends on the type of business you are starting and the long-term goals of the business. Do you want to raise more capital later on and have more shareholders? Do you want to go public? What kind of management structure do you want? What is your exit strategy? While this article attempts to address some of the most common issues, the length of this article prohibits the consideration of all possible issues and can never replace sound legal and accounting advice tailored toward your unique business venture.
Your decision on the form of business entity should include both legal and practical considerations along with federal income tax considerations. The federal income tax planning and/or consequences will many times drive the determination of your business entity form. So, a new entrepreneur should evaluate both the legal considerations as well as the federal income tax considerations. Making the right choice can be critical to your business prosperity.
Let’s review the basics of each:
Corporations. These are separate legal entities that you create to conduct the business. Corporations have their own tax structure and offer legal protection to the shareholders. Generally speaking, if a lawsuit arises, then the Corporation is exposed, not the individual shareholders. Corporations have been in existence for a long time, resulting in long standing and established case law and regulations. Corporate stock, which is the measure of ownership of a Corporation, can be transferred. Corporations have a lot of flexibility with regards to management and ownership structures. There is a filing fee with the home Secretary of State and paperwork formalities that must be adhered to in order to form and maintain the legal protections.
For legal purposes, a Corporation is referred to and formed as a “Corporation” with the home Secretary of State. However, for federal income tax purposes, Corporations can be treated as either a C Corporation or an S Corporation. A common misconception is that an S Corporation is a type of entity. The reality is that an S Corporation is merely a federal income tax designation, but choosing to be treated as an S Corporation for federal income tax purposes requires compliance with some Internal Revenue Service (IRS) rules that impact operation of the company, such as a limit on the number of shareholders, prohibition against multiple classes of stock that treats any class differently and limitation on most non-individuals from owning stock. As discussed below under the section for LLCs, the concept of a C Corporation versus an S Corporation for federal income tax purposes is relevant to the evaluation of an LLC as a business entity form option.
Discussing the difference between treatment as a C Corporation and an S Corporation for federal income tax purposes with your CPA is strongly encouraged, but the basic differences is that a C Corporation pays its own tax at a corporate rate instead of at your personal rate. This tax is assessed only on profits, which is the money that is left over at the end of the year, not the gross income of the business. In contrast, an S Corporation is a pass-through entity that causes the business profits or losses to be ‘passed through’ to the shareholders and reported on their individual tax returns. Even though a corporate income tax is filed, no tax is paid at the corporate level. Business losses can be deducted from some of your personal income. One major advantage of electing S Corporation status allows a company to eliminate the ‘double taxation’ that can occur with a C Corporation.
The Limited Liability Company or LLC is extremely popular and also offers legal protection for all involved. An LLC can be either a single-member LLC (meaning one owner, which are referred to as “Members”) or a multiple-member LLC. Similar to a Corporation, an LLC insulates the Members’ personal property and income from business liabilities. A proper filing in the home Secretary of State is required along with paperwork formalities, but an LLC is typically considered less formal than a Corporation. Some states, such as Texas, offer additional protection from a judgment against a Member that is not related to the business by limiting a creditor to only obtaining a ‘charging order’ against the Member’s LLC interests as opposed to complete control over such LLC interests. Please contact your business attorney for a detailed explanation.
The above paragraph addresses the legal considerations of an LLC, but what about the federal income tax consequences? An LLC offers tremendous flexibility regarding income tax treatment. Remember that for legal purposes, the company is treated as an LLC, but there is no such thing as an LLC federal income tax return. Consequently, you have three different options for filing your federal income tax return. First, if the LLC does not file an election with the IRS to be treated otherwise, the business will be treated as a ‘disregarded entity’ (if the LLC has only one Member or, if located in a community property state such as Texas, the LLC is owned by two Members that are married), which means the taxes are filed on the Member’s individual income tax return like a sole proprietorship files its taxes. If the LLC has more than one Member, then the LLC will be treated as a partnership for federal income tax purposes. Second, an LLC can elect to be treated as a C Corporation for federal income tax purposes (see the tax section under the Corporation discussion above). Third, an LLC can elect to be treated as an S Corporation for federal income tax purposes (see the tax section under the Corporation discussion above).
Partnership. There are several types of partnerships. The most common partnerships are general partnerships and limited partnerships. General partnerships consist of two or more partners who are all personally responsible and liable for the business. They share the assets and profits, as well as the liabilities and management responsibilities for running the business. A general partnership is typically treated as a partnership for federal income tax purposes. Each partner is equally responsible for judgments, taxes and debts – even if that partner had nothing to do with incurring such judgement, tax or debt. No formal paperwork with the home Secretary of State is required. If a partner commits a ‘bad’ act, then the other partners are liable. These arrangements can be volatile, especially if the partners have a falling out. An attorney-drafted contract between the parties is strongly encouraged. If you go into business with at least one other person and do not file any paperwork with any Secretary of State, then most likely, whether you know it or not, you just created a general partnership. Given the complete lack of any personal liability protection from any liability related to the business, a general partnership is one of the most dangerous forms of business ownership.
A limited partnership is widely considered to be less dangerous than a general partnership. A limited partnership is required to file paperwork with the home Secretary of State, pay a filing fee and maintain necessary paperwork formalities. A limited partnership consists of at least one general partner and at least one limited partner. The general partners of a limited partnership, like a general partnership, are personally liable for all business related liabilities, but they also maintain control over the daily operations of the business. Due to the personal liability exposure, many general partners are business entities, such as an LLC or Corporation, as opposed to individuals. In contrast, the limited partners, like an LLC and Corporation, are typically insulated from personal liability for business liabilities, but a limited partner is not permitted to be involved with the daily operation or management of the business. Like a general partnership, a limited partnership is typically, but not always, treated as a partnership for federal income tax purposes.
As you can see, the determination of the appropriate business form for your new venture can be rather complicated. This decision can have a ripple effect for your company.
The Metcalf Adair Law Firm offers experienced business counsel with the determination of the appropriate business form for your new business venture. To learn more about starting a successful business and the pros and cons of different kinds of business entities, or how we can help you on a related matter, contact us today to schedule a consultation.