STARTING A BUSINESS - WHICH ENTITY TO CHOOSE?
Starting your own business can be confusing. Should the business be run as a sole proprietorship? Partnership? Corporation? LLC? This basic question is just the tip of the iceberg.
In an effort to clarify the choices, the following discussion outlines some of the basic choices and some of the benefits and limitations of each. This is not intended as a comprehensive analysis, but rather as a starting point. Each new business and business owner will have special considerations with regard to taxes, type of business to be performed, and governance concerns. These questions are best addressed on a case-by-case basis by an appropriate professional.
The simplest choice is the sole proprietorship. Under this scheme, there is no filing required, and the business is operated individually. It is important to note that if the name of the business does not include the proprietor’s full name, the owner must file for an assumed name with the Secretary of State. Thus, “John Smith Welding” would not require an assumed name, but “ACME Welding” or “Smith Welding” would require an assumed name filing. Once filed with the State, the certificate must be published for two weeks in a legal newspaper in the county.
The principal benefit of a sole proprietorship is the ease of formation and the simplicity of governance. However, there are significant liabilities, such as no limit on personal liability, payment of self-employment taxes, and limitations on business deductions for things such as health insurance. Thus, under a sole proprietorships, the owner’s business, as well as all other assets of the owner, are subject to the losses and creditors of the business.
A general partnership is substantially similar to a sole proprietorship, except that a partnership requires two or more persons. There is no formality to creating a general partnership and no requirement that there be a written partnership agreement. An oral agreement may create a partnership. Like the sole proprietorship, each partner is responsible for the all debts of the partnership. Thus, if one partner is insolvent, the creditors of the partnership may collect the full debt from the remaining partners. Again, there is no limit on personal liability and any distributions (profits) taken by the partnership are subject to self-employment taxes. Each of the following partnership arrangements are also subject to self-employment taxes.
A limited partnership creates two classes of partners: the general partners and the limited partners. General partners are responsible for management of the partnership and are personally liable for all debts and obligations of the limited partnership. The limited partners generally are not personally liable for the debts of the partnership, unless the limited partners have participated in the control of the partnership. The creation of a limited partnership requires a filing with the Secretary of State.
LIMITED LIABILITY PARTNERSHIP
A general partnership may elect to be treated as a limited liability partnership by filing the appropriate documents with the Secretary of State. Once organized as a limited liability partnership, the general partners are shielded from personal liability. Otherwise, a limited liability partnership is functionally the same as a general partnership.
LIMITED LIABILITY LIMITED PARTNERSHIP
This entity combines limited liability with the governance of a limited partnership. Thus, the general partners and the limited partners are shielded from personal liability. Functionally, the LLLP is governed as a limited partnership.
A C-corporation requires the filing of Articles of Incorporation with the Secretary of State. The control of the corporation is centralized and hierarchical with the shareholders electing the board of directors who in turn elect the officers who run the corporation. The shareholders are shielded from personal liability unless the corporate veil is pierced. “Piercing the corporate veil” is a consequence which arises when the shareholders have effectively disregarded the corporate structure, most frequently by using personal money for corporate expenses and corporate money for personal expenses. In this situation, the courts may disregard the corporate entity, and the shareholders may be held personally liable for the debts and obligations of the corporation.
Distributions to the shareholders (profits) are taxed as dividends rather than wages and thus may avoid self-employment taxes. In the case of smaller corporations, the shareholders frequently are employees or the sole employee of the corporation. In this case, the shareholder/employees’ wages earned would be subject to self-employment tax, but any excess distributions would constitute a dividend distribution.
The most significant drawback to a corporation is double taxation. The corporation is a separate entity and must file a corporate tax return paying taxes on any profits. If these profits are then distributed to the shareholders, the shareholders must then pay taxes individually on the dividend distributions. Similarly, as the corporation must file a return, the individuals do not gain the benefit of corporate losses and deductions, which are taken at the corporate level.
An S-corporation is a tax election filed with the Internal Revenue Service to treat a C-corporation as a “flow through entity”. As such, the governance remains the same for the corporation, but gains and losses of the corporation are carried through to the individual shareholders.
The S-corporation election is subject to strict filing requirements and if the election is not timely filed, there are serious consequences, including a ten year phase in with regard to corporation assets. Without going into an extended discussion, it is simple to go from a S-corporation to a C-corporation but very complicated to go from a C-corporation to an S-corporation after the initial grace period.
The S-corporation election is limited to corporations with one class of stock. Voting and non-voting shares are allowed, but the issuance of preferred stock or different classes of debt would preclude the election. All shareholders must agree to the election and there may not be more than 75 shareholders. An S-corporation cannot conduct banking, insurance or similar businesses, and passive income cannot exceed 25% of gross receipts. Passive income generally includes rental income, dividends, interest, etc.
LIMITED LIABILITY COMPANY
A limited liability company (LLC) is similar to an S-corporation with regard to formation, governance and tax effect. The LLC is formed by filing Articles of Organization with the Secretary of State. The owners of the LLC are referred to as members, who elect a board of governors who in turn, elect the managers of the LLC. Generally, the income and losses of the LLC are passed through to the members as in a partnership, however, the members may elect to have the company taxed as a corporation. If no election is made, the LLC is taxed as a partnership.
An LLC is not limited by the type of owner or business it may operate as the S-corporation. Thus, the LLC may be appropriate where partnership tax treatment is desired, but the passive income or ownership requirements of an S-corporation cannot be met. The members are shielded from personal liability, even if they participate in management, however, income from a trade or business carried on by an LLC may be subject to self-employment tax.
DISCLAIMER INFORMATION: THE INFORMATION CONTAINED IN THIS SITE IS DESIGNED TO PROVIDE GENERAL INFORMATION AND IS NOT LEGAL ADVICE. YOU SHOULD NOT DRAW LEGAL CONCLUSIONS OR RELY UPON THE INFORMATION CONTAINED IN THIS SITE AS LEGAL ADVICE OR AN OPINION ON THE LAW OR THE MERITS OF YOUR CASE. THE LAW CONSTANTLY CHANGES AND YOU SHOULD DISCUSS THE INDIVIDUAL FACTS OF YOUR CASE WITH AN ATTORNEY TO OBTAIN COMPETENT LEGAL ADVICE.