CHOOSING A BUSINESS ENTITY
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Copyright © 1994-2004
All rights reserved.
R. Zegarelli, Esq.
Whenever one person starts a business, that business is, by default, a sole
proprietorship. Because a proprietorship is the default entity for any business owned by
one person, there are virtually no legal requirements. For example, a proprietor does not
have to have a separate bank account. Basically, a sole proprietor only has to obtain the
required state and local business licenses and to register any fictitious name that will
be adopted. A sole proprietor does not have to file a separate federal income tax return
for the business. Because the proprietorship is not considered to be a separate
legal entity, the proprietor merely reflects any gain or loss on Schedule C of the
Form 1040. A proprietor does not have to conduct employment withholding on proprietorship
income. The proprietorship will, however, have to conduct withholding for third-party
The primary disadvantage of a proprietorship is that it does not afford the owner
limited liability to third parties. The law regards a proprietorship as having the same
legal identity as the proprietor. Therefore, if a proprietorship is sued, the owner will
have to satisfy any judgment with personal assets such as a home, automobile and
bank account. Another significant disadvantage of the sole proprietorship is that it is
generally not regarded as the best tax-planning entity. For example, a sole proprietorship
must adopt the same taxable year as its sole proprietor. Furthermore, since proprietorship
income is taxed directly to the sole proprietor, income tax planning involving the
"two pockets" theory of income splitting is not available to a sole
In addition, in certain respects, sole proprietorships cannot provide favorable
retirement or fringe benefits. For example, a sole proprietor cannot contribute as great
an amount of income to a retirement plan as if in a corporation. A sole proprietorship
cannot take advantage of the tax savings offered by tax-qualified medical plans to provide
medical reimbursement benefits to the sole proprietor. Furthermore, disability insurance
premiums for policies covering the proprietor are not deductible to the proprietorship,
and a sole proprietorship cannot provide tax-free meals and lodging for the sole
In conclusion, although sole proprietorships are less complicated and inexpensive to
administer, many benefits, such as limited liability and certain tax-planning
opportunities, are unavailable to the owner.
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There are two types of partnerships: general partnerships and limited
Whenever two or more co-owners engage in a business operation to make a profit, by
default, they are considered to be in a general partnership. No written partnership
agreement is necessary to form a partnership. Inadvertent partnerships are common.
General partnerships, like sole proprietorships, do not provide the owners with
insulation from liability to third parties. Generally, partners are agents of each other,
and, as such, they will be jointly and severally liable for the acts of their co-partners.
Any partner can bind the partnership to a contractual arrangement--even if that partner
does not have actual authority from the partnership to do so. For example, one partner
could enter into a contract on the partnership's behalf with a third party and bind the
partnership, even if the other partners did not see the contract. And, because partners
are each personally liable for partnership obligations, the partnership and
the partners would be liable to fulfill the contract's terms.
One of the advantages of the general partnership is that, for federal and state income
tax purposes, the partnership is treated as a "flow-through" entity. This means
that the partnership itself is not subject to income tax. Rather, the partners report on
their individual income tax returns their proportionate share of partnership income or
loss for the year. This type of taxation can be advantageous when, in the start-up phase,
a business is incurring losses which it cannot deduct because it lacks income against
which to offset the losses. In this case, the losses can be used on the partners'
individual income tax returns to offset their other income, including investment income.
Furthermore, if a partnership agreement exists, co-partners can allocate many items of
income, deductions and credits between or among them as they see fit. A partnership
agreement can also provide for the manner in which the partnership will be governed (i.e.,
reallocate voting control).
Partnership agreements have other significant uses as well. For instance, a
partnership agreement may provide a procedure for the admission of new partners; provide
for the termination of the partnership after the passage of a specified period of time or
the occurrence of a stated event; and, allocate control over particular matters involving
the partnership's affairs between co-partners. Thus, it is usually advisable to have a
written partnership agreement between or among the partners. A written agreement can also
protect each of the partners against acts of the other partners. For example, the partners
can limit their liability by providing for rights of reimbursement when one partner
violates the partnership agreement and binds the co-partners on an obligation to a third
party. In short, a written partnership agreement can be extremely helpful to the partners
in establishing their respective rights and obligations and in protecting partners from
certain actions undertaken by their co-partners.
In some cases, a partnership can help its partners defer income taxes by selecting a
different tax year from that of its partners. In general, a partnership may select a tax
year which differs from that of its principal partners by as much as three months. This
can allow the deferral of obligations to pay income taxes on amounts received by the
partnership in the last quarter of a calendar year until the next taxable year. For
example, if the partnership's taxable year were April 1 through March 31 fiscal year,
income earned in the last quarter of the partnership's fiscal year would not have to be
reported to the partners as taxable income until their personal taxable year in the next
calendar year. Although the partnership is not itself a taxable entity, it must file an
annual federal tax return and provide schedules to its partners reflecting their allocable
shares of partnership income, deductions and credits. For withholding purposes, a
partnership is treated the same as a sole proprietorship.
Generally, no formal documents need to be filed with the state to commence business in
general partnership form, other than those necessary to obtain the applicable business
licenses and to file under the applicable state fictitious name statute, if necessary.
However, as previously stated, a written agreement is highly recommended. In the area of
retirement plans and fringe benefits, a partnership is basically treated the same as a
sole proprietorship, i.e., it can establish these types of plans, but its ability
to provide benefits to its partners is limited.
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If a partnership desires to attract investors who are not going to actively
participate in the control of the business, then creating a limited partnership may be the
best form of entity. A limited partnership consists of at least one general partner,
and limited partners. One or more general partners are responsible for the management
of the partnership. The rights and liabilities of general partners in a limited
partnership are, in almost all respects, similar to the rights and liabilities that
general partners have in a general partnership. Limited partners are not permitted by law
to participate in the day-to-day operation of the business. If the business is profitable,
limited partners receive a positive return on their investment, and, if not profitable,
they will realize a loss.
Limited partners have limited liability to third parties in a manner similar to that
associated with shareholders of a corporation, i.e., their potential liability is
limited to their investment in the limited partnership. Thus, limited partnerships can be
an ideal method of raising investment capital by allowing investors a chance to
participate in the growth of the business, without requiring them to be
"at-risk" in the enterpriseexcept to the extent of their investment. And,
the general partner retains exclusive control of the management of the business.
Limited partnerships, like general partnerships, are "flow-through" entities
for tax purposes. In general, as a prerequisite to commencing business as a limited
partnership, a governing document known as the "Articles of Limited Partnership"
must be filed with the state in which the limited partnership will do business. In the
case of a large limited partnership, or one in which ownership interests are widely held,
the limited partnership may also become subject to the reporting and disclosure and
anti-fraud provisions of federal and state securities laws--unless an exception to the
application of such laws applies.
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The corporation is the most complex forms of business entity, and the most costly to
administer. In return, however, it is often capable of providing its owners with the most
significant tax and non-tax benefits.
The principal non-tax advantage afforded by a corporation is that of "limited
liability" of its shareholders to third parties. The shareholders in a corporation
are at risk only to the extent of their investment. They cannot be sued for the actions of
the corporation, and, if the corporation is sued, the maximum amount each investor can
lose is the value of that investor's personal investment. In addition, if the corporation
were to become bankrupt, each shareholder's personal assets and credit rating would not
suffer any harm.
With regard to the tax implications, a corporation is also capable of providing its
owners with considerable advantages. Perhaps the most important advantage is that the
corporation provides its owners with "two pockets" in which to place their
income. Amounts paid to the shareholders as dividends, and to employees as wages, are
taxed to the recipients on their personal income tax returns for the taxable year in which
the income was received. Because a straight "C corporation" (i.e. a
corporation that has not elected S corporation status) is not a
"flow-through" entity, amounts that are not paid to the shareholders during the
taxable year may be retained in the corporation, which is treated as a separate taxpayer.
Retaining funds can be used to help reduce the shareholder-employees' personal
income tax rates (by placing them in a lower tax bracket and reducing their personal
The ability to split one's income may have the effect of reducing the taxpayer's
overall tax rate. Furthermore, because C corporations, unlike partnerships or sole
proprietorships (or S corporations), are treated as separate legal entities from their
owners, a corporation has almost complete freedom in selecting its taxable year. As
discussed above in connection with partnerships, this can result in tax-deferral benefits
to the business' owners. In addition, a corporation has a great deal of flexibility in
terms of how its ownership interests can be held. Persons interested in sharing the
profits of the corporation can acquire common stock, while those interested in
participating in the business in a more risk-free manner can purchase preferred stock or
debt instruments. Different classes of stock can also be given different voting and
liquidation preferences, further enabling the corporation to raise capital and to tailor
itself to the diverse needs of different shareholders. A C corporation is not bound by any
of the restrictions relating to retirement and fringe benefits discussed above that apply
to sole proprietorships and partnerships. Thus, if owners wish to take full advantage of
the tax benefits afforded tax-qualified retirement, medical and disability plans, the
corporation can prove extremely advantageous. For example, owners could install a medical
reimbursement plan to pay not only their own medical expenses, but those of their family
members. And, all amounts paid could be deductible to the corporation.
In return for these very substantial advantages, a corporation must file a separate
income tax return and must withhold income and employment taxes on wages paid.
Furthermore, a corporation must file Articles of Incorporation with the state in which it
incorporates, and it must adopt detailed bylaws to govern its internal affairs. One
disadvantage of the corporate form is that a C corporation, as a legally separate entity,
cannot pass the losses to its shareholders for use on their personal income tax returns in
order to offset their other taxable income. Another disadvantage is that each dollar
earned by the corporation is taxed as corporate income at the corporate tax rate. If the
remaining after-tax dollars are then distributed to the shareholders as dividends, the
shareholders are also taxed for dividend income. In other words, the same dollar earned by
the corporation may be taxed twice.
However, a corporation can elect to be taxed like a partnership, while still
retaining the advantages of corporate form, such as limited liability. This can be
accomplished by electing to become an "S corporation."
Basically, an S corporation is treated for all tax purposes exactly like a partnership. In
other words, in an S corporation, the shareholders are allocated, on their personal income
tax returns for the taxable year, their proportionate share of the corporation's income or
loss--whether distributed or not. This means that electing S corporation status in the
initial years of a business when expenditures well exceed income can prove to be highly
advantageous. A corporation that elects S status can then, in later years, when there are
profits, elect out of S corporation status and be taxed as a C corporation. To be eligible
to elect S corporation status, certain requirements must be met. For example, an S
corporation cannot have more than 75 shareholders; its shareholders, in general, must be
individuals and must be nonresident aliens; and the corporation may only issue one class
of stock. The primary disadvantage of S corporations is that they are bound by the same
restrictions on retirement plans and fringe-benefits as partnerships (for fringe benefit
purposes, a 2-percent shareholder in an S corporation is treated as a partner in a
partnership. S corporations are also subject to the same restrictions on choice of
taxable year as apply to partnerships. See also,
relating to corporation structures.
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LIMITED LIABILITY COMPANIES
Limited liability companies should be viewed as a partnership for
taxation purposes, and as a corporation for liability purposes.
Limited liability companies are permitted to be created in almost every
state in the United States. They are a relatively new type of legal
entity, gaining widespread acceptance in the last 10 years.
Many professional are creating only limited liability companies because
they have the advantages of a corporation for liability purposes and have
the advantages of a partnership for tax purposes. Also, unlike an
S-corporation, they do not have limitations on classes of stock or
ownership. But, be careful. There are a few drawbacks to limited liability
companies, such as limitations to qualified stock plans, more complex
contractual structuring to accommodate the flexible organic structure,
inability to switch to a C corporation upon initiating an initial public
offering, less sure taxation rules, less governance case law. Many
accountants still prefer S corporations.
Accordingly, as a general rule, we keep it simple: we start with the
presumption of a S corporation. We will change to a C corporation upon
request from our client's accountant, which is rare but does occur. If the company will have more
than 75 shareholders, non-resident alien shareholders, more than one class
of stock or corporate investors, we will change to a limited liability
company, unless the company intends to become a public company.
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In conclusion, business owners have a number of options when deciding how to structure
a businesses. Our firm can
assist you in choosing the best business entity to achieve your financial and business
goals. See also our publication on
Corporate Structure and
Contact us today! Our firm can assist
you with understanding and applying the law to your particular situation.
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issues, without expressly indicating, in generalizations. Laws vary between and
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