The choice of business entity in the United States is an important decision which should be made with the assistance of experienced counsel.
The simplest form of business entity is the Sole Proprietorship, consisting of one person who is personally liable for the expenses of the business, and is also entitled to any gains. A Sole Proprietorship is taxed directly to the owner’s income taxes. A major downside to a Sole Proprietorship is that if the company cannot pay its bills, creditors can seek payment from the owner personally.
A Partnership is an agreement whereby two or more individuals or companies decide to go into business together. In a Partnership, gains and losses of the Partnership are allocated among the individual partners. Partners are said to be jointly and severally liable for the obligations of the Partnership. Partnerships do not pay income taxes, rather, the individual partners report gains and losses on their individual returns.
A Limited Partnership consists of a general partner and one or more limited partners. The general partner is responsible for management of the business and is personally liable for the partnership obligations. The limited partners are generally passive with respect to management and are only liable up to the point of their investment in the partnership.
A Corporation is one of the most common business entities and provides limited liability for its owners (shareholders). A Corporation can be perpetual in duration as long as state governed corporate formalities are complied with. A Corporation can sue and be sued in its own name. If a Corporation is unable to pay its debts, the creditors of the Corporation may not seek compensation from the shareholders of the Corporation personally.
The Articles of Incorporation is the document which establishes the Corporation and contains basic information such as the name, stock share structure, and the purpose of the Corporation. They By-laws of a corporation are rules the Corporation adopts concerning how it will be run.
Corporations are managed by a Board of Directors and Officers (president, vice president, secretary etc.). Meetings of the Shareholders and the Board of Directors must be held annually, and some corporate actions require the approval of the shareholders. Various other corporate formalities must be followed to comply with the law.
Depending on their structure, Corporations can be subject to double taxation – once at the corporate level, and then again at the personal level when monies are distributed to the individual shareholders. There are options with regard to avoiding double taxation (such as an S Corporation) and counsel should be consulted concerning these options.
LIMITED LIABILITY COMPANY
A Limited Liability Company (LLC) is often a good choice of business entity as it provides the limited liability of a Corporation, with the choice of “flow-through” taxation, which avoids the double taxation which can be levied against a Corporation.
While an LLC can generally elect how it would like to be taxed (corporation, partnership, sole proprietorship), the Internal Revenue Service (IRS) could reclassify the election based on a number of corporate characteristics. For example, if an LLC chooses to be taxed as a Partnership but has too many of the characteristics of a Corporation, the IRS can reclassify it to be taxed as a Corporation.
To be taxed as a Partnership, and not as a Corporation, an LLC must generally avoid at least two of the following corporate characteristics:
1) continuity of life – while corporations are perpetual, an LLC should limit its existence to a number of years (unless it chooses not to adopt both of the following two characteristics).
2) free transferability of interests – generally, while you can assign your interest in the profits and losses of an LLC, the assignee does not also obtain the right to share in the management of the LLC, unless all members agree. The operating agreement can change this, however, but then the LLC would want to avoid the other two characteristics herein if it did not want to be classified as a corporation for tax purposes.
3) centralized management – a corporation has centralized management. An LLC can also have centralized management (being Manager Managed vs. Member Managed) if it does not adopt the other two characteristics above. It is possible that having a president, vice president etc. could lead to a classification of being Manager (or Officer) managed, leading to being treated as a Corporation for tax purposes (if it adopts another of the above two characteristics).
Choosing the proper form of business entity is an important decision which can affect both a company’s earning potential and its ability to shield individuals from personal liability. The choice of business structure will depend on many factors, such as the size of the company, its projected growth, and the desires of the company’s owners..