Selecting Among the Types of Business Ownership
The selection of a type of business ownership is a decision that a person should make, in consultation with an attorney and an accountant, and taking into consideration issues regarding tax, liability, management, continuity, transferability of ownership interests, and formality of operation. Generally, businesses are created and operated in one of the following forms:
The most common and the simplest type of business ownership is the sole proprietorship. In a sole proprietorship, a single individual engages in a business activity without necessity of formal organization. If the business is conducted under an assumed name (a name other than the surname of the individual), then an assumed name certificate (commonly referred to as a DBA) should be filed with the state or county. A sole proprietorship is not considered to be an entity separate from the owner, may not be owned by more than one person, and provides no protection against liability to the owner. Sole proprietorship income is reported on Schedule C of the owners Form 1040. Profits are treated as income of the owner, and losses are deductible to the owner.
A general partnership is created when two or more persons associate to carry on a business for profit. A partnership generally operates in accordance with a partnership agreement, but there is no requirement that the agreement be in writing and no state-filing requirement. Partnership are usually terminable at will or at the death of any of the partners, and partnership interests cannot be sold or transferred without the consent of the other partners. Partnerships are considered in most states to be an entity separate from the partners, so that a partnership can own property and sue and be sued in its own name. However, a partnership provides no liability protection to its owners. In fact, each partner is jointly and severally liable for all debts of the partnership. General partnerships report their income to the IRS in a Form 1065; however, partnerships do not pay taxes. Rather, each partner’s share of the profits or losses is reported on a Form K-1. Each partner’s share of the profits is taxed as income of that partner, and each partner’s share of any losses is deductible.
Formation of a corporation requires filing documents with the state government. A corporation is a legal person, separate from its owners, with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests. The owners of a corporation are called “shareholders.” The persons who manage the business and affairs of a corporation are called “directors.” However, state corporate law does provide for shareholders to enter into shareholders’ agreements to eliminate the directors and provide for shareholder management. Choosing the best management structure for your corporation is a decision you make with the advice of an attorney. Shareholders are not liable for the debts of the corporation. Ordinarily, a corporation is a tax-paying entity, which reports its income on a Form 1120. Shareholders do not pay taxes on corporate income; nor are corporate losses deductible by the shareholders. However, if the corporation distributes its excess profits to its shareholders through a dividend, then that money is taxed twice: First, the corporation pays income tax on the profits; then the shareholder pays income tax on the dividends.
An “S” corporation is not a matter of state corporate law but rather a federal tax election. S Corporations are exactly the same as other corporations (“C Corporations”) in terms of their organization and treatment under state law. A for-profit corporation elects to be taxed as an “S” corporation by filing an election with the Internal Revenue Service. Please contact the IRS or competent tax counsel regarding the decision to be taxed as an “S” corporation and the requirements for filing the election. Federal law restricts the number and type of shareholders who can own stock in an S Corporation. If a corporation elects to be an S Corporation, then it is taxed exactly like a general partnership.
Limited Liability Company
A limited liability company is created by filing a documents with the state. The limited liability company (LLC) is not a partnership or a corporation but rather is a distinct type of entity that has the powers of both a corporation and a partnership. Depending on how the LLC is structured, it may be likened to a general partnership with limited liability, or to a limited partnership where all the owners are free to participate in management and all have limited liability, or to an “S” corporation without the ownership and tax restrictions imposed by the Internal Revenue Code. The owners of an LLC are called “members.” A member can be an individual, partnership, corporation, trust, and any other legal or commercial entity. Generally, the liability of the members is limited to their investment and they may enjoy the pass-through tax treatment afforded to partners in a partnership. As a result of federal tax classification rules, an LLC can achieve both structural flexibility and favorable tax treatment. Nevertheless, persons contemplating forming an LLC are well advised to consult competent legal counsel. A limited liability company can be managed by managers or by its members. The management structure must be stated in the certificate of formation. Management structure is a determination that is made by the LLC and its members.
A limited partnership is a partnership formed by two or more persons and having one or more general partners and one or more limited partners. This type of business ownership operates in accordance with a partnership agreement, written or oral, of the partners as to the affairs of the limited partnership and the conduct of its business. While the partnership agreement is not filed for public record, the limited partnership must file a certificate of formation with state. General partners are fully liable for the debts of the partnership, while limited partners are not liable for the debts of the partnership, but may not participate in management of the business. Limited partnerships are taxed exactly like general partnerships.
Limited Liability Partnership
In order to limit the liability of its general partners, most states allow a general partnership may opt to register as a limited liability partnership. Legally, the limited liability partnership is exactly the same as a general partnership, except that general partners are not held liable for claims against the partnership in which they had no personal involvement. Limited Liability Partnerships are taxes exactly like general partnerships.
Choosing Among the Different Types of Business Ownership
Choosing among the types of business ownership involves a balancing of competing concerns. In the start-up phase of a new closely-held business, when the company is probably losing money, "pass-through" tax structures (general partnership, limited partnership, limited liablity partnership, S-corporation, or limited liability company) are preferable. Most of these structures have some disadvantages if the entity is successful and wishes to grow and attract capital from outside investors. Partnership structures provide the best legal protection to minority owners, but leave all the owners exposed to unlimited liability. Limited partnership shield limited partners from liability, but limited partners are prohibited from active participation in management. Limited liability partnerships shield some partners from liability but only if they have no involvement in the transaction creating the debt or liability. The most useful type of business ownership for large and growing organizations is the corporation, which combines limited liability, separation of ownership and control (allowing for passive investors) and permanence. The limited liabililty company is the newest type of business ownership and was created by the legislature as a hybrid to get the best of both worlds: limited liability and pass-through taxation. The caveat for business owners setting up an LLC is that these companies are designed to be primarily governed by contract. There are fewer rules and much more legal uncertainty regarding these organizations than with corporations. Therefore, the governance and operations of an LLC needs to be carefully thought through and planned and detailed in an operating agreement.