Selecting and forming the optimal entity for a business venture can take mere minutes, but has a decades-long impact that shapes a company’s ownership, management, finances, tax obligations and liabilities. Government agencies have made the process of creating a corporation or limited liability company exceedingly simple – anyone with an Internet connection and credit card can bring a new entity into existence in 15 minutes. The decisions and legal issues underlying that creation, however, are complex and require a thorough review of a wide range of considerations. The sections below outline features of the most common business structures and statutory entities, and also provide a little more depth on traditional or typical business structure issues encountered by emerging companies.
Legal Entities – Common Business Structures
- Sole Proprietorship
- General and Limited Partnership
- Limited Liability Company
This is the default structure for a single owner business; if no other action is taken or election is made, this is the form a business takes on. A sole proprietorship is the simplest, and least expensive type of business to start because it has few legal requirements. It is owned by one individual who has complete control of the business and is responsible for all business decisions and financial obligations. Revenues are considered personal income and are taxed at the owner’s personal tax rate.
- Easy to organize
- Less reporting
- No double tax
- Autonomous Management
- Unlimited liability
- Fewer tax benefits
- Potential adverse tax consequences upon sale
- Limited ability to raise capital
Partnerships involve two or more people who are conducting a business together. With respect to taxes, the owners of a partnership are taxed but the partnership itself is not.
A general partnership consists of general partners who share the management of the entity and are personally responsible for the partnership’s obligations. All partners in a general partnership share unlimited liability for the obligations and actions of the partnership and its partners. The best practice is to have a written partnership agreement prepared with an attorney’s assistance.
- Few formalities
- Combination of resources & talents
- Possible personal tax benefits
- Unlimited liability
- Power of each partner to bind the other
- Dissolution upon death of a partner
- Partnership profits taxed as income to the partners
A limited partnership consists of two classes of partners: general partners and limited partners.
The general partners manage the limited partnership and are personally responsible for its obligations. The limited partners do not share in management decisions. Limited partners share in the profits of the partnership, but their losses are generally limited to the amount of their capital contribution.
- General partners have access to additional capital
- Limited partners have limited liability
- Structured allocation of income and losses
- Avoids “double tax”
- Finite existence
- Initial cost high
- Limited partners have no control
- Partnership profits taxed as income to partners
- More formalities and controls than a general partnership
Limited Liability Company
Limited Liability Companies – Taxes and Members
LLCs are relatively simple to form and do not have the recurring formalities and annual filings common to corporations. Like a corporation, an LLC provides liability protection for its founders and members. Business tax issues are extremely complex, but at a basic level, LLCs are “pass-through” tax entities. This means the LLC itself doesn’t pay taxes, and all income and losses are attributed directly to the LLC’s member(s). The member(s) will have taxable income (or losses) attributed to them (and will have to pay those taxes), but the LLC will not.
LLCs can also have different classes and types of members, and each LLC must have an operating agreement, a legal document which lays out ownership, management, succession, taxation and other operational and financial structures. Other than its operating agreement, LLCs in many states are relatively straightforward and are not required to have annual meetings, make annual filings, have separate agreements, etc., like a corporation must.
But unlike corporations, LLCs must choose whether to be “member-managed” or “manager-managed.” A member-managed LLC is run and operated by its members, and the various mechanisms for decision-making among the members are laid out in the operating agreement. A manager-managed LLC selects a single manager, or a group of managers, to run the company. Managers are often, but are not required to be, members of the LLC, and many operating agreements leave day-to-day operations to the manager but require unanimous member consent for big, enterprise-wide decisions like selling the company, merging with another, adding members, etc.
Because LLCs are relatively simple to form and provide a lot of flexibility along with liability limitations and pass-through taxation, they are a popular choice.
- Limited liability without limits on management participation
- Flexible ownership and capital structure
- No double tax
- Allocation of tax benefits among members
- Initial organizational cost high
- Poor tax treatment of fringe benefits
- Transferability must be governed by buy/sell provisions
- Case law is still evolving
Limited Liability Company – Must elect taxation for State Unemployment reporting purposes of either a Sole Proprietorship or Partnership or Corporation.
Limited Liability Partnership (LLP) – A LLP differs from a LLC in that the members of an LLP are liable for the debts of the partnership, but an LLC member is only liable to the extent of their investment in the company.
General business corporations are the most traditional of statutory entities. Like an LLC, corporations limit the liability of individual owners. The shares of a corporation are relatively easy to transfer; corporate law and transactions are familiar to the business world. Corporations are managed by directors and officers pursuant to corporate bylaws and are required to have and report annual meetings.
Unlike LLCs and partnerships, however, corporations do not have default pass-through taxation. The corporate entity is required to pay taxes on its income, and then if excess cash is distributed to shareholders as a dividend, the shareholder must also pay tax on that cash. This “double-taxation” is obviously unattractive to shareholders, and so many small-business corporations make an IRS S-corporation election. This means the corporation is exempt from taxation and the shareholders are attributed the corporation’s profits and losses in a pass-through manner (like an LLC).
- Limited liability of shareholders
- Perpetual existence
- Flexibility of financing through outside investors
- Transfer ownership by sale/gift of stock
- Tax benefits available to corporate employees
- Well accepted form of doing business
- Initial organizational costs high
- Annual reporting requirements
- Double taxation
- Same as for the C-Corporation
- Taxed at the individual shareholder level
- Except for the tax consequences, same as for a C-Corp
- With minor exceptions, only individuals can be shareholders
- Limited number of shareholders
- Limited to one class of stock
- Must use calendar year
A Note on Nonprofit Corporations
State statutes also create and make possible the formation of a liability limiting entity that does not seek to make a profit. Nonprofit corporations allow the creation of a formal entity that can engage in a variety of activities, but is not “owned” or run in the same sense that other entities are owned by their shareholders or operated by their members or managers. Nonprofit corporations are usually managed and operated by a board of directors and its committees, or by officers (who are often paid employees of the entity). But nonprofits do not have shareholders, and no individual or entity can own or have an interest in the nonprofit’s holdings, property, etc. Nonprofits are not taxed in the same manner as for-profit business entities, and can also seek specific tax-exempt status from the IRS. A tax-exempt corporation is not taxed on its profits, and contributors to the organization can receive tax benefits for their donations. But again, people involved with the nonprofit corporation cannot take or enjoy those profits individually. Nonprofits are subject to as many, and maybe more, formalities, filings and governance issues as general corporations, and are limited in the activities in which they can engage. The nonprofit structure may make sense for organizations with charitable, community-based or philanthropic purposes, and those organizations can still make money. But structuring and management of such efforts requires careful planning and solid professional guidance.