Whether you are starting a new business or running an existing business, it is important to select the proper legal entity for your business operations. This article looks at four standard legal structures that might be selected for your business operations.
There are four basic choices for establishing a business entity: sole proprietorship, partnership, corporation or limited liability company (LLC). Each form has different legal requirements for creation
and operation. Each offers different levels of protection from the debts and liabilities of the business. And each type of business results in different income tax treatment for the business income. Let’s consider each of these forms separately.
A sole proprietorship is the simplest form of business. You can select a business name for your business, but a sole proprietorship is not a separate legal entity from the person operating the business. All of the income earned by the business and all of the liability for the business operation falls upon the owner/operator. Bank accounts held in the name of the business simply use the Social Security number of the owner/operator as the tax identification number for the business.
When two or more people come together to form a business association, the entity is considered a general partnership. Even if no formal written partnership agreement is signed, the law often will presume
that the operators are partners.
In a general partnership, responsibility for the debts and liabilities of the company are “joint and several” among the partners. This means that each partner is 100 percent liable for the liabilities of the business, regardless of the percentage of the partnership owned by each partner. Profits, losses and income taxes are allocated according to the percentage of ownership of each partner.
Two or more people may also form a limited partnership in order to protect non‐active partners from business liability. Limited partnerships are taxed just like general partnerships, but the limited partners are only liable for their own financial contribution to the business. Limited partners typically have limitations on their ability to control the business operations. General partners manage the business and are still personally liable for business debts.
A corporation is organized and owned by one or more people who are called shareholders. Shareholders are only liable for their own financial contributions to the corporation and do not take on further liability
for corporate debts or tort damages.
A corporation is established by filing Articles of Incorporation with the state where the business is to be
formed. Shareholders are also required to adopt formal Bylaws for the corporation and elect a board of directors that is responsible for running the company. The board of directors in turn elects officers of the
corporation to run daily operations. In small, closely held corporations, the shareholders, directors and officers are often the same people.
Upon formation and in order to remain in good standing with the state, corporations require strict adherence to state statutes. Failing to follow formal state law corporate requirements can lead to dissolution or personal liability by the directors and shareholders for the debts of the company. This is called “piercing the corporate veil.”
Corporations are subject to different income tax treatment depending upon the election of the organizers of the company. A C-Corporation is taxed by the IRS as a separate and distinct entity from its shareholders. The C‐Corporation files its own separate tax return and pays taxes on its own profits. When
profits are passed on to shareholders in the form of dividends, there is a second taxation on the money earned at the shareholder level.
An S‐Corporation is taxed in a manner similar to a partnership—that is, the profits of the S‐Corporation are “passed through” the entity to the shareholders according to their percentage of ownership of the corporation. There is no taxation of income at the corporate level.
Limited Liability Company
Limited Liability Companies were first authorized as a type of business entity in the United States in 1977 by the State of Wyoming. Since then, every state has passed laws allowing the creation of LLCs. LLCs have become popular for every type of business, including professional services, real estate investment and development, construction, manufacturing, retail sales, personal services and just about all other types
of business operations imaginable. There are a number of reasons why LLCs have become so popular. These include:
LLC owners, called members, enjoy the same limited liability protection as corporation shareholders.
LLC members can elect any income tax treatment they desire. Profits and losses can pass through
the business and be taxed on the owners’ individual tax returns—just like a sole proprietorship, partnership or S‐Corporation—or an LLC can elect to be taxed like a C-Corporation.
LLCs are simpler than corporations to set up and operate. LLCs are formed by filing Articles of Organization with the state. Typically, the members also adopt an Operating Agreement to govern the operations of the company. The LLC is not required to elect directors or officers or to hold annual meetings of its members.
LLCs can be more flexible in the way that they are structured and operated. Management and control does not have to be tied strictly to the percentage of ownership of the members. LLC members are not required to divide profits in the same proportion as the capital contributions of each member. Instead, profits can be split in any manner that the members agree upon.
Foley & Foley recommends that you consult a lawyer and a CPA to help you select, organize and operate the business form that is right for you.