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Whether starting a new business or
dealing with the growing pains of an
existing business, business owners
should give careful consideration
and periodic review to the type of
legal entity they use. This article
will provide the reader with some
background information on the
various legal forms a business
enterprise can take and will discuss
some of the basic advantages and
disadvantages of each type of
entity.
The basic legal forms of business
include (1) the sole proprietorship;
(2) the partnership (including
general partnerships and limited
partnerships); (3) the regular
corporation (also known as a
Subchapter C Corporations); (4) the
S Corporation (named for Subchapter
S of the Internal Revenue Code); and
(5) the limited liability company
(also known as an LLC). This article
will not discuss a variety of other
specialized entities such as
professional service corporations
(typically used by doctors,
dentists, attorneys, and other
professionals), limited liability
partnerships (available only for law
firms, accountancy firms, and
architects), and nonprofit
corporations.
A number of issues arise when it
comes to forming a business entity
which are beyond the scope of this
article. These include such matters
as designing the financial structure
of a business entity (e.g., debt
versus equity, funding with capital
contributions versus leasing of
capital assets, special allocations
of profits and losses and
preferences for certain
shareholders, etc.) and structuring
a compensation package for business
owners and key executives (e.g.,
fringe benefits, qualified and
nonqualified pension plans, stock
options, life insurance and other
compensation substitutes).
Determining the appropriate capital
and compensation structures are
essential components in selecting
the type of business entity to use
as well as in honing the tax
efficiency of a business enterprise.
However, before jumping into such
complex topics, business owners need
to understand some of the basics of
business structures, namely what
types of business entity should be
considered when starting or growing
a business.
OVERVIEW OF BUSINESS
ENTITIES
1. The Sole Proprietorship. A sole
proprietorship is the simplest form
of doing business since it does not
require the formation of a new legal
entity nor does it require that
assets be transferred to such an
entity. Because of its simplicity,
the sole proprietorship is the most
frequently used structure (or lack
thereof) for small start up
businesses. But the simplicity of a
proprietorship can also be its
biggest disadvantage in the long
run. For instance, all profits are
immediately taxed to the proprietor
and the proprietor directly bears
all the business risks associated
with the operation, including
unlimited personal liability for all
debts and obligations arising out of
the operation of the business. In
other words, because there is no
separation between the business
entity and the individual, the sole
proprietor has unlimited liability
for the debts of the business,
including exposure to any judgments
arising out of lawsuits relating to
business activities.
a. Formalities of Sole
Proprietorships. A sole
proprietorship requires little
in the way of compliance or
housekeeping formalities. The
proprietor may be required to
file a fictitious business name
statement in order to transact
business under an assumed name
and must obtain the appropriate
business licences, permits and
workers compensation insurance
for employees. But apart from
such basic requirements (most of
which apply to all employers)
the owner of a sole
proprietorship can avoid many of
the formalities of other
business structures such as
partnership or operating
agreements, articles of
incorporation and bylaws, and
other formalities such as annual
shareholders meetings and
resolutions.
b. Other Tax Characteristics.
Because the proprietorship is
not a separate tax-reporting
entity, all profits and losses
are directly attributed to the
individual and reported as
personal income (or loss) on his
or her individual income tax
return. This can be beneficial
in the case of a start up
company because early losses can
generally be deducted as
ordinary losses by the
individual proprietor. A
shareholder of a corporation
generally does not have this
advantage unless an
S-Corporation is used. Earnings
of a proprietorship are treated
as earnings from self employment
for purposes of the
self-employment tax which is
15.3%, made up of social
security (12.4% OASDI) and
medicare (2.9%) components.
c. Weighing the Pros and Cons.
Because of the relative
simplicity of operating a
business as a sole
proprietorship, many businesses
start out with this format.
However, because of the
potential drawbacks such as the
potential unlimited liability of
the owner for business debts and
lawsuits, most successful
businesses graduate to one of
the other structures discussed
below. Good insurance coverage
is essential for the sole
proprietor.
2. Partnerships -- General and
Limited . A partnership can either
be a general or a limited
partnership. In either situation,
the partnership is an association of
two or more persons who intend to
carry on business or investment
activities as co-owners for profit.
In a general partnership, all
partners are presumed to have the
same level of participation (i.e.,
the same basic management powers,
duties, and responsibilities) as the
other general partners. In a limited
partnership, the general partner or
partners have exclusive management
authority and the limited partners
are limited in their ability to
participate in management and
control of the business.
a. Formalities of Partnerships.
In addition to the formalities
applicable to sole
proprietorships, partnerships
must also have a partnership
agreement. The partnership
agreement can be oral, but for
obvious (and not so obvious)
reasons it is much preferable to
have a written partnership
agreement. In order to operate
as a limited partnership, the
partners must file a Certificate
of Limited Partnership
(California Form LP-1) with the
Secretary of State in addition
to having an agreement.
Generally, assets must be
transferred to the partnership
in the form of capital
contributions. A limited
partnership interest is
generally treated as a security
so various securities law
requirements must be met in
issuing interests.
These formalities add to the
cost of forming and operating a
partnership, but the costs are
often less than the costs of
formation of a corporation.
Partnerships are enormously
flexible business structures and
to take full advantage of this
fact it is best to use a lawyer
who is familiar with both
partnership law and tax law.
While the necessity of drafting
a partnership agreement will add
to the expense of formation, the
expense is justifiable and can
be amortized (i.e., deducted)
over a five year period.
b. Partnership Tax
Characteristics. A partnership
is a separate tax reporting
entity for income tax purposes
and must file separate
informational returns (Federal
Form 1065 & CA Form 565). But a
partnership does not pay tax as
an entity. Rather, all the
income, deductions, and other
tax attributes of a partnership
are allocated directly to the
individual partners generally in
accordance with the partnership
agreement. The income tax
attributes flow through to the
individual partners as specified
on Form K-1 (Profits and Losses
of Partner). There is a great
deal of flexibility on dealing
with the tax attributes provided
the agreement has "substantial
economic effect." Limited
Partnerships must pay a separate
"franchise tax" for the
privilege of doing business in
California that format.
c. Partnership Liability Issues.
The primary legal disadvantage
to using a partnership as a
business entity is that general
partners are exposed to
unlimited liability for the
debts and lawsuits that arise in
connection with the business,
even when such liabilities are
based on the acts or omissions
of another partner. This is the
result of the fact that partners
are "jointly and severally
liable" for the debts and
obligations of the partnership.
Joint and several liability
means that any one general
partner can be forced to pay the
entire partnership debt or
liability regardless of whether
other general partners were the
source of the liability.
However, in a properly formed
limited partnership those
partners designated as "limited
partners" generally only have
exposure for liabilities to the
extent of their capital
contributions (and obligations
for contributions) to the
partnership as detailed in the
partnership agreement.
Contribution and tax provisions
of the partnership agreement
could unwittingly expose limited
partners to additional liability
over and above their
contributions. Nevertheless, a
limited partner is generally
said to have limited liability.
The only way to mitigate the
liability exposure of the
general partner in a limited
partnership is to use an entity
such as a corporation as the
general partner.
3. Corporations -- Regular and
Subchapter S. A corporation is the
only type of business entity that is
treated as a separate legal person.
There are a number of advantages and
disadvantages to this fact which
should be considered when selecting
an entity. The primary advantage is
the limited liability for the
shareholders while the disadvantages
typically are the potential double
taxation and the costs of compliance
with the numerous formalities that
come with properly operating a
business as a corporation.
a. Corporate Formalities. The
formalities which must be
observed to preserve the
advantages of corporate
existence are more numerous than
with other legal entities. In
addition to the formalities
required of a sole
proprietorship, a corporation
will not validly exist unless
articles of incorporation are
filed with the secretary of
state in the appropriate format.
The incorporator must appoint an
initial director or directors
and corporate bylaws must be
adopted and approved. An
organizational meeting must be
held electing Directors and
Officers of the Corporation.
Assets must be transferred to
the corporation. Unless a
shareholder's agreement is
drafted and a close corporation
format is used, annual meetings
of shareholders and directors
must be held at which directors
and officers are elected,
compensation issues are
resolved, major transactions are
approved or disapproved, and
numerous other items are dealt
with. Many major (and some
minor) actions cannot be taken
without approval of the
directors and/or shareholders.
These include such minor things
as resolutions to authorize an
officer to open a bank account
as well as major transactions
such as approving a lease or
purchase of real estate. An
annual Statement of Domestic
Stock Corporation must be filed
with the Secretary of State.
b. Taxation of a Corporation. A
corporation is a separate legal
entity both for tax reporting
and tax paying purposes. Thus a
regular corporation is subject
to federal and state income
taxation on its earnings at the
corporate level. However, when
these earnings are distributed
to the shareholders of the
corporation on liquidation or by
dividends, those shareholders
are also taxed on their receipt
of corporate profits, unless the
payments are made in the form of
reasonable compensation rather
than for services rendered. This
results in double taxation which
is one of the principal
disadvantages of using a
corporation. All corporations
are also subject to a minimum
franchise tax for the privilege
of doing business as a
corporation in California.
There are a number of ways to
minimize or even eliminate the
double taxation of a regular
corporation through the
manipulation of the compensation
structure. The advantage to
doing this is that regular or
C-Corporations are entitled to a
number of tax-advantaged fringe
benefits that are not fully
available to other entities. But
beware of holding appreciating
assets in a C-Corporation. Under
some circumstances a corporation
can elect to be treated as an
"S-Corporation" for income tax
purposes. This status enables
the corporate level income to be
taxed immediately to the
shareholders, rather than to the
corporation. The intent is to
emulate, more or less, the tax
treatment of a partnership,
although there are a number of
distinct differences.
The primary benefit of an
S-Corporation is that it limits
the potential for corporate
double taxation while still
achieving limited liability (if
correctly formed and operated)
for its shareholders. If you are
going to hold appreciating
assets in your corporation, you
should consider using an
S-Corporation.
c. Liability Issues for
Corporate Shareholders. In
general, shareholders are not
personally liable for corporate
obligations (assuming they have
not independently agreed with
some creditor to be liable for
those obligations as is the case
if they issue a personal
guarantee). In other words,
shareholders are generally said
to have limited liability in
that their risk of exposure is
limited to the amount of their
contribution to the corporation.
A number of circumstances exist
for "piercing the corporate
veil" and, thereby, holding
shareholders individually liable
for corporate debts. These
include inadequate
capitalization and failure to
keep up with corporate
formalities such as annual
meetings. 4. Limited Liability
Companies. One of the newest
forms of legal entities is the
Limited Liability Company.
Wyoming was the first state to
introduce this entity dubbed by
its acronym, LLC.
Limited Liability Companies were
designed to provide the best of
both worlds of partnerships and
corporations. An LLC generally
will be treated for Federal and
State income tax purposes as a
partnership (although it can
elect to be treated as a
corporation). Unlike a
partnership, however, an LLC
provides all its member-owners
with liability protection
similar to that available to
shareholders of a corporation.
Unfortunately the California
legislation is probably the most
restrictive in the nation. The
LLC format is not available in
California for any type of
business which requires a
license under the California
Business and Professions Code.
This excludes a great many types
of business, including all
professionals (e.g., architects,
attorneys, doctors,
veterinarians) and any other
business which requires a
license, including
cosmotologists, appraisers, real
estate brokers and developers,
mortgage brokers, etc.
SOME FINAL THOUGHTS
Regardless of the type of legal
entity a person selects for his or
her business, the first line of
defense against casualty losses and
liability hazards should be
insurance. The business owner should
always carry adequate insurance
coverage for known or reasonably
foreseeable risks such as fire,
automobile accidents, slip and
falls, worker injuries and the like.
This means obtaining automobile,
fire and casualty insurance, general
liability coverage and workers
compensation insurance as an
integral part of protecting the
owner's personal assets from the
numerous risks associated with
owning a business.
Another way to shelter some assets
from lawsuits is to establish a
Qualified Pension or Profit sharing
plan for your retirement savings
rather than using one of the various
forms of IRAs (e.g., Roth, SEP/IRA,
Simple IRA, etc). This is because
IRAs are not exempt assets in a
bankruptcy proceeding and,
therefore, are exposed to creditors
and lawsuits. Qualified plans,
including 401Ks are typically exempt
in bankruptcy proceedings.
As with most subjects, there are
many complexities involved in the
selection of a business entity.
Determining which type of entity
will be most beneficial to an
individual business owner will
depend upon a number of variables
that are beyond the scope of this
article. You should not make
decisions on the selection of an
entity without consulting your tax
and legal advisers.
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