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When starting a new business, it is critical to start with a solid foundation. One of the first steps in forming many new businesses is to separate personal assets from business assets, and to select and form a legal entity for the business to attempt to protect individual assets of the owner(s) from the liabilities that may be incurred by the business.
There are five principal kinds of business entities, each with different advantages and disadvantages. Choosing the correct entity depends on a number of factors, including liability issues, federal income taxes, state, local and self-employment taxes, multi-state tax and nexus issues, availability of liability insurance, personal needs, the number and type of owners and the requirements of the particular business. The 2017 Federal Tax Act has added some new considerations and complexity to the choice of entity analysis. Some businesses can benefit from a new pass-through entity tax rate for some part of their taxable income. Working with the client and their accountant, Williamson, Friedberg & Jones, LLC attorneys help clients select and form the best entity for their particular type of business, whether it be a sole proprietorship, general partnership, corporation, limited liability company or limited partnership. The firm’s attorneys work as a team with clients and their advisors on day-to-day business matters and business planning, tax planning and special projects. Detailed discussion on the relevant factors is recommended before the client makes a decision on which type of entity is most appropriate for his particular current and projected business.
When there is more than one owner, the owners should have a written Partnership Agreement, Shareholders Agreement, Operating Agreement or Limited Partnership Agreement, as applicable for the type of legal entity that they have chosen.
The five principal types of business structures are as follows:
Sole Proprietorships
General Partnerships
A general partnership is very similar to a sole proprietorship, except that two or more individuals are owners of the business. Each Partner in a general partnership is generally liable for all the debts and claims against the business.
The advantages of a partnership include:
- Relatively simple structure
- Easy to establish
- Some tax advantages
However, there are some disadvantages:
- Unlimited personal liability of each partner if problems arise
- Any partner, acting alone, can commit the business to obligations
- Death of partner ends business
- Some tax disadvantages
Partnerships should have a partnership agreement. This should be a written document that addresses how the partnership will operate. The agreement should address management, control, the contributions expected of each partner, how profits and losses will be allocated, how and when distributions may be made, specify any guaranteed payments to partners, and also establish how the partnership can be terminated.
No formal filing is required to form a general partnership, but the general partnership must obtain certain tax numbers and registrations before starting business.
Corporations
The historically most common form of business entity is the corporation. With a corporation, owners are issued stock which represents their ownership interest. Owners of a corporation are referred to as “stockholders” or “shareholders”. The shareholders elect a board of directors who have the power to make major business decisions effecting the business. The Board of Directors elect the officers of the Corporation who are responsible for the day to day operations of the business.
The advantages of forming a corporation include:
- Liability of each shareholder limited to the amount he or she invested
- Corporation survives the death of an owner
- Transfer of ownership simplified
- Some tax advantages
- S Corporation Election almost always essential
- Self Employment Tax advantage possible
- Lease real estate from separate entity
Some of the disadvantages include:
- More expensive to form
- More ongoing paperwork and record-keeping
- Separate tax returns for the entity
- Payroll tax issues for owners
To form a corporation the shareholders transfer items of value (money or property) in exchange for the corporation’s stock. In Pennsylvania, a corporation is formed by filing Articles of Incorporation with the Department of State. Corporations that have already been formed in another state or country can file an application for a “Certificate of Authority” which permits that corporation to conduct business within Pennsylvania.
There are different types of corporations under federal and state tax law, including “C” corporations and “S” corporations. Your attorney and tax advisor can discuss the differences with you, and help guide you with this decision.
Limited Liability Companies
The Limited Liability Company (LLC) is the newest type of business organization, and has become very popular and is often, but not always, the best choice. The owners of the LLC are called members. The LLC can be managed by the members (a “Member managed LLC”) or by managers (a “Manager managed LLC”). This decision is initially made at the time of formation when the Articles of Organization are filed. Most states permit members to be individuals, corporations, foreign entities, and even other LLC’s. In many states, but not all, a single member (individual, corporation, foreign entity or another LLC) can own the entire LLC.
An LLC is a separate business entity and the liability protection may be similar to the liability protection afforded by a corporation. An LLC with 2 or more owners (called members), is treated for tax purposes like a partnership unless the LLC elects to be taxed like a corporation (which might be eligible to make a Subchapter S Election). An LLC with only one member (sometimes referred to as a single member LLC) is a disregarded entity for IRS tax purposes and is taxed like a sole proprietorship unless the LLC elects to be taxed as a corporation (usually a mistake unless an S Election is timely made by the LLC). The decision on whether to select an LLC or a Subchapter S Corporation is usually based upon an analysis of competing tax considerations.
The advantages of forming a limited liability company include:
- Flexibility in allocation of Profits and Losses and Distributions
- Usually taxed similar to a partnership rather than an “S” Corporation
- Fewer formal requirements than a corporation
Some of the disadvantages include:
- Self Employment Tax Issues
- PA Capital Stock Tax
- Corporate Clearance Certificate on sale
- Detailed Operating Agreement is essential
- If single member, taxed as sole proprietorship
- Same liability protection as corporation not certain in all states
Limited Partnerships
A limited partnership is a separate form of business entity that is a hybrid between a general partnership and a corporation. A limited partnership has two distinct types of owners, one being general partners and the other being limited partners. Limited Partners might be described as investment partners who invest in the limited partnership and are entitled to a share of the profits, losses and distributions from the limited partnership. Limited Partners generally have no right to participate in the management or the day to day decision making of the business operated by the limited partnership. The general partner(s) of the limited partnership have the management powers and duties with respect to the business of the general partnership and the general partner is generally liable for all the debts and obligations of the limited partnership. In contrast, limited partners are not liable for the debts and obligations of the limited partnership and only the amounts that limited partners invest in the limited partnership are at risk of loss. If a limited partner participates in management activities of the limited partnership, the limited partner may lose his or her liability protection. It is often recommended that a separate legal entity be formed to act as the general partner of the limited partnership to provide liability protection to the individuals who own the general partner interest. The separate legal entity that is formed to be the general partner is often an LLC or a corporation.
The advantages of forming a limited partnership include:
- Liability protection for the limited partners
- Flexibility in allocation of profits and losses and distributions
- Separate management interests from investment interests
- Often used for real estate businesses or investments
- Family limited partnerships are used for business and estate planning
Some of the disadvantages include:
- A detailed limited partnership agreement is essential
- Recommended that two separate entities are formed
- Limited partners should not be involved in management
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