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Choosing the Right Business Entity

Updated on June 18, 2009

Intro to Business Entities

If you have been thinking about starting a business or placing your existing business into a formally organized entity, it is important to give due consideration to the type of entity that you choose. First, make sure you understand the various business entities under your state's law or the state in which you choose to form the entity. Below is brief introduction to the types of business entities available in most states.

Sole Proprietorship

A sole proprietorship is not really a separate entity per se. Rather a sole proprietorship is the designation given to a business form that is essentially your alter ego. It is you "doing business as" a given type of business. In a sole proprietorship, the owner is fully exposed to any liabilities of the business. Additionally, sole proprietors have to pay self-employment tax to the IRS on the income generated from the business.

Corporations

A corporation is probably the most formal and complex form of business entities, usually reserved for larger entities or those that expect to go public. Typically, a corporation will have officers, who run the business in its day-to-day operations. Additionally, most corporations feature a board of directors who serve as overseers of the corporate structure and big picture direction of the corporation's ventures. Finally, ownership of a corporation is found in its shareholders, who own stock in the corporation and have little input on corporate decision-making for all but the most serious issues. Shareholders, however, have the power to elect directors who have the decision-making power.

Corporations are taxed separately from their shareholders based on the profits and losses of the corporation. Additionally, shareholders pay taxes on dividends that they receive when the corporation compensates them by distributing profits. (The dividends are taxed at a lower rate than ordinary income though.) This is why you sometimes hear the phrase 2-tier taxes on corporations.

Note, however, that a type of corporation called an S-Corp is available to form based on Subchapter S of the Internal Revenue Code, which disposes of the 2-tier tax and allows only shareholders to pay taxes on earnings of the corporation. This is called a "pass through" tax, which makes sense because the taxing responsibility passes through the corporation and on to the shareholders. The previous-mentioned 2-tier taxation scheme applies to C-Corps, based on Subchapter C of the Internal Revenue Code.

Corporations offer limited liability for officers, directors and shareholders. The corporate form acts as a shield from liability for all parties involved. In most cases, shareholders are only placed at risk for the value of their investment. Creditors of the corporation cannot come after shareholders for debts of the corporation. Officers and directors have no liability to third-parties as they relate to the corporation so long as the officers and directors fulfill the fiduciary duties of the roles.

General Partnerships

A partnership is a business form that arises by operation of law in most states when two or more people or entities join together for a business endeavor for the purpose of sharing profits. Typically, only a general partnership can be created without some filing in an official state office. In a general partnership, all partners share responsibilities in the performance of the business' goals. Likewise, the partners share in profits and losses on a pro-rata basis, unless they agree otherwise.

General partnerships are subject to the pass through tax like an S-Corp or a sole proprietorship. As a result, general partners also have to pay self-employment tax because the partners are treated like sole proprietors for federal income tax purposes.

Partners in a general partnership are joint and severally liable for liabilities of the partnership. This means that any creditor can look to any single partner in a for satisfaction in full of any liability of the partnership. Typically, this results in creditors coming after the "deep pockets" partner in a general partnership.

Limited Partnerships

In a limited partnership, there must be at least one general partner who is reponsible for operation of the partnership and who is liable for the liabilities of the partnership. Other limited partners must join in to serve as investors in the partnership. These limited partners are much like shareholders in a corporation. They have no control over the day-to-day operations of the business; however, they are also exposed to limited liability for the debts of the partnership. Typically, a limited partner is only at risk of losing their investment for owning a stake in the partnership.

Limited partnerships are also subject to the pass through tax like general partnerships. As a result, the entity pays no federal income tax. As is true with the other entity forms, however, states may impose different taxation schemes than the federal government. In limited liability entities, like limited partnerships, states often impose a franchise and excise tax on them as a sort of tax for the privilege of having limited liability. Essentially, these often amount to a state income tax on the business entity.

Limited Liability Companies

A limited liability company, or LLC as it is often called, is a hybrid sort of entity that gained popularity in the 1980s. It has many features of the corporation in the form of liability protection, yet it functions much like a partnership in taxation and governance functions. LLCs are very popular for small businesses due to their simplicity of organization and managment flexibility.

The governance options vary somewhat from state to state; however, it is typical to see a member-managed LLC, a manager-managed LLC or a board- (or director-) managed LLC.

In a member-managed LLC, the members both own and manage the day-to-day operations of the company. In a manager-managed LLC, the members own the company, yet they appoint a person or persons to manage the day-to-day operations of the company. Finally, in a board- or director-managed LLC, the members act more like shareholders, who appoint a board to manage the company by overseeing employees and officers, much like a corporation's board of directors.

LLCs are taxed like partnerships for federal income tax purposes. That is, the tax responsibility passes through the entity and becomes the responsibilty of the individual members of the LLC on the same basis on which they share profits and losses.

In recent years, LLCs have become even more flexible through state actions that have empowered members to tweak the structure and operation of an LLC through a contract called an operating agreement. The operating agreement sets forth the terms of the company's operations and ownership rights among the members. In many cases, the terms of the operating agreements may override statutory default rules regarding the goverance of LLCs.

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