Business Entity Types
Before starting a business, the owner should decide how to conduct the business–should it be an entity; if so, what are the entities available; which one should be picked; once it is picked, how does it get formed; and once it is formed, how should it be run. Like any other decision-making process, a mistake at the beginning of the process can have far-reaching and possibly adverse results.
An owner may choose one of several ways of conducting the business. These range from a sole proprietorship to general and limited partnerships, corporations, and limited liability companies. Each has different features, benefits, and drawbacks.
Sole Proprietorships are businesses owned and operated by a single person and are the simplest form of organization. The owner is responsible for all debts and claims against the business. This includes all business debts and any obligations for actions by the business, the owner, or employees. All business profits pass directly to the owner with no business income taxes.
General partnerships and joint ventures involve two or more partners who jointly carry on a business for a profit. All partners are personally liable for everything done by any partner, the partnership, or its employees. Partnerships can be created by an oral agreement or by a written agreement. All income and losses flow through to the partners who will pay taxes on net income or deduct net losses against other income, if any. The partnership must file a partnership tax return and send each partner a tax document called a K-1 showing its share of net income or net losses. A well drafted written partnership agreement can prevent many disagreements, including ownership percentages and what happens when a partner dies, becomes disabled, or is involved in a divorce. These, plus many other contingencies, should be addressed, agreed upon, and reduced to writing in a partnership or joint venture agreement before trying to run a business as a partnership.
Limited partnerships have at least one general partner who is personally liable for all partnership debts and for managing the partnership's business and operations. Limited partners, subject to applicable legal theories letting creditors pierce the limited partnership and holding them liable, generally will have no liability for limited partnership obligations beyond their capital contributions (money contributed to the limited partnership). Like general partnerships and joint ventures, limited partnerships file tax returns, and issue K-1 tax statements to both the general and limited partners, who then include the net income or losses on their tax returns.
Limited Liability Companies
Limited liability companies are relatively new business entities in most states. LLCs limit the liability of their members but can enjoy the same tax benefits as sole proprietorships and partnerships.
There are two types of corporations: Subchapter C Corporations (sometimes called C Corporations) and Subchapter S Corporations (often called S Corporations or sub-S Corporations). The subchapters refer to the Internal Revenue Code subchapters dealing with how corporations and their shareholders are taxed. Both types of corporations help shield shareholders from corporate debts and liabilities, again subject to veil piercing theories that may hold shareholders liable for corporate debts. S Corporations are limited in the number and types of shareholders they may have. Their profits pass directly to shareholders, who then pay taxes on them.
Subchapter C Corporations include most large, publicly held businesses and many older businesses formed before there were viable alternatives. Shareholders are protected from most corporate debts and liabilities. Profits are distributed to C Corporation shareholders as dividends subject to double taxation. C Corporations must pay business income taxes, and shareholders must pay personal income taxes on dividends received from the C corporation.
Significance of Entity Choice
The business structure one chooses will carry consequences affecting several key business areas:
Taxes– What amounts and types of taxes are owed and by whom
Management–Who manages the business
Liabilities–Who is ultimately liable for debts and obligations of the business
Succession– How ownership can be transferred by sale, gift, dissolution, or death
The business organization should be chosen carefully and thoughtfully. Although you may change entity types if business needs require, the ability to switch between different entity types may be limited, difficult, and/or expensive.
This informational article from the law offices of Thomas D. Solomon is provided as a courtesy to provide an overview of buying or selling commercial real estate. It is not and is not intended to be an exhaustive treatment of its subject matter but a presentation of some elements of such transactions. It is not intended to be legal advice or a legal opinion and should not be relied on in making legal or business decisions. If you have questions, please call or email.