Business Entities (Part I)

Starting a business? Choosing which type of entity to conduct your business (Partnership, Corporation, Limited Liability Company etc.) is a critical decision which should be made as early as possible. Do you already own a business? Perhaps the type of entity already chosen by or for you may not be in your best interest. Should you change? At what cost? Regardless of the entity, do you have an agreement among your co-owners in writing? If not, you should. These issues will be discussed in this and succeeding posts.

The first question is why should you care. The most important reasons are that you want to pay as little tax as possible and you want to keep your personal liability for business debts to a minimum. Different entities provide varying levels of tax and liability protection. There are other factors to be considered in selecting a business entity such as continuity of a business’s life, centralization of its management and free transferability of an owner’s interest in the business, but taxes and liability protection generally take precedence.

The possible entities that can be used to conduct a business are as follows.

SOLE PROPRIETORSHIP
This is an unincorporated single owner business. The sole proprietor is personally liable for all of the business’s debts. The income of the business though is taxed only once, on the owner’s personal income tax return. There are no penalty taxes. The business terminates upon the owner’s death, so there is no continuity of life. The authority to manage the business is held by its owner. Transferability of the owner’s interest is difficult.

PARTNERSHIP

This is an unincorporated multi-owner business. All General Partners are personally jointly and severally liable for all of the business’s debts. Jointly and severally means that each General Partner can be liable to a creditor for the entire amount of the debt, not just for their proportionate share. Limited Partners though are not personally liable unless they participate in the management and control of the business. Like a sole proprietorship, the income of the business is taxed only on each Partner’s personal income tax return and there is no possibility of penalty taxes. There is no centralization of management at least in a General Partnership because as a matter of law, every General Partner is entitled to manage the Partnership. There is also no continuity of life of the business or free transferability of a General Partner’s ownership interest because again as a matter of law, the Partnership terminates upon the death of a General Partner. Limited partnership interests are sometimes freely transferable.

CORPORATION

This is an incorporated legal entity separate and distinct from its owners. The owners (shareholders) are responsible for the business’s debts only under rare and unique circumstances. The income of the business is taxed to the corporation at corporate tax rates. Distributions to shareholders are taxed on the shareholders’ personal income tax returns, thus resulting in a double tax. There is also a potential for penalty taxes such as the Personal Holding Company Tax, the Accumulated Earnings Tax and the Corporate Alternative Minimum Tax. The shareholders of certain “Small Business Corporations” though can elect to pay tax personally on the Corporation’s business income, effectively eliminating the double tax. Such a Corporation is called an S Corporation. If no such election is made, the entity is termed a C Corporation. Because a Corporation is a separate entity, there is centralization of management and continuity of life. While there is no legal prohibition on transferring an owner’s interest, most closely held Corporations would be well advised to consider such a prohibition in their shareholder agreements..

LIMITED LIABILITY COMPANY (LLC)

This is an unincorporated legal entity separate and distinct from its owners. It is not a Corporation. The owners (members) are generally responsible for the business’s debts only to the extent corporate shareholders would be so liable. The owners can actually choose how the LLC’s business income will be taxed. The income would normally be taxed only once at the personal level although an election can be made to treat the LLC as a Corporation in which case the possibilities of double taxation and penalty taxes exist. Such an election would rarely be made by an entrepreneur. By law, there is neither centralization of management, continuity of life nor free transferability of the owner’s interest unless the members decide otherwise.

It seems rather obvious that in the vast majority of circumstances an entrepreneur would prefer an LLC over the other choices. The next post(s) will explore the advantages of each entity in more detail and raise the question whether an existing entity should convert to an LLC and if so, at what cost.