The following descriptions will give you a basic understanding of each entity listed. For answers to your questions or more detailed analysis of a particular entity or entities please contact us.
There are six different business legal entity structures, each offering certain benefits.
A sole proprietorship is simply “you doing business.” No filing requirements and no formal paperwork is necessary unless you are operating under a fictitious name in which case you will need to file a d/b/a with the appropriate government agency.
As a sole proprietor you report your income on schedule C of your federal tax return. The main downside of a sole proprietorship is the unlimited risk of liability that you face as you and the business are considered one and the same by the courts. Everything you own is at risk. If your business goes bankrupt, you will have to file for personal bankruptcy as well. There are also a number of tax advantages to forming an entity that are not available to the sole proprietor.
A general partnership is formed when two or more individuals or entities agree to carry on business together for a profit. There may or may not be a written agreement.
The partnership itself does not pay taxes, but instead files an informational return on IRS form 1065 which summarizes the income, expenses and the profit or loss of the partnership business. All profits or losses flow through to the partners and are reported on schedule E of their respective individual income tax returns. The partnership will send each partner an IRS form K-1 explaining their share of the profit or loss.
A general partnership affords no liability protection for the partners, and in fact, any partner can be held jointly and severally liable for the tortious acts of the other partners.
A corporation is an entity that exists separate and apart from its shareholders. To establish a corporation, “articles of incorporation” must be filed with the appropriate secretary of state, and the list of officers and all annual fees must be maintained. The corporation issues stock to the owners/shareholders, the shareholders elect a board of directors and the directors appoint the officers of the company.
The major decisions are made by the board of directors noted through minutes of meetings and/or resolutions while the day to day operations are performed by the officers of the company.
In most states one individual can act in all capacities – director, president, secretary and treasurer. It is important to disclose which capacity he/she is acting in when making various decisions and taking various actions.
There are two types of corporations for tax purposes, C-corporations and S-corporations. All corporations start out as C-corporations. You must make an election — a choice — on form 2553 with the IRS to be taxed as an S-corporation.
All large, publicly traded corporations are C-corporations as well as many small and family owned businesses. C-corporations file their own tax return on IRS form 1120, and they pay their own taxes which can be considerably lower than some personal rates on the first $50,000 to $100,000 of net income. If those profits are later paid out to the shareholders, they are taxed again as dividends. The current tax rate on dividends has a maximum rate of 15%.
An S-corporation is a “flow through” entity. It files an informational return on IRS form 1120-S, and reports the shareholder’s profit or loss on form K-1. A big advantage to the S-corporation is the reduction in self employment taxes that can be taken.
The S-corporation has some ownership restrictions in that it can only be owned by US citizens, another S-corporation or a single member LLC, and it can have no more than 75 shareholders.
A limited partnership is made up of at least one limited partner and one general partner. Most states require that a limited partnership certificate along with the required fees be filed with the secretary of state in order for the limited partnership to become effective.
Limited partners generally have no liability over and above their contributions to the partnership, and they are not liable for the tortious acts of the other partners. In exchange for this limited liability, the limited partners must give up all rights to participate in the control and management of the partnership.
The general partner controls and manages the partnership including any disbursement of cash to the limited partners. The general partner has unlimited liability to the creditors of the partnership including wrongful conduct within the partnership business to third parties.
The limited partnership does not pay federal income tax, but files an informational return on IRS form 1065, and issues K-1’s to the limited partners. The partners must pay federal income tax on their proportionate share of any income whether or not it is distributed.
Creditors of individual limited partners cannot replace a limited partner, but may only receive the partner’s share of distributions, if any. This benefit to the limited partner is called a “charging order.” The creditor receives no right to participate in the management of the partnership.
Limited liability Companies (LLCs) are formed by filing “articles of organization” with the secretary of state. The LLC is owned by members rather than shareholders, and, like the shareholders of a corporation, are not liable beyond their contributions to the LLC. Unlike a limited partner, members can participate in the management of the company.
The LLC can be run by its members or by a manager which can be either a corporation or an individual who may or may not be a member. When an LLC is “manager-managed” (as apposed to “member-managed”), it is similar in operation to a limited partnership. The manager makes all the day to day decisions and signs for the obligations, but, unlike a general partner, is not liable for the debts or other obligations of the company. When the LLC is managed by its members, all of the members can participate in the management and control of the company. The members, however, are not liable for the debts and other obligations of the company. The decision on how the LLC will be managed should always be spelled out in the “operating agreement” – the replacement to the bylaws in a corporation.
LLCs with two or more members are taxed as a partnership with the LLC filing an informational return on IRS form 1065. The members receive a K-1 reflecting their proportionate share of profit or loss.
The LLC is the only entity that offers the flexibility of a partnership with all of the protection of a corporation. The LLC is an excellent tool for asset protection as it offers ease of operation, tax savings and maximum protection. The charging order mentioned under the limited partnership section of this page is also applicable to the LLC.
An LLC can also be owned by one member only, providing the protection as above, but with the simplicity of being a disregarded entity for tax purposes. The income flows directly to the individual’s or entity’s tax return with no filing requirements of its own. The “single member” LLC is also the only entity that can be used for 1031 real estate transactions when owned by an individual.