FAQ's - Choosing a Business Structure

What are the most popular forms of business?

They are: Proprietorship, General Partnership, Limited Partnership, Limited Liability Company, Corporation and S Corporation.

Proprietorship is the simplest form of business ownership since no formal legal action is necessary to establish it. Unfortunately, as a proprietorship the owner is personally liable for any debts and actions of the business and must pay taxes on all income as it is earned.

A General Partnership is a business with two or more persons (or entities) owners, usually all are active participants in the business. Legal documents need not be created to form a partnership. In fact, the law may construe a partnership when two or more are working together even if the entities do not intend there to be a partnership. However, a formal partnership agreement is usually used to document the division of responsibilities and benefits. Each partnership is fully liable for all debts and actions of the partnership by any partner. A General Partnership is taxed as a pass-through entity, meaning that each partner, and not the partnership, will pay tax on their share of the firm's income (or loss).

A Limited Partnership (LLP) is a hybrid between a partnership and a corporation. It has one or more general partners and one or more limited partners. The general partner(s) is fully liable for the partnerships debts and actions. The limited partner(s) is liable to the partnership or creditors for the amount of money the limited partner agrees to invest in their partnership interest. A limited partner does not have to be an active worker in the partnership. A Limited Partnership is taxed as a pass-through entity similar to the General Partnership.

The Limited Liability Company (LLC) is also a hybrid organization possessing characteristics of both corporations and limited partnerships. The owners are called "members" and are only liable to the company or creditors for the amount of money each agrees to invest in his/her membership interest, similar to limited partners in a Limited Partnership. However, unlike a Limited Partnership, no member is liable to the extend of a general partner. The members are bound by and the LLC is governed under an "operating agreement," similar to a partnership agreement. There are two basic types of LLC's: member-managed and manager-managed. In a member-managed LLC all members have management responsibility. In a manager-managed LLC the management responsibility is delegated to one or more persons, who may or may not be a member. Members and managers of LLCs are not liable for the obligations of the LLC unless they voluntarily agree to assume such liabilities. A LLC can be taxed as either a partnership or as a corporation, as determined by an election made by the founders. Usually, a partnership tax treatment is elected so the firm has both the limited liability of a corporation and pass-through taxation of a partnership. Recently, the Internal Revenue Service provided guidance on how to classify LLCs as partnerships. Care should be taken in structuring the operating agreement so that the LLC will lack certain "corporate characteristics," thereby allowing it to be treated as a partnership. An LLC will be the preferred entity only if it can be classified as a partnership. A single member LLC can be taxed as a corporation or as a proprietorship. The North Carolina Limited Liability Company Act was adopted in 1993. LLCs have become increasingly popular alternatives to partnerships and S corporations. To form a LLC an Articles of Organization is filed with the Secretary of State and usually an operating agreement is established.

A Corporation (often referred to as a "C" corp.) is owned by any number of shareholders. Their liability is limited to the amount that each invested for their stock. Shareholders elect directors, who, in turn, hire or elect officers. Shareholders pay taxes on the dividends that are paid by the corporation out of its after-tax profits. Thus, income taxes are paid twice - first by the corporation (possibly at a lower rate than the personal income tax rate) and then by the stockholders for their dividends. Losses of the corporation are not passed on to the shareholders for tax purposes. A corporation may retain earnings to fund future growth and not issue dividends, creating the possibility that lower income taxes may be incurred overall. To form a Corporation an Articles of Incorporation must be filed with the Secretary of State.

An S Corporation is a "small" Corporation that the IRS has agreed to treat all of the owners as partners for tax purposes. For purposes of state corporate law it has the characteristics of a regular or "C" corporation. However, to satisfy special treatment by the IRS, it must have 75, or fewer, stockholders, generally only one class of stock, and must elect to be treated for tax purposes under the terms of Subchapter S of the Internal Revenue Code as a pass-through similar to a partnership. Stockholders may be certain trusts, estates and charitable organizations but cannot be a nonresident alien.

Do you need an attorney to incorporate?

No, an attorney is not a legal requirement to incorporate. You can prepare and file the articles of incorporation yourself; however, you need to be thoroughly versed in the laws of your state.

What are some of the key considerations in choosing between the various business structures?

(Click Here) for an Excel Spreadsheet that compares a Sole Proprietorship, LLC, Corporation, and a Subchapter S Corporations.

Comparison of LLCs to Partnerships
While an LLC is typically taxed as a partnership, there are some important differences between them. General partnerships offer no protection from liabilities. In limited partnerships, the general partner or partners are subject to unlimited liability. Moreover, if a limited partner substantially participates in the management of the limited partnership, he/she may risk being treated as a general partner and be exposed to unlimited liability. To achieve limited liability, limited partnerships are often structured by having the general partner be a corporation. However, such a structure may be too burdensome for a small business.

Unlike limited partnerships, participation in management by members of an LLC does not expose them to personal liability. While members of an LLC are not subject to the liabilities of the LLC, a creditor of an LLC (or partnership) may require as a condition for making a loan that the members (or partners) guarantee the debt. The LLC is more attractive than a limited partnership where there is a risk of non-creditor liability, such as tort liability, as no members would be at risk, whereas the general partner of a limited partnership would be exposed.

Comparison to S Corporations
An "S corporation" is a corporation that meets certain requirements and whose shareholders file an election with the Internal Revenue Service under which the net income of the corporation will be taxed to the shareholders themselves. Thus S corporations and partnerships (and LLCs) are similar in that income is allocated to and taxed to the owners. As with any corporation, S corporations offer the advantage of limited liability for its shareholders, except to the extent a creditor may require the shareholders to guarantee a loan to the S corporation.

An S corporation may have no more than 75 shareholders; there is no such limit on members of an LLC. Limitations are placed on the types of shareholders an S corporation may have. For example, an S corporation may not have a corporate shareholder; there is no such limitation in the case of an LLC. An S corporation may have only one class of stock, whereas an LLC can be structured so that members have varying rights such as to distributions and allocations. An S corporation may not own more than 80% of the stock of another corporation; there is no such limitation on LLCs.

If an S corporation or an LLC incurs losses, such losses will flow through to the shareholders or members. However, the ability to deduct such losses by the shareholders and members may differ. A shareholder of an S corporation may deduct losses up to his tax basis in his shares plus the sum of any loans made by him to the S corporation. Loans from third parties, however, are not included. In an LLC, the member may deduct losses up to his tax basis, including his loans to the LLC and his allocable share of all third party debts. Thus, where it is anticipated that there will be substantial third party debt, the LLC may offer the advantage of greater deductions by owners. There is also greater flexibility in allocating losses among the members of an LLC than among the shareholders of an S corporation.

S corporations are limited in the types of income they may receive. If an S corporation earns a substantial amount of passive income, such as dividends and interest, it may risk the loss of its S corporation status and the imposition of a corporate level tax. Generally, an LLC may receive passive income without adverse tax consequences, although special limitations are placed on LLCs (and partnerships) on investing in marketable securities.

Choosing between a S Corporation and a LLC.
It's smart to protect personal assets from business debts and liabilities. Both owners of S Corporations and LLC's enjoy limited personal liability. By contrast, sole proprietors and partners have unlimited personal risk.

Traditionally, business owners who chose to form an entity to protect personal assets but allow income/losses to be reported on a personal tax return had to create an S Corporation. Today, that can also be accomplished with an LLC. All 50 states and the District of Columbia recognize LLC's, and their popularity has soared. Nolo's Legal Guide for Starting and Running a Small Business states, "For the majority of small businesses, the relative simplicity and flexibility of the LLC make it the better choice. This is especially true if your business will hold property, such as real estate, that's likely to increase in value."

Both S Corporations and LLC's allow owners to avoid "double taxation" and to pay income taxes on a flow-through basis like sole proprietors and partners. However, LLC's are quickly becoming a preferred entity among small business. Here are some key examples of the benefits of an LLC verses an S Corporation:

• An LLC is simpler and faster to form. It may be formed in one step, while an S Corporation election with the IRS, by filing a simple form #2553, can only be made after a General Corporation is formed first.
• An LLC is not required to hold annual meetings or to keep formal minutes, while an S Corporation is required to do so.
• LLC members can split profits/losses in any way they choose. In an S corporation, shareholders must receive dividends according to the number of shares that they own, regardless of the amount of effort put into the business.
• An LLC can be owned by any combination of individuals or business entities. Only United States citizens and resident aliens may own an S Corporation. Other entities generally may not own an S Corporation.

While many business owners are enjoying the simplicity and flexibility of the LLC, it may not be the best choice in every case:

• Most states allow single-member LLC's, however Massachusetts requires two members. Married owners often accommodate this by naming a spouse.
• Enticing or compensating employees with stock options or stock bonuses requires forming a corporation since LLC's do not issue stock.
• S Corporation shareholders pay Medicare and Social Security tax only on money received as wages or salary, but not on profits received as dividends or that stay within the company. Under certain conditions, LLC members may need to pay Social Security and Medicare taxes on the entire amount of LLC profits. In particular, LLC's that provide professional services such as health, law or engineering should consult a tax advisor on this issue. By Karen J. Lange, The Company Corporationï¿?

How do I select a business structure based upon succession planning?
One of the most important decisions a business owner must make in estate planning is selecting the appropriate business entity. That decision will affect the income and transfer tax consequences to the owner and the family and the ease with which the business can be shifted from one generation to the next.

Gift Giving and the Business Entity
An immediate consequence of the choice of business entity is the ability of the owner to make lifetime gifts to the next generation. Making lifetime gifts of interests in the business is an essential part of the estate plan for three reasons:

1. the interest given away is removed from the owner's estate, thereby reducing the overall estate tax;
2. all appreciation in the value of the interest after the gift, is removed from the owner's estate; and
3. all income earned by the interest after the gift, is removed from the owner's estate.

C Corporation - Estate Issues
A C corporation, unlike a sole proprietorship, is a separate legal entity. As such, a C corporation has the right to sue or be sued, enter into contracts, and hold and dispose of property in its own name. More importantly, a C corporation is a separate taxable entity. Therefore, the major disadvantage of a C-corporation is double taxation. In other words, a C corporation pays income tax at corporate level on its earnings and then the shareholder pays income tax at the individual level on the after-tax earnings distributed as dividends.

Making gifts of stock of a C corporation is relatively simple. Usually, the business owner wants to maintain control over the business while making gifts to the younger generation. One way to accomplish this is to create two classes of stock- preferred stock and common stock. The only difference between the two classes is that the preferred stock has voting rights while the common stock does not. The owner can then make gifts of the nonvoting common stock to the younger generation and, by retaining the voting preferred stock, maintain control over the corporation.

Because the owner is giving away a minority interest, a discount from the value of the interest is available for gift tax purposes. The discount is based upon both the lack of control and the lack of marketability of the stock that the donee receives. A discount of 30% to 40% for both the minority interest and lack of marketability is generally considered reasonable.

S Corporation - Estate Issues
An S corporation is a corporation, which has made an election under the Internal Revenue Code to be treated as a pass-through entity for tax purposes. All income and losses are passed through to the shareholders, and there is no corporate level tax. The principal disadvantage of an S corporation is the strict requirements for making and maintaining the election.

One of those requirements is that an S corporation may have only one class of stock. However, differences in voting rights are disregarded so long as all of the outstanding shares have identical rights to distributions and liquidation proceeds. Therefore, an S corporation may be re-capitalized to create preferred stock and common stock if the only difference is the voting rights of the shares.

Another requirement is that an S-corporation may have no more than 75 shareholders. More importantly for estate planning purposes, with certain limited exceptions, a trust is not an eligible S corporation shareholder. That restriction challenges S corporation owners who wish to make lifetime gifts of stock to the younger generation.

Generally, the same valuation discounts that are available for gifts of stock of a C corporation are also available for gifts of stock of an S corporation.

Family Limited Partnership (FLP) - Estate Issues
Use of family limited partnerships has become an increasingly popular means of transferring the family business to the younger generation. In a limited partnership, the general partners have unlimited liability for debts incurred in the business and complete control of the management of the business. The limited partners are not liable for the debts and liabilities of the limited partnership in excess of their capital contributions and generally have no control or management rights. Consequently, the business owner can transfer earnings and appreciation to the next generation by making lifetime gifts of limited partnership interests while maintaining complete control by retaining a small general partnership interest. Again, valuation discounts of 30% to 40% for gift tax purposes may be appropriate. There are certain assets which should not be placed into a family limited partnership, including:

1. the family home;
2. individual retirement accounts and other qualified plan interests;
3. stock in an S corporation;
4. stock in a professional corporation;
5. risky assets, such as cars, planes, and boats that are likely to attract liability in the form of large lawsuits; and
6. personal use assets, such as art, jewelry, antiques, or other collectibles.