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Choice of Business Entities
In order to carry on a trade or business, a type of business entity
must be chosen. For all practical purposes, the four major business
entities for the current 2000 year are: sole proprietorship,
partnership, corporation, and limited liability company. For the
purposes of this discourse, all references will be made to the
active conduct of a business, rather than passive or
limited-activity types.
The most efficient way of selecting a business entity revolves
around trying to match the needs (present and future) of the
business and its owners in legal, financial, and tax-related areas.
In other words, this selection process becomes a form of a needs
analysis study. In some cases, it is relatively easy; in fact the
choice may be practically automatic. In other cases, it can be quite
complex to coordinate the current and future needs of both the
business and its owners.
There are a number of variables that should be addressed in this
process to help delineate it. Further, the advantages and
disadvantages of each type of entity from a legal and tax
perspective play important roles in the overall planning process.
Definitions Of The Four Major Types Of Business Entities
A good starting point is to first know what each of the entity
choices represents:
SOLE PROPRIETORSHIP: This is a self-employed individual who
operates a trade or business where all the tax consequences fall to
that proprietor, including all liabilities, debts, profits, and
losses.
PARTNERSHIP: An organization or association of two or more
participants who carry on a trade or business together, and allocate
the ownership and profit/loss aspects according to their contractual
terms. This partnership is a separate entity for tax filing
purposes, but not tax paying. Rather it is a form of a conduit where
income, losses, credits, and certain deductions are passed along to
the partners' tax situation instead. There is no liability
protection for the general partners.
CORPORATION: A separate, legal entity formed through a state
charter using articles of incorporation. It is authorized to perform
primarily all the business activities an individual can, including
such things as filing and paying taxes, signing contracts, and
making loans. It is formed through the issuance of stock or
securities. There are two main types: Regular ("C") or Subchapter S
("S").
LIMITED LIABILITY COMPANY(LLC): This is a hybrid, or
combination, with some of the features of a partnership and the
limited liability aspect of a corporation. To qualify as an LLC, it
can't have at least two of the main components of a corporation:
continuity, centralized management, transferability of ownership.
Thus, the two most significant features of an LLC are that it
affords the partners some degree of limited liability protection,
yet it still acts as a conduit like a regular partnership. This
choice is not available in all states, but the majority allow it.
While the list of determining factors for making the best choice for
the type of business entity can be quite long, an overview of the
more common ones that tend to affect the vast majority of businesses
is in order. In effect, the business owner selects the features or
attributes of the entity that best suit the current and future
combined needs of business and owner. This is not always easy since
many factors are not always so "black and white," but, rather, fall
into the "shades of gray" category. Nevertheless, the following
represents a list of the more common significant factors to compare
the business entity types:
LIABILITY OF OWNERS
Sole Proprietorship: Unlimited liability for business actions
Partnership: Unlimited liability for business actions
Corporation: Possibly limited to assets in corporation
LLC: Possibly limited to assets in company
TREATMENT OF INCOME/LOSSES
Sole Proprietorship: Taxable to individual proprietor
Partnership: Taxable to partners
Corporation: Taxable to regular "C" corporation; taxable to
shareholders for "Sub S"
corp on federal(and most states) level
LLC: Taxable to partners
CONTINUITY OF EXISTENCE OF BUSINESS
Sole Proprietorship: Ends with death of proprietor
Partnership: Ends with death, bankruptcy of partner or more than 50%
change of ownership
Corporation: Continues indefinitely
LLC: May end with death, bankruptcy of partner, or change of
ownership
TRANSFERABILITY OF INTEREST
Sole Proprietorship: Relatively easy transferability
Partnership: May require partner's approval
Corporation: Easy unless restricted by agreements
LLC: May require partner's approval
CHOICE OF TAX YEAR
Sole Proprietorship: Proprietor's tax year which is usually on a
calendar year basis
Partnership: Usually calendar year unless business purpose is met
Corporation: Can be calendar or fiscal for most "C" types. Must be
calendar for "Sub S" types unless business purpose and special
permission is granted
LLC: Usually calendar unless business purpose is met
EASE OF SETTING UP
Sole Proprietorship: Very easy, no state charter, or legal
agreements usually required, few
administrative, filing headaches
Partnership: Reasonably easy, but agreements are generally
recommended, state and federal tax identification numbers needed
Corporation: More difficult and costly, often requiring state
applications, legal paperwork, fees, state and federal tax
identification numbers to be filed
LLC: Somewhat more difficult than a regular partnership to qualify
for LLC status; agreements generally recommended, state and federal
tax ID numbers required
OWNERSHIP LIMITATIONS
Sole Proprietorship: Only the individual proprietor can own
Partnership: No limit
Corporation: No limit for "C" types; maximum of 75 qualified
shareholders for "Sub S" types
LLC: No limitations
EASE OF SHIFTING OF FUNDS IN AND OUT OF BUSINESS
Sole Proprietorship: Very easy; draw account is used
Partnership: Easy; partner's draw or capital account used, but must
be tracked
Corporation: More complicated for deductibility purposes, liability
protection, etc.
LLC: Easy; partner's draw or capital account used, but must be
tracked
MINIMUM RECORDKEEPING REQUIREMENTS
Sole Proprietorship: Easiest of the four entities; no balance sheet
requirements, no accounting to other owners, partners
Partnership: Fairly complicated, especially if partners' capital
accounts are tracked
Corporation: Complicated; balance sheet requirements, minutes of
meetings, resolutions, other "arms length" requirements to be met
LLC: Fairly complicated, more so than regular partnership to keep
qualifications as LLC intact
MANAGEMENT TYPE
Sole Proprietorship: A centralized system with sole owner
Partnership: Not centralized; partners' agreements usually required
Corporation: Centralized with appointment by board of directors
LLC: Not centralized; partners' agreements usually required
AVAILABILITY OF QUALIFIED RETIREMENT PLANS
Sole Proprietorship: Deductible retirement plan available
Partnership: Deductible retirement plan available
Corporation: Deductible retirement plan available
LLC: Deductible retirement plan available
PASSIVE LOSS DEDUCTIBILITY
Sole Proprietorship: Can't offset ordinary business income
Partnership: Can't offset ordinary business income
Corporation: May be able to offset ordinary income for "C" types;
not for "Sub S" types
LLC: Can't offset ordinary business income
POSSIBLE DOUBLE TAXATION ISSUE
Sole Proprietorship: No double taxation problems
Partnership: No double taxation problems
Corporation: Double taxation possibility for "C" type; no double
taxation for "Sub S"
LLC: No double taxation problems
POSSIBILITY OF TAX-SAVING FAMILY INCOME SPLITTING TECHNIQUES
Sole Proprietorship: Very possible, if owner is employing offspring,
especially those under 18
Partnership: Definite possibilities to shift income to family
members in lower tax brackets
Corporation: Limited possibilities for "C" type;more possibilities
for "Sub S" type
LLC: Definite possibilities to shift income to family members in
lower tax brackets
DEDUCTIBILITY OF VARIOUS FRINGE BENEFITS
Sole Proprietorship: Limited, especially in health, accident, life
insurance, medical reimbursement, death benefits
Partnership: Limited similar to sole proprietorship
Corporation: Much more fringe benefit possibilities, especially for
"C" types; some
restrictions on "Sub S" types
LLC: Limited similar to partnership or sole proprietorship
ABILITY TO RETAIN EARNINGS TO DEFER INCOME TO OWNERS
Sole Proprietorship: Cannot retain earnings; taxable to owner in
year posted
Partnership: Cannot retain earnings; taxable to partners in year
posted whether or not they are distributed
Corporation: "C" types can retain earnings up to certain limits;
"Sub S" types cannot
retain; they are taxable to the shareholders whether distributed or
not
LLC: Cannot retain earnings; taxable to partners in year posted,
whether they
are distributed or not
LEGALITY ISSUES FROM A STATE PERSPECTIVE
Sole Proprietorship: Legal form of business in all states
Partnership: Legal form of business in all states
Corporation: "C" types recognized in all states; "Sub S" types not
recognized for income tax purposes in all states, but recognized as
a legal entity in all
LLC: Not recognized similarly in all states, so formation, filings,
and limited
liability protection may be questionable especially if operations of
business extend to multi-states
TAX RETURNS TO BE FILED
Sole Proprietorship: Certain business schedules get included on
individual 1040 form, but no independent, stand-alone return is
filed
Partnership: Federal Partnership Tax Return, Form 1065 must be filed
Corporation: Federal Corporation Tax Return, Form 1120 for "C" type;
Federal Form 1120S for "Sub S" type
LLC: File similar to partnerships, Form 1065
General Advantages/Disadvantages Of The Four Entity Types
As can be seen, while the four main entity types have some common
denominators, they are mostly intended to fulfill different business
and individual needs. There are advantages and disadvantages within
each of these entities:
SOLE PROPRIETORSHIP: This is usually the easiest type of
entity to set up or terminate. Losses from the business can offset
income from other sources. Management is totally centralized since
there is only one legal owner. Recordkeeping may be a bit easier.
Taking money out of the business is very easy.
However, there are some notable disadvantages, also: There is no way
to "retain" earnings like other business forms; the owner has no
limited liability protection; continuity and transferability of
interest is limited; and certain deductible fringe benefits are not
available as with other forms of business.
CORPORATION: Advantages include limited liability protection
to owners, easy transferability of ownership, continuity even if
original owners no longer exist, easier estate tax planning
opportunities, more possible tax-free fringe benefit plans, and more
flexible pension plans. In addition, it allows for a number of
owners to participate. Obviously there can be numerous advantages.
The disadvantages can be equally as numerous. A corporation is
usually more difficult and costly to set up or terminate. Much more
planning is required to avoid double taxation issues. Recordkeeping
can be quite complicated to preserve the limited liability feature.
Taking money out of the corporation can also get tricky. Finally,
tax return filings tend to be more involved.
GENERAL PARTNERSHIP: If there is more than one owner, it is
the easier of the entity types to set up. Active losses can be used
to offset other income for the owners. Some degree of income tax and
estate tax planning is possible since ownership percentages can be
transferred fairly easily.
The disadvantages are similar in scope to a sole proprietorship: No
limited liability protection exists; the partnership usually ends
upon the termination of a majority partnership interest, so
continuity is limited; earnings cannot be retained, and tax-free
fringe benefits are limited.
LIMITED LIABILITY COMPANY: This entity has some of the better
aspects of a partnership coupled with that of a corporation. It has
limited liability protection, yet allows for the "flow through" of
income and losses to the partners so there is less chance for double
taxation. Unlike the "Sub S" corporation with its limitations on the
number of shareholders, and the type and status of these
shareholders, there is much more flexibility here. Income and losses
can be allocated more easily as well.
However, the disadvantages center around the fact that these LLC's
are still relatively new, and the states have varying rules and
regulations concerning their operation, legal status, and degree of
limited liability protection available. In addition, like a general
partnership, tax-free fringe benefits are restricted. From a
qualifying perspective on the federal level, there is always the
possibility that the LLC will be challenged on its qualification.
This could lead to a disastrous situation where it is re-classified
as a corporation, and a double taxation event could occur.
Conclusion
Selecting the best type of business entity is as much an art as a
science. This should match the type of business, and the individual
needs and wishes of the owners. In addition, it should anticipate
the developmental aspects of a changing business so a look into the
future is often necessary. To try to make this selection process as
efficient and effective as possible, two actions are in order.
First, make out your own "wish list" of what you want and need in a
business organization. Second, consider getting professional advice
from a legal and accounting perspective as early in the selection
process as you can. It can be some of the most important advice your
business will ever receive.
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