Posted May 24, 2010

Preeo, Silverman, Green & Egle, P.C.
Tax Library

Choosing the Right Business Entity – A Review of Some of the More Common Forms of Doing Business To Help You Make An Informed Decision
By Steven M. Weiser, J.D., LL.M. (Taxation)

Choosing a business entity is no easy task.  Gone are the days when the decision was limited to three choices:  corporations, partnerships and sole proprietorships.  In those days, if you wanted personal protection from the debts and obligations of the business (limited liability) you formed a corporation.  If ease of formation and operation was what you preferred you formed a partnership or sole proprietorship.  Changes in state and federal laws have resulted in the availability of several business forms, making the decision of what type of entity to employ in conducting business more difficult than ever.  Today people can choose between corporations, S corporations, general partnerships, limited partnerships, limited liability partnerships, limited liability limited partnerships, limited liability companies, or sole proprietorships.  Some states, like Colorado, even have a few more business entities to choose from (e.g. limited partnership associations).  In this article we compare and contrast some of the more common forms of doing business in the United States for our friends and clients.

Sole Proprietorships

The sole proprietorship is perhaps the most basic form of doing business in the United States.  A single individual without the creation of a separate legal entity operates the proprietorship.  A sole proprietorship ordinarily operates under a business name, but for legal and tax purposes is treated as if the individual owner is conducting business herself.  The individual owner is liable for all debts and obligations of the business and no protection is provided for the business owner’s personal assets.

For tax purposes, the business owner is treated as if directly engaged in the business activity since a separate entity has not been formed.  A separate tax return is never needed and instead, the business owner reflects all results of business operations on her own individual tax return (specifically, Schedule C).  Owners of sole proprietorships are subject to individual income taxes on any income generated by the business, as well as self-employment taxes.  Self-employment taxes consist of the 12.4% social security tax and the 2.9% Medicare tax.  In an ordinary employer-employee relationship, the employer is responsible for paying one-half of employment taxes, while the rest is withheld from the employee’s pay.  A self-employed individual is responsible for paying both portions of these taxes, but is allowed a partial income tax deduction for self-employment taxes paid.  The ability to control the amount of income subject to employment taxes is often an issue upon which small-business owners focus most intently.  As we will see below, this sometimes should not be the case.

A sole proprietorship is the simplest business entity to form, operate and dissolve, but is also the riskiest entity to operate due to the owner’s unlimited personal liability for the debts and obligations of the business.  With the availability of S-corporations and limited liability companies (both discussed below) for single person owned businesses, no one should ever assume the risk of unlimited liability by operating a sole proprietorship.

General Partnerships

A general partnership is like a sole proprietorship in many respects, the main difference being that it has multiple owners.  Some tend to think of a general partnership as a collection of sole proprietors.  A general partnership is defined as two or more co-owners carrying on a business for a profit, who are personally liable for all debts and obligations of the enterprise.

A general partnership is often operated in accordance with a written partnership agreement.  A partnership agreement generally outlines the terms for the sharing of profits and losses among partners, each partner’s ownership interest, management and dissolution of the partnership, the ability to incur debt or other liabilities in the name of the partnership, and the transfer of partnership interests.  In other words, the partnership agreement details each partner’s interests in, obligations to, and rights with regards to the partnership itself.  To the extent these matters are not addressed in a partnership agreement, state laws tend to dictate how these matters are addressed.

Like a sole proprietorship, the general partnership comes with substantial risks.  Most notably among those risks, are a partner’s unlimited liability for debts and obligations of the partnership, including those that arise on account of actions taken by another partner.  Sophisticated business owners may hold their interests in a general partnership through entities that provide some form of liability protection to shield them from risk.

General partnerships are nearly as easy to create and dissolve as sole proprietorships, save for the creation of a partnership agreement, if any.  Generally, there is no need to file a document with the state government to create a general partnership.  For federal income tax purposes a partnership is recognized as a separate entity, and must file an annual information return with the Internal Revenue Service (IRS), though the partnership itself pays no tax.  Profits and losses of the partnership “flow-through” to the partners who pay income taxes on their share of profits or deduct their share of losses in arriving at their individual taxable incomes.  In theory, partnership tax laws should be fairly simple since a general partnership pays no tax and all items of income, gain, loss, or deduction “flow-through” to the partners.  However, in practice, the partnership tax laws are among the most complex in the Internal Revenue Code.  Sometimes these complexities are a benefit to partners in terms of tremendous flexibility in the way partnerships are structured, or can be a curse to the unaware partner who becomes trapped with unintended taxable income.

A partnership can provide for preferential returns to certain partners or can otherwise vary distributions among members from year to year.  Generally, as long as the allocations of income, gain, losses and deductions have “substantial economic effect” (i.e., they have real bottom-line financial meaning) or otherwise satisfy certain regulatory criteria, members can receive tax-favorable special allocations of items.  By comparison, income of corporations and S corporations (discussed below) generally must be allocated to shareholders on a per-share basis.

Like sole proprietors, general partners are also responsible for paying self-employment taxes on their share of partnership income.

Limited Partnerships

A limited partnership is a partnership of one or more general partners and one or more limited partners.  Like partners in a general partnership, the general partner in a limited partnership has unlimited liability for the debts and obligations of the partnership.  General partners are in charge of the management and operation of the partnership.  Limited partners, on the other hand, are viewed as passive investors in the enterprise and are generally prohibited from managing the partnership’s business or they will be treated as a general partner.  In exchange for foregoing management rights, the limited partner is not liable for the debts and obligations of the partnership and may lose no more than his investment in the enterprise (provided the limited partner does not participate in the management of the enterprise in his capacity as a limited partner).

A limited partnership is a creature of state law.  Unlike the sole proprietorship and general partnership, a limited partnership must file a certificate of limited partnership with the appropriate state agency (often the Secretary of State).  If the entity fails to file the certificate of limited partnership it will be treated as a general partnership instead.  It is recommended, but never required, that the partners enter into a limited partnership agreement that outlines the terms for the sharing of profits and losses among partners, each partner’s ownership interest, management and dissolution of the partnership, the ability to incur debt or other liabilities in the name of the partnership, and the transfer of partnership interests.

Limited partnerships are extremely flexible in terms of structure.  Often, the general partner is given complete control over almost all operational aspects of the partnership while holding a minimal ownership percentage as a general partner (e.g., a 1% general partner interest).  This structure is ideal for a business owner who wants to control the operational aspects of a business in which he or she may have outside investors, even though the business owner has little capital at risk.  It is also possible for a partner to own a minimal interest as a general partner and a greater interest as a limited partner (e.g., a 1% general partner interest and a 10% limited partner interest).  This is ideal where the partner wishes to control the entity, will provide some capital to the partnership, but has other investors that will provide the bulk of capital.  To limit the general partner’s liability, some form of limited liability entity is often interposed to provide some form of protection.  In other words, rather than having an individual own a general partner interest, we might form a single member limited liability company (discussed below) through which that individual will hold the general partner interest.

Limited partnerships are excellent choices for family estate and wealth transfer planning purposes.  The limited partnership allows elder family members to retain control over the entity through general partnership interests while transferring equity to succeeding generations at discounted rates.  For planning purposes, the general partnership interest is usually relatively small and accounts for a small percentage of the overall value in the entity.  Older family members usually hold the majority of their value in the entity through limited partnership interests of which they will periodically transfer portions to younger generations.

A limited partnership is also an ideal entity through which real estate can be held.  Appreciating real property can easily be transferred to, and distributed from, a partnership without creating a taxable event, whereas it is difficult to do the same with a corporation or S corporation without the imposition of income taxes.

Limited partnerships are taxed in the same manner as general partnerships.  Items of income, gain, loss and deduction flow through to the partners without the imposition of income taxes at the entity level.  Like the general partnership, the limited partnership must file an annual information return with the IRS.

General partners of limited partnerships are subject to self-employment taxes.  On the other hand, limited partners are not subject to self-employment taxes on their share of partnership earnings.  However, to the extent limited partners receive certain guaranteed payments self-employment taxes may be imposed.

Limited Liability Partnerships and Limited Liability Limited Partnerships

Several states, like Colorado, have two other forms of partnerships known as limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs).  Both are creatures of state law.  General partnerships and LLPs are nearly identical.  An LLP is simply a general partnership that has filed a certificate of registration (or similar document) with the appropriate state agency.  While a general partnership affords no limited liability protection to its partners, LLPs enjoy the advantage of shielding their partners from debts and obligations arising from the acts of other partners in the course of partnership business.

A LLLP is similarly formed when a limited partnership files a certificate of registration with the appropriate state agency.  LLLP status insures that the general partner of the limited partnership is protected from debts and obligations arising on account of the actions of any other partner.

When operating in a state that recognizes LLPs and LLLPs, there should be no reason to ever form a general partnership or limited partnership. Business owners wishing to form partnerships in these states should always take advantage of the liability protection afforded by filing a certificate or registration.  However, LLP and LLLP partners should beware when conducting business in states that do not recognize LLPs and LLLPs.  For example, a Colorado LLP doing business in a state that does not recognize LLPs may be treated as a general partnership in the other state, exposing all partners to unlimited liability for partnership debts and obligations.

Corporations

A corporation is another creature of state statute.  A corporation must be formed in accordance with state law and the requisite documents (articles of incorporation) must be filed with the appropriate state agency.  A corporation is generally a separate and distinct legal entity from its owners. Unlike partnerships, the owners of a corporation (known as shareholders or stockholders) are not liable for the debts and obligations of the corporation.  Shareholders may lose nothing more than their investment in the corporation.  However, in certain circumstances, U.S. courts have disregarded the corporate form and held shareholders liable for certain acts or losses of the corporation.  This is known as “piercing the corporate veil.”  To prevent this from occurring, the corporation should not intermingle its operations, property and records with its shareholders, should observe corporate formalities, be adequately capitalized, and should not hold itself out as the “alter-ego” of its shareholders.

State corporate laws are generally well developed and provide a framework for forming and operating a corporation.  These laws often require the appointment (by shareholders) of a board of directors and certain officers responsible for the day-to-day operation of the corporation.  Annual shareholder meetings are another example of corporate formalities imposed by state laws.

Different classes of corporate ownership may be created.  Often, corporations issue preferred and common stock to shareholders, the primary difference between the two classes of stock being that preferred shares are often granted preferential treatment when it comes to the distribution of corporate earnings (dividends).  Furthermore, it is not uncommon to see several different classes of preferred or common stock.  These additional classes of stock are often distinguished based on their rights to elect members of the board of directors, effectively granting greater control over the board and day-to-day operations of the corporation to a certain class of shareholders.

As stated above, a corporation is a separate legal entity.  This is particularly true with regard to the tax laws where corporations are viewed as taxpaying entities.  A corporate income tax is imposed upon the earnings of a corporation.  Additionally, when corporate earnings are distributed to shareholders in the form of dividends, a separate shareholder level income tax is imposed.  The concept of separate corporate and shareholder level income taxes has come to be known as the “double taxation” of corporate earnings.  The double taxation of corporate earnings is a primary reason why business owners often choose to operate through a “flow-through” entity (e.g., sole proprietorships, partnerships, and limited liability companies).  The effects of double taxation can be illustrated by this simple example:

It should be noted that for the years 2003 through 2010 individuals receiving “qualified dividends” are subject to capital gains tax rates on that income, rather than higher ordinary income tax rates.  In general, “qualified dividends” are dividends paid by certain qualifying corporations, including domestic corporations, so long as the stock in such corporation was held at least 61 days during the 120-day period that begins on the ex-dividends date (loosely defined as the date on which a new acquirier of the stock will not be entitled to the next forthcoming dividend).  These provisions will expire after December 31, 2010, and all dividends will be subject to the higher ordinary income tax rates thereafter.

S Corporations

The S corporation is a creature of federal law.  Congress enacted the S corporation provisions in response to the concerns of small business owners who wanted the liability protection formerly available only to ordinary corporations, but were severely hurt by the double taxation or corporate earnings.

An S corporation is a corporation formed under state law, for which the shareholders have made a federal tax election to be taxed as an S corporation.  As a result, an S corporation is taxed in much the same way as a partnership (no double taxation) and is still entitled to liability protection granted to shareholders of a corporation under state law.  An S corporation is operated in the same manner as an ordinary corporation.  Today, few closely held businesses operate as ordinary corporations because of the double taxation of corporate earnings, and instead choose to operate as S corporations.

In order to be eligible to make an S corporation election, the corporation may have no more than 100 shareholders.  Additionally, S corporations may issue only one class of stock (although flexibility is available with regard to differences in voting rights), and shareholders are limited to U.S. citizens and resident aliens, certain trusts and other S corporations that own 100% of the subsidiary S corporation.  Changes in ownership structure can result in the loss of S corporation status (for example, when a resident alien shareholder transfers stock to a nonresident alien shareholder).

The federal tax rules concerning S corporations can be extremely complex.  They retain certain aspects of partnership taxation and certain aspects of corporate taxation.  These rules become increasingly burdensome where the S corporation was previously taxed as a C corporation.

Generally, shareholders in S corporations do not pay self-employment taxes on their share of S corporation earnings.  However, shareholders performing services for or on behalf of the S corporation may receive a salary or wages on which employment taxes are due.  Historically, many closely held S corporation shareholders paid themselves very small salaries in order to minimize self-employment taxes and withdrew a majority of S corporation earnings as dividends on which self-employment taxes are not imposed.  The IRS is very concerned with this strategy and often requires business owners to pay themselves reasonable salaries on which self-employment taxes are imposed. 

S corporations are less than ideal entities through which to hold real estate or other highly appreciating property.  Distributions of appreciated property by S corporations to their shareholders are taxed like distributions of appreciated property from corporations, not partnerships.  Partnerships may distribute appreciated property to partners free of income taxes, but when a corporation distributes appreciated property to its shareholders a taxable event occurs.  Contributions of appreciated property to an S corporation may be a taxable event as well.

Deductions of S corporation losses flow through to its shareholders and may be used by the shareholders to reduce individual taxable incomes.  However, this is not always the case.  A shareholder’s share of net losses may not exceed that shareholder’s basis (investment) in S corporation stock.  A shareholder’s basis in S corporation stock is unaffected by any debt incurred by the S corporation in the conduct of its business.  This inability to get basis for company debt greatly restricts the ability of shareholders of an S corporation to utilize company losses.  Contrast this with a partnership, where losses are also limited to basis, but basis is increased by the partner’s proportional share of partnership debt.  This is particularly important to new businesses that generate losses during their start-up years, and incur debt to finance operations during those times.  Often, new business owners can take better advantage of losses in the partnership setting than the S corporation setting.  This factor generally outweighs self-employment tax issues; therefore, we often recommend that start-up businesses that expect to incur debt initially form as partnerships, and later consider converting to S corporations when the businesses become profitable and self-employment taxes more of a concern.

Limited Liability Companies

Limited liability companies (LLCs) are creatures of state law that have been gaining popularity and familiarity with people in recent years.  LLCs were designed to combine the best of the corporate, partnership and sole proprietorship worlds.  The LLC is a single entity of which all owners (known as “members”) have liability protection from the debts and obligations of the LLC, much like the protection afforded to shareholders in a corporation.  Earnings of an LLC flow through to its members without the imposition of an entity level income tax much like a partnership (two or more members) or sole proprietorship (one member).  However, members of the LLC can elect to have the LLC taxed as a corporation (as can sole proprietors or partners in a partnership).  It should be noted that several states impose on LLCs certain taxes (e.g., franchise or capital taxes) ordinarily associated with corporations. 

To create an LLC, articles of organization (or a similar document) must be filed with the appropriate state agency.  It is recommended, but not necessary, to also execute an operating agreement that governs the operation of the LLC and the rights of its members, much like a partnership agreement does for a partnership.  Members in an LLC may choose to operate the entity themselves, or they may choose to appoint a manager to operate the business for them.

LLCs that have two or more members must file annual partnership information returns with the IRS (unless the members elect to have the LLC taxed as a corporation).  An LLC with a single member is taxed as a proprietorship (unless the member elects to have the LLC taxed as a corporation) and the owner must complete a Schedule C and attach this schedule to her annual individual tax return.

The application of self-employment taxes to members in an LLC has been the subject of much uncertainty.  Since the taxation of general partners and limited partners is very different, the self-employment taxation of members in an LLC, that may participate in company management is unclear.  The U.S. Treasury Department has previously issued proposed treasury regulations concerning the application of self-employment taxes to members in LLCs, but the Taxpayer Relief Act of 1997 prohibited those regulations from being finalized until July 1, 1998.  Although this moratorium has passed, Treasury has made no efforts to withdraw or finalize these proposed regulations.  As a result, taxpayers are urged to use those proposed regulations in determining whether self-employment taxes apply to LLC members.  These regulations require members to make a determination based on several factors of whether the members meet the definition of a “limited partner” contained in those regulations, thus avoiding self-employment taxes.  In general, to the extent members of the LLC are actively involved in the operations of the LLC, the flow through income of the LLC will be subject to self-employment taxes.

The following table summarizes some of the key similarities and differences between available business entities.

Click here to view the table.

   Readers should note that choice of entity is often a matter of state law.  For purposes of this article all references to state law are to the laws of the State of Colorado.  Additionally, this article is not intended to be comprehensive, addressing all legal issues associated with each entity.  To do so would be impractical and confusing.  Always consult with legal counsel before forming a new business entity.