Choosing the form of entity by which to conduct business is one of the first, and often most important, questions faced by someone starting a business. Several factors determine which form of business entity is most appropriate for a particular business, including protection of the owners of the business from debts, obligations and liabilities of the business, and achieving favorable tax treatment. This article will help you understand the basic differences in business entities and the advantages and disadvantages of the several options from which to choose. In making your ultimate choice, you should discuss these and other factors with your legal and tax advisors.
In Utah, you have several options when choosing the form of entity for your business. The entities discussed in this article are: A) Sole Proprietorships, B) General Partnerships, C) Limited Partnerships, D) Corporations, E) S-Corporations and F) Limited Liability Companies. Not discussed are more specialized entities such as professional corporations, non-profit corporations, limited liability partnerships and business trusts.
A. SOLE PROPRIETORSHIPS: A sole proprietorship is a single individual who owns and operates a business typically using his or her own assets. The sole proprietorship is the simplest form of business entity, with little distinction between the owner and the business.
1. Advantages. A sole proprietorship is simple and requires no formalities or state filings. A sole proprietorship avoids the double taxation disadvantage of corporations. The owner may deduct business expenses and losses from his or her personal income.
2. Disadvantages. An owner is personally liable for all obligations of the business. Creditors of the business can seek recovery from the owner’s personal assets, as well as business assets. Also, all profit may be subject to self-employment tax, even if part of the profit is attributable to a return of capital.
B. GENERAL PARTNERSHIPS: A general partnership is an association of two or more persons formed for the purpose of conducting a business for profit. A partnership may be created by a formal agreement or merely by the parties’ actions.
1. Advantages. The biggest advantage of a partnership is its relatively favorable tax treatment. There is no separate tax at the partnership level and individual partners get the benefit of business expenses and deductions to offset income from other sources. Partners may also specially allocate income and losses, thus allowing them to shift tax benefits and burdens. A partnership can be formed and operated with minimal formality and no filings or agreements are necessary. Partnerships are relatively easy to manage.
2. Disadvantages. Each partner is jointly and severally liable for all obligations of the partnership. On dissolution of a partnership, a creditor of the partnership can sue any of the partners personally for unpaid partnership debts. In the absence of any agreement to the contrary, the death or withdrawal of one partner dissolves the partnership. Management of a partnership can be difficult if many partners are involved or if partners do not get along well. Interests in partnerships are not freely transferable. There is no centralized management in a partnership, and any partner can bid the partnership and the other partners in any matter of partnership business. Raising capital is difficult in the partnership form since the partnership cannot obtain funds through broad ownership distribution. It takes at least two persons to form a partnership.
C. LIMITED PARTNERSHIPS: A limited partnership is a partnership comprised of one or more general partners who operate and manage the business, and one or more limited partners who do not actively operate or manage the business. Articles of limited partnership must be filed with the state. A partnership agreement would normally describe the rights and duties of the partners.
1. Advantages. A limited partnership enjoys the same basic tax advantages as a general partnership, subject to the passive income and loss rules, and except that limited partnerships may be more limited in how they can specially allocate income and losses. The limited partnership affords investors limited liability, much like a corporation, so long as they do manage the business.
2. Disadvantages. The general partners of a limited partnership are liable for all partnership obligations. As with a general partnership, the death or withdrawal of a general partner will dissolve a limited partnership, absent a partnership agreement provision to the contrary. Although more freely transferable than general partnership interests, limited partnership interests are still not as freely transferable as corporate interests.
D. CORPORATIONS: A regular corporation, or “C Corporation” to the IRS, is the most common form of entity for doing business. A corporation is a legal entity, formed pursuant to state law that exists separately from its owners. Articles of incorporation must be filed with the state. The management structure and financial and voting rights of the shareholders are typically embodied by bylaws or shareholder agreements.
1. Advantages. It is difficult to “pierce the corporate veil” to hold shareholders, officers or directors personally liable for corporate obligations. Protection from liability is the principal reason a corporation is preferred as a form of business entity. Also, with a long history of use in this country, corporate law is well developed and fairly standard throughout the states, and therefore legal issues are more predictable and more readily settled. Ownership interests (stock) in a corporation are freely transferable.
2. Disadvantages. A C corporation’s income is subject to double taxation: first on the net income when it is earned by the business, and again on the dividends when paid to the shareholders out of the corporation’s remaining income. Also, a corporation requires more formalities and is somewhat more complex than a sole proprietorship, a general partnership or a limited liability company. Annual reports must be filed and corporate formalities, such as keeping proper corporate minutes, should be followed to maintain the separate identity of the corporation. Also, corporations are less flexible from a tax standpoint than other entities.
E. S-CORPORATIONS: An S-corporation is a corporation that, by complying with IRS requirements, avoids the double taxation of C corporation, and is taxed more like a partnership than like a C corporation. Articles of incorporation must be filed with the state and a form must be filed with the IRS indicating the corporation’s election to be treated as an S-corporation.
1. Advantages. Shareholders enjoy the same protection from liability for the obligations of the business as shareholders of a regular corporation. The primary advantage of an S-corporation over a C corporation is the avoidance of double taxation. Another advantage is that, to the extent there are losses in the corporation, those losses may be passed through to shareholders to be offset against shareholders’ income from other sources, subject to certain limitations.
2. Disadvantages. An S-corporation is limited by the number (100 or less) and type of shareholders it can have. It is also limited to one class of stock. These limitations may make it more difficult for an S-corporation to raise capital. Also, unlike a partnership, income and losses cannot be specially allocated to shareholders.
F. LIMITED LIABILITY COMPANIES: A limited liability company (LLC) is a relatively new form of business entity in Utah combining features of partnerships and corporations. An LLC has the tax advantages and operational flexibility of general partnerships, together with the limited liability protection of a corporation. The LLC is a separate legal entity which is organized by one or more persons or entities. Articles of organization must be filed with the state. The rights of the owners or “members” with respect to management and financial matters may be set forth in an operating agreement.
1. Advantages. Members of an LLC are not personally liable for the obligations of the company. LLCs enjoy favorably flow-through tax treatment without double taxation. LLCs can specially allocate income and losses among members. There is no limit on the number or type of members, and an operating agreement can, in effect, create different classes of ownership interests. There are relatively few formal requirements to create and operate an LLC. Finally, LLCs also offer certain other tax advantages of an S- corporation.
2. Disadvantages. One disadvantage of an LLC is that it is still the newest form of business entity and as such, is still somewhat untested in court cases. There still remains some uncertainty with respect to issues such as piercing the veil of an LLC, the treatment of the LLC and its members in bankruptcy, and the like. However, each year adds more experience so these concerns are becoming less disadvantageous. Another area of disadvantage of the LLC is that there still is no strong uniformity of state laws governing LLCs. An LLC entity conducting multi-state business may find it difficult to comply with the laws in all the various states. Also, to the extent an LLC engages in business in a state which has not passed LLC legislation, there is a risk that a court might not recognize the limited liability of members, and might hold the members personally liable in that state for the obligations of the business. However, most every state now recognizes LLCs as a type of business entity.
Each business is different, but determining which factors are most important to your business will help you better determine which type of entity will work best for you.