Entity Formation: Partnership, Corporation or LLC – What’s Right for Me?
Modern business owners typically realize they need to form an entity to protect their assets. However, this task can be daunting and many business owners are confused by today’s menu of potential business entities. Each entity offers its own benefits, practical operational matters, and tax issues. Below is a brief discussion of various business entity options including: a sole proprietorship, general partnership, a limited partnership, a limited liability company, and a S or C corporation. The following is merely a basic outline of options. It is important to consider your individual goals and business to find the perfect entity for you. Please contact me at (979) 821-2110 or marca@lawbyme.com to discuss the right fit for your business!
Types of Business Entities
1. Sole Proprietorships
A sole proprietorship is the simplest of the operational forms, but it is also the riskiest for its owners. Sole proprietorships are the business entity typically entered into by “mom and pop” businesses. This entity does not require any filings with the state or formal agreements.
A sole proprietorship does not have the benefits of limited liability that come with other types of business entities. Operationally, a sole proprietorship operates under the owner’s social security number. All contracts and obligations are the owner’s responsibility. The business owner is personally liable for all debts and obligations (including law suits and negligent acts of employees). No protection is provided for the owner’s personal assets other than any protection offered though business liability insurance. Additionally, all income of the sole proprietor that is classified as “self-employment income” under federal tax law is subject to self-employment tax.
2. General Partnership
A general partnership is essentially a collection of individuals or entities operating together to produce a profit though a business. Typically, partnerships are governed by a written agreement, however, in Texas no formal is agreement is necessary to form a partnership.
As with the sole proprietorship, the general partnership is not a preferred entity because each partner is jointly and severally liable for debts and obligations of the general partnership. This means Partner A is liable for the acts of Partner B, as well as the acts of employees of the partnership, i.e. car accidents, sexual harassment, discrimination, etc. For federal income tax purposes, the income and losses of the general partnership flow through to the partners.
3. Limited Partnership
A limited partnership is structured with one or more general partners and one or more limited partners. The general partners have control of the day-to-day operations of the partnership and other matters as set forth in the Limited Partnership Agreement. It is a good idea for the general partner to be another entity such as a corporation, LLC, or another limited partnership because the general partner is ultimately liable for all of the debts and obligations of the limited partnership. Limited partners can be individuals or entities because they do not have liability for the operations of the limited partnership unless they participate in the management of the business in their capacity as a limited partner. However, a limited partner participating in the management of the limited partnership as an employee will not cause the limited partner to be liable for the debts and obligations of the limited partnership. All limited partnerships should have an agreement which clearly sets out the rights and obligations of the parties to avoid liability for limited partners. Limited partnerships are flow through entities for tax purposes. The partnership itself does not pay federal income taxes.
Limited partnerships are popular for the transfer wealth at a discounted rate. It is popular with many elder family members who wish to retain control of the business operation while transferring equity to succeeding generations.
4. Limited Liability Company
The limited liability company (LLC) is a hybrid entity that combines the desirable features of a corporation and a partnership. It provides limited liability for all of its owners (called members), however, for federal income tax purposes, it is treated as a partnership (unless an election is made to be taxed as a corporation). Therefore, it combines the benefits of the limited liability of a corporation for all the owners of the LLC while retaining the tax advantages of a partnership. Single member LLCs are classified as sole proprietorships for federal income tax purposes and no federal income tax return is filed for the LLC. Therefore, while the single owner has limited liability, he or she receives the benefit of less complexity as they do not have to file a separate federal income tax return for the LLC. If there are two or more owners of the LLC, then the LLC is treated as a partnership for federal income tax purposes unless the owners elect to be treated otherwise. While an LLC does not require the formalities of a corporation, it does require proper formation and maintenance.
An LLC provides flexibility in tax liability as well as limited liability for its members, making it a very popular entity option.
5. S Corporation
An S corporation is a regular corporation for state law purposes. Shareholders can make an election with the IRS to be taxed as an S Corporation for federal income tax purposes which will cause all income and deductions of the corporation to flow through to the shareholders. As with LLCs, the owners are not subject to the debts and obligations of the corporation unless they have otherwise agreed to become obligated. The advantages of the S corporation are that it is a single entity providing liability protection for its owners and it is a state law corporation with which most parties are familiar.
6. C Corporation
A C corporation is a regular corporation created under state law. The difference between the C corporation and the S corporation is that the shareholders of a C corporation do not elect for the corporation to be taxed as an S corporation thereby not causing all the income and losses of the corporation to flow through to the shareholders. Therefore, both the corporation itself and the individual shareholders will be subject to taxation. Corporations require more maintenance than LLCs. In a corporation, there is a somewhat rigid operational structure (e.g. annual shareholder meetings, annual Board of Director meetings, election of officers, evidence of authorization of corporate acts, minute books, etc.). That is why business owners often opt for the LLC since it provides the limited liability of the corporation without all the maintenance.
The outline above is merely a simple overview of a complex area of the law. The entities discussed above are excellent tools to protect your future and grow your business, but they only work if you use them. You’ve done your job (creating a business) now let me do mine (helping you get the most out of entity formation for that business)!
Phone: (979) 821-2110
Email: marca@lawbyme.com