As a prospective business owner, you will be faced with many important decisions, including what business structure will best suit the needs of your new venture. Understanding the various types of legal structures which are available and the selection of the appropriate structure are critical steps in establishing your new business. Liability insulation, tax treatment, and ease and convenience of administration are the three most important factors to consider. Liability insulation, or protecting and shielding personal assets from creditors, is perhaps the paramount factor for business owners who are, now more than ever, under increased exposure to customers, patients, partners and clients.
This article provides a brief overview of the liability protection, tax and administrative considerations of several of the more common types of legal structures available today. Please note that this article focus on the basics of only a few of the many structures in existence and is not an all-inclusive discussion of every type of entity structure available.
A sole proprietorship is the most basic of the available business structures. A sole proprietorship is a “business of one” with no separate legal distinction between company and owner. The sole proprietorship and its owner are one and the same.
Liability Protection: Because a sole proprietorship is legally the same as its owner, the owner has no protection whatsoever against business-related liability. The owner is personally liable for any and all business-related claims and all personal assets of the owner are potentially at risk.
Tax Considerations: No tax returns for the sole proprietorship must be filed. All profits and losses are reported on the owner’s individual income tax return.
Administrative Requirements: No legal formalities must be observed and, therefore, administrative requirements are almost non-existent. However, depending upon the type of business conducted, the owner may be required to file, and publish, an assumed name affidavit with the county in which it does business.
A “regular” or “C” Corporation is a very common form of business organization. A C Corporation may have one or more owners and is a legal entity which is separate and distinct from its owners (called “shareholders”).
Liability Protection: A C Corporation offers its shareholders a high degree of protection against liability. A shareholder is generally not personally liable for the debts, obligations or liabilities of the corporation. The liability of an owner is generally limited only to the amount of assets contributed to the corporation by such shareholder.
Tax Considerations: A C Corporation must file its own income tax returns and pay tax on its earnings. Each owner is also taxed on any distributions paid from the corporation. So, taxation occurs on two levels: on the corporate level and on the owner level. This is known as “double taxation”.
Administrative Requirements: Considerable administrative requirements are imposed upon a C Corporation. A corporation is created by filing Articles of Incorporation. The corporation must adopt written bylaws, which govern the internal operations of the corporation. A shareholders agreement, which governs the relationship among the shareholders, should be considered. In addition, managing a corporation on a day-to-day basis requires compliance with certain corporate formalities, such as conducting regularly-scheduled board meetings, preparing accurate minutes of meetings, providing formal notice of meetings and electing directors. A bank account for the corporation must be established.
An S Corporation has the same liability protection and virtually the same administrative requirements as a C Corporation. What makes an S Corporation different from a C Corporation is the way it is taxed. Unlike a C Corporation, an S Corporation avoids double taxation. Earnings “flow-through” to the owners (also called “shareholders”), who pay taxes on corporate profits on their individual income tax returns. Accordingly, the S Corporation itself does not pay tax on its profits. In addition to “flow-through” taxation, the S Corporation structure affords its owners an important tax savings feature. S Corporation earnings distributed to the shareholders are not subject to Social Security (OASDI and Medicare) taxes, which often times result in substantial tax savings to the shareholders. Given these tax benefits, the S Corporation structure is one of the most popular forms of business entities utilized in the United States today, with more S Corporation returns filed each year than for any other type of business structure.
A general partnership is formed when two or more people or other business entities associate for the purpose of operating a business and sharing profits.
Liability Protection: None. Owners (called “partners”) are personally liable for all debts and obligations of the partnership, including liability for the acts and omissions of other partners, agents and employees of the partnership. Therefore, potentially all of the personal assets of a partner are at risk.
Tax Considerations: The partnership structure provides “flow-through” taxation to its partners, meaning that the earnings of the partnership are only taxed once, at the partner level.
Administrative Requirements: No filing is required in Illinois to form a general partnership; however, the partnership should consider filing a Statement of Authority, which provides notice to the public as to the scope and authority of each partner with respect to the partnership’s business and property. A partnership agreement, which governs the operations of the business and the relationship among the partners, should be executed. A bank account for the partnership must be established.
A principal advantage of the limited partnership over a general partnership is that a limited partner in a limited partnership is generally not personally liable for partnership obligations. A limited partnership must have at least one limited partner and one general partner and the limited partner may not participate in the management and control of the business.
Liability Protection: A limited partner’s liability for partnership obligations is generally limited to the amount of the limited partner’s capital contribution to the limited partnership. The general partner has no protection against personal liability.
Tax Considerations: The partnership structure provides “flow-through” taxation to its partners, meaning that the earnings of the partnership are only taxed once, at the owner level.
Administrative Requirements: A Certificate of Limited Partnership must be filed to form a limited partnership. A limited partnership agreement, which governs the operations of the business and the relationship among the partners, should be executed. A bank account for the partnership must be established. Some administrative formalities, such as recordkeeping and filing requirements, are necessary.
Limited Liability Company (“LLC”)
The limited liability company (“LLC”) structure has gained significant popularity since 1977, when the Wyoming legislature adopted the first LLC law. By 1990, all states had allowed the creation of LLCs. What sets the LLC apart from other business structures is that the LLC structure affords the greatest flexibility among all other entity choices in terms of management structure, operations and allocation of profit and loss.
Liability Protection: Using an LLC to own business assets offers a significant layer of liability protection. Each owner (called a “member”) is generally limited to the amount of capital such member has contributed to the LLC.
Tax Considerations: The earnings of an LLC “flow-through” to the members and are taxed only once at the member level, on the member’s tax return.
Administrative Requirements: An LLC is formed by filing Articles of Organization (or in some states, a Certificate of Formation). An operating agreement, which governs the operations of the business and the relationship among the members, should be executed. A bank account for the LLC should be established. Few other administrative requirements are imposed by law.
It is important to remember that no one type of legal entity fits all businesses.