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Guide to Business Entities

Businesses can be categorized by law in several manners. And these classifications matter when it comes to determining how a business is recognized, how it’s taxed, and the personal liability, or lack thereof, of the business owners. Knowing how their business is set up and how it is categorized under the law is crucial for business owners to protect their rights, determine their profit, and protect themselves from liability.

Here’s a brief overview of the different types of business entities.

An Overview of the Types of Businesses

 

The types of business structures include the following:

  • Sole Proprietorship- In a sole proprietorship, there is only one owner who has full control of the business and gets 100% of the profits after tax. A sole proprietor and the business are not separate entities. Hence, the sole owner can be held personally liable for business debts, liabilities, and obligations.
  • Partnership- When there are multiple owners in a business, the corporate entity can be categorized as a partnership — either a limited partnership (LP) or limited liability partnership (LLP). In the former, only one general partner has unlimited liability while the others have limited liability.  On the other hand, in a limited liability partnership, there is limited liability to all partners or owners. Hence, they are all protected against personal liability.
  • Limited Liability Company (LLC)- In an LLC, the owners are all protected and are not held personally liable for the debts and liabilities of the business entity. In this type of business structure, the owners are protected, as well as their personal assets.
  • Corporation- There are many classifications of a corporation, each with different rules when it comes to personal liability.
  • C Corp – The business is separate from the owners, which offers protection to the owners against personal liability.
  • S Corp – A business entity that is similar to a C Corp, but allows the business to avoid corporate taxes.
  • Close Corporation – Their corporate structure is less traditional and used by small family-owned businesses often.
  • Nonprofit corporation – An organization that is organized by charities, religious institutions, educational institutions, etc. They do not pay state or federal taxes.
  • Cooperative- A cooperative is a type of business that’s operated for users who avail of its services. They are owned by members who get a share of the profits made by the cooperative.

Why You Need to Know Your Type of Business Entity

It’s important for business owners to know how their business is set up in order for them to properly understand their rights, liabilities, and obligations under the law. Without the proper business structure, business owners can be held personally liable for the debts of the business and risk their home, car, finances, and future in case of issues with their company.

Knowing the categorizations of businesses and how they work can make businesses more aware of what to do to protect themselves.

I have created a comprehensive guide to selecting a business entity that covers everything a business owner needs to know to set up their business, whether as a sole proprietor, an LLC, partner, or corporation.  Contact me if you would like a free copy of the full Guide to Business Entites.

In addition, here is a table that shows some of the common features of different business types:

Summary of Entities

Entity Limited Liability Company (LLC) S Corporation C Corporation Partnership

Description

An LLC can only be formed by filing articles of organization or certificate of formation with the secretary of state in the state of formation. Owners are called members and the LLC may be managed by the members, similar to a partnership, or by managers selected by the members, similar to a corporation. Treated as a partnership for tax purposes unless contrary election is made.

Nontax formalities for formation are identical to C corporation (i.e., filing with secretary of state). Assuming all the requirements for election are satisfied, shareholders are taxed instead of corporation. Income from business subject to single level of taxation.

A corporation is formed by filing articles or certificate of incorporation with the secretary of state in the state of formation. Absent an election by the shareholders be treated as S corporation, income from business may be subject to double taxation at entity level and again on distribution to the shareholders.

 

A general partnership may be formed without any governmental filing by oral or written agreement. A limited partnership can generally only be formed by certain filings with the state of formation’s secretary of state. Partners are taxed instead of partnership. Income from business subject to single level of taxation.

Liability for Entity Debts

Members have limited liability for debts of the business. Shareholders have limited liability for debts of the business. Shareholders have limited liability for debts of the business

General partners have unlimited liability for the debts of the business while limited partners have limited liability.

Participation in Management

 

Flexibly determined by members in operation agreement. Members can participate directly in management of the business or may elect to delegate authority to one or more managers.

See C corporation.

 

Directors and officers have responsibility for the management of the business; shareholders generally are not entitled to actively participate in management unless they are directors or officers or an election is made to operate as a statutory close corporation.

General partners have the exclusive right to manage the business; limited partners’ rights are restricted to preserve limited liability.

 

Transferability of Interests

 

Securities law restrictions on transfer and restrictions may also be imposed in the operating agreement. A member may assign right to distributions, but the assignee can only become a member if other members consent as provided in operating agreement.

Securities law restrictions on transfer and restrictions may also be imposed in the shareholders agreement, if any. Shareholders may also agree not to make any transfers that would lead to termination of S corporation status.

Securities law restrictions on transfer and restrictions may also be imposed in a shareholders agreement, if any. Securities law restrictions on transfer of limited partnership interests and restrictions may also be imposed in the partnership agreement. A partner may assign right to distributions, but the assignee can only become a partner if other partners consent as provided in the partnership agreement.

Ability to Raise Capital

Good if there is no intention to go public. Venture capitalists are still unlikely to invest in non-corporate entities; however, an LLC can be easily converted into C corporation to admit investors if necessary. Very limited -100 shareholders maximum -one class of stock -U.S. individuals only.

 

Best if public offering or venture capital funding is planned; however, an LLC can easily convert into C corporation.

 

Equity capital for general partnership is limited to contributions from the active general partners. As for limited partnerships, see LLC.

 

Preferences Among Owners

Substantial flexibility to create preferences with respect to distributions and allocations in the operating agreement; however, allocations must have “substantial economic effect.” Very limited due to inability to create more than one class of stock. Substantial flexibility through use of various classes and series of preferred stock.

Substantial flexibility to create preferences with respect to distributions and allocations in the partnership agreement; however, allocations must have “substantial economic effect.”

Term

Perpetual, although limited duration can be specified in articles of organization. Perpetual. Perpetual.

Determined by partnership agreement.

Securities Issues

Membership interests are generally considered to be securities. Shares of stock are securities. Shares of stock are securities. Limited partnership interests are considered to be securities, while general partnership interests are not.
Entity Level Federal Income Taxes No federal tax at LLC level unless LLC elects to be taxed as corporation. Generally no tax at S corporation level; some excise taxes, and built in gains taxes may apply. Income tax on earnings at corporate level.

 

No federal tax at partnership level.

 

Number of Required Owners

 

Most states now allow an LLC to be formed with any number of members, including just one member. No more than 100.

 

Any number.

 

At least two.

 

Eligibility Requirements of Owners

No restrictions.

 

US citizens or resident individuals, certain trusts, and certain tax exempt entities. No restrictions. No restrictions.

 

Entity Level State Taxes

While LLC is generally not subject to an entity level tax, some states imposes a fee or tax at the entity level based on income of LLC.

 

As at federal level, generally no tax at S corporation level; but some states do impose a corporate level tax on S corporations at lower rates than that imposed on C corporations. As at federal level, income is taxed at corporate level.

 

While partnerships are generally not subject to an entity level tax, some states tax the entity.

 

Tax on Distributions of Appreciated Property

 

Generally, no tax to either LLC or member (certain exceptions apply). Taxable gain on distribution passed through to shareholders.

 

Taxable gain to corporation and dividend to shareholders.

 

Generally, no tax to either partnership or partner (certain exceptions apply).
Special Allocations of Income or Deduction Allowed, subject to substantial economic effect rules. Not allowed — all allocations are pro rata. Not allowed.

Allowed, subject to substantial economic effect rules.

Distribution Preferences Allowed. Not allowed — one class of stock requirement. Preferred stock allowed.

Allowed.

Deductibility of Losses by Owners

Members may deduct their shares of losses to extent of basis, which includes LLC level debt (certain other limitations apply). Shareholders may deduct their shares of losses to extent of basis, which does not include corporate level debt. No deduction at shareholder level. Partners may deduct their shares of losses to extent of basis, which includes partnership level debt (certain other limitations apply).
Fiscal year Generally calendar. Generally calendar. No restrictions. Generally calendar.
Status of Owner/ Employment

 

Not clear, but more likely treated as self-employed.

 

If ownership interest is greater than 2%, then treated as self-employed.

 

Treated as employees; therefore entitled to § 105 (accident and health) § 101 (death benefits) § 125 (cafeteria plans) § 119 (meals/ lodging). Self-employed.

 

Self-Employment and Social Security Taxes

 

Earnings generally subject to self-employment taxes, except for earnings from passive investment type interests.

 

Social security taxes imposed on wages of employee-owners/no self-employment tax on distributions.

 

Social security taxes imposed on wages of employee-owners/no self-employment tax on distributions.

 

Earnings generally subject to self-employment taxes, except for earnings attributable to limited partnership interests.

 

Nontaxable Fringe Benefits (group health insurance, accident or health benefits, meals or lodging, cafeteria plan benefits)

Cash value of fringe benefits generally not excludable from member’s income or deducible by LLC.

 

Cash value of fringe benefits generally not excludable from shareholder—employee’s income or deductible by S corporation. Deductible by corporation—not included in income of shareholder —employee.

 

Cash value of fringe benefits generally not excludable from partner’s income or deductible by partnership.

 

Option Plans, NSO’s, ISO’s

 

Employees & consultants can be given options to acquire LLC interests, but such options are generally more complex. ISO’s not available. ISO’s commonly granted to employees. NSO’s may be granted to consultants and advisors. ISO’s commonly granted to employees. NSO’s may be granted to consultants and advisors. Employees & consultants can be given options to acquire partnership interests, but such options are generally more complex. ISO’s not available.
Adjustments to Basis on Death of Owner Inside basis may be adjusted on death or transfer under Code § 754. No Code § 754 adjustments to basis. No Code § 754 adjustments to basis. Inside basis may be adjusted on death or transfer under Code § 754.
Termination on Transfer of Interests

 

LLC terminates for tax purposes on transfer of 50% or more of capital and profits in 12 months. No termination of entity on transfer of interests. No termination of entity on transfer of interests. Partnership terminates for tax purposes on transfer of 50% or more of capital and profits in 12 months.
Increase in Basis for Debt Members increase outside basis by share of LLC debt. No increase in basis in stock for corporate level debt. No increase in basis in stock for corporate level debt.

Partners increase outside basis by share of partnership debt.

Treatment of Foreign Owners

Foreign members subject to US tax on their share of LLC’s effectively connected income; branch profits tax may apply. Foreigners cannot be shareholders of S corporation. Foreigners are subject to withholding tax on dividends from US corporation, subject to treaty rate or exemption. Foreign partners subject to US tax on their share of partnership’s effectively connected income; branch profits tax may apply.
Foreign Individual Owners—Transfer Taxes Membership interest may be subject to US estate and gift taxes. N/A. Foreigners cannot be shareholders of S corporation. Corporate stock is not US situs asset for gift tax purposes. Partnership interest maybe subject to US estate and gift taxes.
Conversion to Another Entity

 

Generally may be incorporated (by conversion or otherwise) tax free (certain exceptions apply). Can convert to C corporation by revoking election; may be tax on converting to LLC. Can convert to S corporation by making election (built in gains tax may apply to later dispositions of appreciated property). Conversion to LLC may be taxable. Easily converted to LLC or generally may be incorporated tax free (certain exceptions apply).

 

Taxes on Sale or Liquidation

 

One level of tax on sale of stock or assets, generally capital gain except for amount allocable to certain assets. One level of tax on sale of stock or assets, generally capital gain on stock sale. Potential double tax. Corporate tax on sale of assets. Shareholder level tax on sale of stock or liquidation. One level of tax on sale of stock or assets, generally capital gain except for amount allocable to certain assets.
Exit Strategy Superior for: (a) asset sales—gains subject to single tax; (b) liquidation—not a taxable event. NOTE: Easy to convert from LLC to C corporation—difficult to go the other way. See C corporation. Superior for: (a) public offering but can start as LLC and convert later (however, may be taxable); (b) stock sale may be eligible for 1202 treatment; (c) tax-free reorganization (e.g., merger).

See LLC.

Ease and Expense of Organization

Can be relatively high if many members and preferences. Requires more tax planning. Medium. Medium, unless preferred stock in which case expenses can increase.

See LLC.

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