One of the most fundamental areas of Business Law is, of course, Business Entities. That is the different type of companies that may be established to operate a business through. The primary different business entities include: sole proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability companies (LLC for short) and corporations.
Business entities were created primarily with the purpose of enabling one or more individuals to create a business entity, such as a corporation, to entice entrepreneurs to engage in commerce without incurring the risk of liability to themselves individually for the business debts and liabilities. This primary purpose remains true to this day.
Because, the business entity choice can affect how your business is governed, operated, maintained and taxed, it is important to understand the different entity options and the legal and tax implications of each, before making your entity choice.
DIFFERENT TYPES OF BUSINESS ENTITIES:
While the Sole Proprietorship is usually listed on any list of business entities, a Sole Proprietorship is really simply an individual that is doing business, without establishing a separate business entity (a sole proprietorship is really no business entity at all). The individual sole proprietor may adopt a business name that may be registered as a “dba” (doing business as) or “fictitious name” filing with the local governmental agency that governs fictitious name registrations (often this is done at the county level, rather than at the state level (usually the Secretary of State or Department of Commerce) where corporations and other business entities are registered. A DBA or Fictitious Name registration puts the world on notice that the sole proprietor is using a name that is “fictitious” and is not the sole proprietor’s real name. The DBA or Fictitious Name registration (some states call it a dba registration, while others call it a fictitious name registration – both terms mean the same thing) may make the sole proprietorship look like a business entity, but the reality is that the sole proprietor with a dba registration is really the individual doing business. As such, there is no business entity that shields the individual sole proprietor from the debts and liabilities of the business, as the individual and the business are one and the same. Therefore, while the sole proprietorship may be attractive from a simplicity and cost standpoint, it is really very unattractive from a legal liability standpoint. In general, therefore, it is virtually always a bad idea in our modern world to do business as a sole proprietorship.
Whenever two or more individuals or entities come together with the intent to engage in business for profit, a General Partnership has been created, unless another business entity type has been formed. This is a General Partnership by default, which may be created at law, even though the partners did not realize that they were creating a General Partnership. Partnerships may also be created with the intent to do so. Generally, a General Partnership will have a partnership agreement (it is always advisable to have a written partnership agreement which spells out the terms of the partnership). In the absence of a written partnership agreement, the terms of the partnership will be based on the agreement of the partners. If an issue of what the terms of the partnership are comes up and it results in litigation, determining the terms will be based on the evidence that is demonstrated and determined to be fact in court. Generally, states also have a statute (law) that defines the default law in that state that governs partnerships. In many states, the partnership statutory provisions are “fall back” provisions that will govern the partnership in the absence of a partnership agreement that covers the issue in question.
One of the biggest problems with the General Partnership structure is that the individual partners in the partnership are individually liable for the debts and the liabilities of the General Partnership. So, like the sole proprietor, there is no shield of protection for the individual partners of the partnership from business liabilities. Thus, the General Partnership structure is usually not the best entity choice. A possible exception to that general rule would be a situation be where the individual partners of the General Partnership are each a business entity, such as a corporation or LLC. In this instance, the General Partnership is often called a Joint Venture. A Joint Venture is usually just a general partnership. Most often (but not always) a Joint Venture is comprised of two or more existing business that are engaging together in a venture for profit.
A Corporation is an entity that is enabled to be created by statute (under the law of the State where the corporation is incorporated). A Corporation is a fictitious entity that exists only because the law says that it does. A Corporation, in most or maybe all states, is defined as a “person” in that it can buy, sell, lease, conduct business, trade, invest, sue or be sued etc. in its own name. A Corporation consists of officers, directors and shareholders. The Shareholders of the Corporation are the owners of the company. The Corporation, at the time of formation, authorizes a certain number of shares of stock to be issued to potential shareholders. The shareholders (stockholders) purchase a certain number of shares of stock of the Corporation. The Corporation is initially funded by the money (or assets) that it receives in exchange for the shares of stock that are purchased by the purchasers of the company stock. The shares of stock that are purchased by the purchaser are “issued” to the purchaser who then becomes a stockholder (or shareholder – they are synonomous terms). After the initial formation and issuance of all of the outstanding stock, the corporation may authorize the issuance of additional shares of stock to raise additional capital that the corporation may need. A corporation that is not publicly traded need only have the authorization of the directors (and possibly a majority vote of the existing shareholders) in order to issue additional shares of stock in the Corporation. A publicly traded corporation or a corporation that falls within the purview of the Securities and Exchange Commission may need to get authorization from the Securities and Exchange Commission before it can legally issue additional shares of stock.
In terms of Officers, a corporation generally must have at least a President, a Secretary and a Treasurer. Additional officers, such as a Vice President, Chief Executive Officer (CEO), Chief Financial Officer (CFO) may be authorized by the Corporation’s Bylaws. The Bylaws of the Corporation will define the duties and powers of each office therein authorized.
A Corporation must have a Board of Directors. In some states, a corporation need only have one director. In others, more than one director is required. Corporations that are not closely held generally have a number of Directors that are elected to sit on the Board of Directors. The appointment of Directors are by vote of the stockholders (usually done annually at the corporation’s annual meeting of the stockholders or by special meeting if a vacancy must be filled before the time for the annual meeting).
The officers and directors of the Corporation must be individuals (a company or trust may not fill an officer or director position).
The Corporation is governed by its Bylaws. The Bylaws of the Corporation serve as a sort of constitution for the Company – in order for certain acts to be lawful, they must be in accord with the Corporation’s Bylaws. The following matters are generally set forth in the Bylaws: procedures for annual and special meetings of the Shareholders and Directors, the offices of the Corporation are authorized and defined, the classes (types) of stock are defined and authorized. Stock certificates are authorized and any restrictions on their transfer may be set forth. Other matters may be addressed in the Bylaws as may be desired or as may be required by the Corporate Statute (law) in the State of formation (domestication) can be spelled out in the Bylaws as well.
The Stock of a Corporation consists of one or more classes of shares. Common stock is the basic stock of the corporation. Common stock shareholders receive distribution of the dividends (profits) on their stock when a dividend is declared and authorized by the Board of Directors. Preferred Stock is a stock share that has a preferential right that common stock shareholders do not have with regard to distribution of dividends and/or amounts distributable upon the Corporation’s liquidation. Within the different stock types, there may be multiple classes of stock (e.g., class A and class B shares of common stock) that define certain preferences such as the right to vote (some stock shares have voting rights and others are non-voting and, as such, the shareholder would have no voice/vote in important company matters but rather only a dividend/profit right).
Limited Liability Company (LLC)
An LLC is a business entity form that is enabled by statute in the state where the LLC is formed. An LLC generally has fewer business formality requirements than a corporation does. While the LLC does provide protection of the business owners in the same way that a corporation does, the LLC is really structured more like a partnership than a corporation (but unlike the general partnership, the LLC members are personally shielded from the LLC’s debts and liabilities). The ownership interests in the LLC are called “membership interests”. The membership interests may be allocated among the members as percentages of the total outstanding membership interests or they may be designated as membership units (much like shares of stock in a corporation). The LLC does not generally have officers and directors. Instead, the LLC is managed by one or more of the members of the LLC or by one or more non-member managers. The LLC is usually governed by an “operating agreement” which is really a contract between the members of the LLC. The operating agreement is akin to the partnership agreement in a partnership. The members and managers of an LLC may be individuals, business entities (such as a corporation or another LLC) or they may be trusts. Because of the general lack of statutorily imposed business formality requirements (which corporations generally have) and the freedom to govern the LLC internally as the members agree (usually memorialized in a written operating agreement), LLCs have become very popular. They are also a good business entity choice because of the fact that the LLC generally has “charging order protection” (which varies some from state to state) that prevents a judgment creditor of a member of the LLC from seizing the membership interest in the LLC.
A Limited Partnership is a business entity that is enabled by statute in the state of formation. A Limited Partnership consists of at least one “general partner” and at least one “limited partner”. The limited partner is shielded from personal liability for the debts and liabilities of the company. The general partner is personally liable for the debts and liabilities of the company. The limited partner may not participate in the management and affairs of the company and is as a passive investor in the company that receives profits from the partnership in his or her percentage of ownership in the partnership. If the limited partner participates in the management of the partnership, the limited partner may be deemed to have become a general partner in the company and, as such, may become personally liable for the debts and liabilities of the partnership. Because of the potential for liability, it is important that the passivity of the limited partners be maintained. In addition, due to the potential for the personal liability of the general partner for the debts and liabilities of the partnership, it is wise if the general partner of the limited partnership is a business entity such as a corporation or LLC (or a trust, in states where a trust meets the legal definition of a “person” and can own property in its own right and can sue and be sued in its own right). Like the LLC or general partnership, the partners of a limited partnership have “charging order protection.”
Because Limited Partnerships have often been used as a component in estate plans, a Limited Partnership is ofter referred to as a Family Limited Partnership or FLP for short. Whether it is referred to as an FLP or Family Limited Partnership, the legal reality is that an FLP is simply a Limited Liability Company.
Limited Liability Partnership
A Limited Liability Partnership (LLP) is an entity that is designed to protect the individual partners in the partnership from the liabilities of the other partners. The LLP structure is most often used by professionals such as lawyers, accountants and doctors. The LLP enables the individual practitioners to have the benefit of a form of partnership together while each of the partners is protected from the other partners’ malpractice liability in the event that occurs. It can also enable referrals between the partners of the LLP where referrals otherwise may be prohibited or restricted.
TAXATION OF BUSINESS ENTITIES
How the business entity will be taxed can be an important issue when deciding which business entity structure to choose. The following is a basic overview of how the different entity types are treated for Federal Taxation purposes:
Taxation of Corporations
By default (meaning unless the corporation elects to be taxed otherwise, by filing the proper election form with the Internal Revenue Service (IRS), a Corporation is taxed under 26 U.S. Code Chapter 1, subchapter C. A corporation taxed under subchapter C is commonly referred to as a “C Corporation” or a “C Corp”. A C Corporation is its own taxable entity, separate and apart from it’s owners/shareholders. As such, the C Corporation files its own tax return (IRS Form 1120) and pays its own taxes. When the corporation distributes dividends (profits) to the shareholders of the corporation, the shareholders then must report the dividend income on each of their own individual tax returns. Thus, with a C Corporation, there is a double-taxation effect – the corporation generates profits and pays taxes on those profits and then the it distributes the profits in the form of dividends to the stockholders and the stockholder pay taxes individually on the dividends.
A Corporation that has fewer than 100 shareholders may file an election with the IRS to elect to be taxed under 26 U.S. Code Chapter 1, subchapter S. A corporation that has elected to be taxed under subchapter S is commonly referred to as an “S Corporation” or “S Corp”. In addition to having fewer than 100 shareholders, in order to be able to elect to be taxed as an S Corporation, the corporation must meet the following requirements:
-all shareholders must be individuals (or certain qualifying entities such as certain trusts, estates or tax exempt organizations)
-none of the shareholders may be a non-resident alien
-the corporation may not have more than one class of stock
If the corporation has effectively and timely filed the election to be treated as an S Corp (IRS form 2553), it will be deemed to be an S Corporation. An S Corporation will file an 1120s corporate tax return to report the income or loss of the corporation, but the S Corp does not pay any taxes on its profits. The individual shareholders each then must report their respective share of the profits or losses of the corporation on their individual tax return (IRS form 1040).
It is important to note that the distinction between and S Corporation and a C Corporation is only for Federal Taxation purposes. In the “real world”, outside of the “tax world”, a corporation is simply a corporation.
Taxation of LLCs
The way that a Limited Liability Company is treated for Federal Taxation purposes depends upon how many members the LLC has. A single member LLC is deemed to be a “disregared entity” by the IRS. What this means is that the LLC itself is not taxed, but rather disregarded for taxation purposes. As such, the disregarded entity is treated as if it were a sole proprietor for Federal Taxation purposes. Therefore, the LLC does not file any tax return at all [even though the LLC generally will have its own federal tax identification number (EIN)]. Instead, the individual reports the profits or losses of the LLC on schedule C of his or her personal 1040 tax return. This is often referred to as “flow-through” or “pass-through” taxation (an S Corp, as discussed above is also a pass-through entity, but it does file a tax return to report the income or loss).
If the LLC has more than one member (that are not husband and wife – the husband and wife scenario is discussed later), by default it will be treated as a partnership for federal taxation purposes. The LLC that is treated as a partnership will file IRS Form 1065 with the IRS to report the profit or loss of the business, but the LLC itself does not pay any federal income taxes. Each individual member (partner) will report his/her respective percentage of the profits or losses of the LLC from the Schedule K-1 that they receive from the “Partnership” (LLC). The individuals report their share of the profit or loss of the LLC on schedule C of their individual 1040 tax return. [If there are only two members and they are husband and wife and they live in a community property state, they may choose to have the LLC treated as a Disregarded Entity, as if it were a single member LLC].
An LLC may also elect to be taxed as a C Corporation (IRS Form 8832) or as an S Corporation (IRS Form 2553) (if the LLC has under 100 members and all members would be qualifying shareholders under subchapter S – see section on S Corporations above). If the LLC elects to be taxed as a C Corportation or as an S Corporation, as far as the IRS is concerned the LLC will be a C or an S corporation as elected, even though in the “real world” it is an LLC. The ability to elect a different entity classification for tax purpose gives the business owners the option to take advantage of the many benefits of being an LLC but still being taxed as a corporation where that is deemed to be more beneficial.
Taxation of Partnerships
As already discussed, a partnership is not a separately taxable entity. The partnership will file a tax return to report the profit or loss of the partnership. The partnership will issue a schedule K-1 to each partner. The individual partners will each then report their respective shares of the partnership’s profits or losses from the schedule K-1 on their individual tax returns.