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November 2008
Business Insights

By Sonjui Kumar & Nikhil Prahbu

What Legal Entity is Right for Your Business?

So you’ve come up with a great business idea and are ready to move forward. What business entity is right for your purposes? A partnership? A limited liability company? A corporation? Should your corporation be an “S” or a “C”? What’s the difference between them anyway? Before you call an attorney or an accountant, learn some of the basics about these forms of ownership and their pros and cons.

Sole proprietorships

Sole proprietorships are the simplest form of business entity. It is a business that is owned by an individual directly. There are very few restrictions and very little paperwork needed to establish a sole proprietorship. As a sole proprietor, there are no formalities, no minutes, and no officers or directors. You don’t have to prepare a separate tax return for the business or open a bank account. You do, however, have to get a business license and maintain business records for tax and legal purposes. The main drawback is that sole proprietors are personally liable for the debts and obligations of their business. As a sole proprietor, you may find that a creditor may be able to seize your personal assets to repay (your) business debts and obligations. Sole proprietorships cannot use certain tax benefits available to other forms of business, such as retirement plans, group medical and dental plans and stock options.

Partnerships

Partnerships are another simple form of business entity. A general partnership is easy to establish and maintain. You do not have to register with the state, pay fees, or file a separate income tax return. The partners can determine the responsibilities that each is accountable for and the amount of capital or know-how that each will contribute to the business. These agreements should be formalized in a partnership agreement to avoid future disputes. Also, the way the business profits and losses will be split can be determined by an agreement among the partners. Partnerships also have their drawbacks. The business acts of one partner can legally bind all other partners, greatly increasing each owner’s risk. Just like sole proprietors, all partners can be personally liable for business debts and lawsuits. Partnerships also cannot use certain tax benefits such as retirement plans and group insurance plans.

Corporations and LLCs

Avoiding personal liability is one of the main reasons to form a corporation or limited liability company. This article will not discuss the use of limited liability partnerships, which are more complex to operate and establish. A properly incorporated and operated company provides owners with limited legal liability for the company's business activities and debts. A creditor can only reach the assets held by the company, not an owner’s personal assets. Corporations and LLCs can also utilize a number of tax benefits, including deductions for employee benefits and insurance.

So, why doesn’t everyone incorporate their business? Forming a corporation requires up-front and on-going expenses and administration. In addition to documents that need to be filed with the State (and most likely drafted by an attorney), owners must pay filing fees, hold regular business meetings of corporate officers and directors, keep records of corporate activity, and maintain the corporation's ongoing financial independence. Furthermore, the taxation relating to corporations is more complicated than with sole proprietorships or partnerships. A standard corporation, known as a “C” corporation, is taxed on all income and must file a separate income tax return. Shareholders of a corporation are also taxed on any profits distributed to them from the business. This may result in “double taxation.” One solution to the double-taxation problem is for corporations to elect "S" corporation tax status, which allows a corporation to “pass-through” its profits and losses to its shareholders. “S” Corporations, however, are limited as to the number and types of owners. An “S” Corporation cannot be owned by other entities or foreign persons, and may not have more than 100 owners.

Another popular choice of entity is the Limited Liability Company (LLC). LLCs combine the characteristics of both corporations and partnerships. LLCs may be managed by all its members or by a designated manager or group of managers. An LLC has the benefit of protecting its members from personal liability, much like a corporation. Just like a corporation, LLCs are organized by filing organizational documents with the State and obtaining separate tax identification numbers. Like a partnership, the profit distribution in an LLC is flexible and can be determined in an agreement among the members. Similar to “S” corporations, double taxation is avoided because profits are passed through to each individual owner. In addition, an LLC can be operated less formally than a corporation; members of an LLC do not need to have regular meetings or elect officers and directors. LLCs can have an unlimited number of owners, including non-U.S. residents and other entities. So why doesn’t everyone establish their business as an LLC? Although LLCs have become increasingly popular, LLCs do not offer some tax planning advantages available to corporations. Also, LLCs are not currently publicly traded on a stock exchange and cannot issue tax incentive employee stock options.      

Personal liability

Keep in mind that even owners of a corporation or an LLC can have personal liability unless certain legal and financial formalities are followed. All business accounts must be separated from personal funds, good corporate records should be maintained, and documents should be signed in the company’s name showing a title underneath the signature. Also, company owners are often required to provide personal guarantees to banks, landlords and other third parties, making the largest debts of a company subject to personal liability even if you are operating under a company.

Choosing a business entity is an important decision and should not to be taken lightly. There are important legal, tax, accounting and practical issues to be considered. Do your homework before making this choice and seek the advice of your attorney or accountant.

Disclaimer: This article is for general information purposes only, and does not constitute legal, tax or other professional advice. This article is a brief discussion on a specific subject matter and it is not intended to, nor does it, cover each and every legal issue that may be important to your particular situation. We do not accept any responsibility for any loss that may arise to the reader from reliance on the information contained in this article. No reader should act or refrain from acting based on information contained on this article without first seeking advice of an attorney.

Sonjui L. Kumar is a founding member and partner in Kumar Pathak, LLC, and her areas of practice include general corporate representation, complex commercial transactions, both domestic and international, contract law and trust and estate planning, including succession planning for privately held businesses. Her client list includes numerous entrepreneurs, technology and service companies.

Nikhil R. Prabhu is a founding partner of Kumar Pathak, LLC, and his areas of practice include complex commercial and real estate transactions, landlord-tenant law, general business law, and corporations/partnerships/LLC law.


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