Choice of Business Entity
Selecting the best business form for your company requires evaluating all the available options rather than simply choosing the most popular or familiar structure because several factors like ownership, type of investment, and type of transaction may play critical role in your decision-making process. (For example, non-citizens cannot form an S corporation.) By making your choice carefully, with the guidance of knowledgeable advisors, you can avoid the catastrophic mistakes made by many well-educated business owners. Consider the following example in evaluating your choice for a business structure.
Raj and Shanty Patel both lawyers by trade decided to select a Limited Liability Company (LLC) to run their practice without consulting an attorney who specializes in forming entities. Unfortunately for them, not only they had to file for bankruptcy, they lost their licenses to practice law as well. The following paragraphs help explain their story.
Raj and Shanty quit their stressful jobs as IT consultants and decided to attend Land Grant University School of Law. Three years later, their hard work paid off when they graduated with honors.
Upon graduation, they decided to form their own firm. When doing so, Raj and Shanty—despite having studied Business Organization—failed to access all their business form options, assuming that the trendy limited liability company (LLC) was the right choice. The LLC offered Raj and Shanty limited liability and flow-through taxes, allowing them to avoid double taxation. Avoiding double taxation was attractive because Raj and Shanty, who had already spent their life-savings on tuition and living expenses, were starting out on a shoestring budget.
Even though they invested most of their remaining money in the company, Raj and Shanty soon discovered that the LLC could not even pay for necessities such as Westlaw subscription or a paralegal’s salary. To pay for these and other foreseeable expenses, Raj was forced to borrow $10,000 with a personal guarantee. Then tragedy—rather two tragedies—struck.
The first tragedy was a personal one: a year later, Raj suffered a heart attack. When tending to Raj and the practice became too much for Shanty, she hired Deep Chopra as a paralegal and delegated the accounting and banking functions to him. With only one of the partners working, the practice began to show signs of trouble—it could no longer sustain itself and could not even cover rent. To help the business stay afloat, Deep, on behalf of the LLC applied for a $50,000 line of credit.
The second tragedy was professional, but ultimately became personal: one evening when Shanty forgot to turn off the space heater, the office burned to ground. Even though the insurance company paid to rebuild the office, the LLC did not have the funds to replace the equipment lost in the fire because of a lack of business interruption insurance as well as lack of income since Shanty was devoting all of her time to Raj’s health issues, assisting clients whose files had been lost in fire, and not generating new business.
Shanty finally decided to face the realty and close the practice. However, she was horrified to discover that simply dissolving the LLC left her with two major problems. Shanty first learned that dissolving the LLC did not relieve her from all of her obligations because she and Raj had personally guaranteed the debt. She then discovered that, because she had mingled the LLC funds with personal funds to pay for Raj’s medical bills, the bank would likely pierce the corporate veil for the $50,000 line of credit. Her only way to avoid the liability was to file for bankruptcy and give up her license to practice law since filing bankruptcy would likely disqualify her to practice law.
The most effective way to select the best business form for your company is to consider the array of possibilities and understand how their significant differences could affect your goals, which could sway your decision. The examples and explanations below offer these comparisons for (1) a sole proprietorship, a general partnership, a limited partnership, and an LLC; (2) an LLC, a chapter C corporation, and subchapter S corporation; (3) an LLC, a professional limited liability company (PLLC) and a professional corporation (PC); and (4) an LLC and a limited liability partnership (LLP).
1. Comparison between a Sole Proprietorship and a General Partnership, Limited Partnership, and an LLC:
Choosing an entity means that you must consider not only the differences between these structures but also your personal goals, e.g., need to collect social security at retirement, which may necessitate you to pay social security taxes rather than avoid them. The basic four factors that you should evaluate in order to understand the difference before choosing an entity are (a) Public Notice; (b) Management Structure; (c) Taxation Issues; (d) Liability Issues.
a. Public Notice
When selecting a business form, know that some, but not all, business forms require new business owners to (1) notify the public by registering the business name, (2) obtain a business license or a certificate if using an assumed name. Generally, most cities require a business license. To learn about the licensing requirement, you can call the city and the author will not discuss those here. The list below indicates the notice, if any, required for each of the four business forms.
Sole proprietorship no public notice required
General partnership no public notice required
Limited partnership public notice required
LLC public notice required
b. Management Structure
The business form you choose will affect the flexibility you have with your company’s management structure. With a sole proprietorship, the sole proprietor is the management structure for a company meaning the sole proprietor makes all the management decisions. With a general partnership, the general partners can manipulate the management structure in a variety of ways, e.g., all members or some members may manage the entity. With a limited partnership, the partner with limited partnership interest cannot manage the day-to-day operation, which means partners with only general partnership interest can manage the entity. An LLC is similar to a general partnership, in that LLC members can manipulate the management structure in a variety of ways.
Therefore, if you want a fixed management structure, then consider creating a sole proprietorship or a limited partnership; however, if flexibility with management structure is a desired option, then consider creating a general partnership or an LLC.
c. Taxation Issues
For many people, their choice of business form is strongly influenced by taxation issues, especially whether the form will allow taxes to “flow-through.” “Flow-through” taxes means the sole proprietor pays ordinary income taxes on profits of the business, and losses are offset against other income of the sole proprietor. In other words, because the IRS does not recognize sole proprietorship as a separate entity for its owner, which allows the sole proprietors to pay ordinary income taxes on profits and deduct losses against other income. Even though taxes are based the IRS determination whether the entity in question is a separate entity from its owners/members/shareholders and thus, subject the to an entity level taxation, the IRS permits partnerships and LLC’s to manipulate the tax structure by simply making an election on the tax forms. As a result, sole proprietorships, partnerships, and LLC’s can all offer “flow-through” taxes, each with their own advantages and restrictions.
Sole proprietor—“flow-through”—ordinary income taxes on profits and deduct losses against other income
Partnerships—“flow-through”—partners must file an informational return, which shows the proportionate share of partnership profits or losses allocated to each partner, but partners pay taxes on “allocated” profits, not just “distributed” profits.
LLC—“flow-through”--whether an LLC is a “flow-through” depends on its federal tax classification. Federal tax classification permits an LLC owner to choose its classification as a disregarded entity or as a corporation (both chapters C or S). If an LLC is classified as a single-member LLC, or as an S corporation, it would be a “flow-through” entity. A multiple-member LLC too can choose its classification as a partnership or as a corporation.
While ease of operating and flexibility are attractive features of a sole proprietorship, they loose their attractiveness if the owner needs equity capital or debt financing to grow.
d. Liability Issues
You cannot simply rely on a business structure alone to limit your liability exposure stemming from owning and running a business because no business form alone eliminates all the risk. However, some business structures do permit you to limit the exposure based on your capital contributions and other similar factors, which are discussed below. To properly insulate yourself from the liability, you must take other steps, e.g., purchase an insurance policy to cover those losses left unprotected by the business form alone. But before selecting a form, your analysis should include two factors: one, the liability protection permitted under the sole proprietorship, general and limited partnership, and LLC form in your jurisdiction (meaning your current state), and another, the liability protection permitted in a foreign jurisdiction for those considering expanding into other markets (meaning another state if you intend to expand your business).
Sole proprietorship—structure offers no liability protection because the owner is liable for all the debts and obligations of the business. However, since the decision-making process rests with the owner, the owner can control the exposure. The exposure, under this structure, would be similar regardless of the jurisdiction because there is established case law to predict the outcome to some certainty.
General partnership—there are three reasons why general partnership form offers no protection. One reason is because the exposure from the business debt is too great since the partners are personally liable for the debts and obligations of the partnership without regard to their capital contributions for debts and obligations incurred in the ordinary course of business. In fact, the amount of capital contribution is irrelevant to the share of profits, losses, distributions allocated, and the liability protection. To some extent, a partnership can be riskier than a sole proprietorship, since the partnership options expose either some or all of the owners to personal liability for the debts and obligations of business organization.
Another reason is that partners can be agents of the partnership, which means each partner has the statutory apparent agency authority to bind the partnership for the partnership’s debts incurred in the ordinary course of the partnership’s business. Even though, in a manager-managed company, members can modify the statutory authority, that may or may not be enough.
Finally, the exposure, under this structure, may or may not be similar in all jurisdictions even though there is an established case law, e.g., to determine what rules would govern the internal control or other similar issues. But because general partnerships have been around, there is plenty of case law to determine how a court might rule.
Limited partnership—form does offer more liability protection than general partnership because liability is proportionate to the capital contributions. In other words, limited partners are not subject to the obligations of the partnership beyond their respective capital contributions. The predictability under this structure would be very similar to general partnership.
LLC—this form offers the most liability protection because no owner, as an owner, is exposed to personal liability for the debts and obligations of the LLC. But the limited liability protection is not absolute since members of an LLC are liable for their own tortious acts, omissions, or contract guarantees undertaken on behalf of the entity.
Even though this form offers the most protection, two important factors to consider are: one, this is the newest form of business structure. As consequences, there is not enough case law to explain how some or all of the provisions of this statute will be interpreted. Another, the liability protection may differ in a foreign jurisdiction because not all states provide the same protection to foreign entities as they do to their domestic entities. Experts speculate though that a foreign jurisdiction would provide the foreign LLC at least the same liability protection in multi-state transactions that it permits a domestic LLC, which makes the LLC structure more attractive than any other form of entity, e.g., an LLP (limited liability partnership). To translate that rule into a business language, if predictability is important in a business environment, this structure may not be the answer for you if you are considering expanding and have the need to predict in advance to hedge against the business risks.
2. Comparison between an LLC (if classified as a partnership) and a chapter C and a subchapter S corporation: No matter what structure you are considering or comparing, the above mentioned analysis is critical. In other words, you must discuss your personal and business goals with your CPA and an attorney to determine an entity that is right for you. Again, the basic four factors that you must evaluate remain the same, which are (a) Public Notice; (b) Management Structure; (c) Taxation Issues; (d) Liability Issues are the same here as well.
a. Public Notice
As previously discussed, some business forms require new business owners to (1) notify the public by registering the business name, (2) obtain a business license or a certificate if using an assumed name. Again, to learn about the licensing requirement, you can call the city and the author will not discuss those here. The list below indicates the notice, if any, required for each of the three business forms. In addition to the notice and license requirements, forming chapter C and S corporation have some unique filing requirements, which, if they apply, the author will discuss those.
LLC public notice required
Chapter C corporation public notice required
Subchapter S corporation public notice required --- organizing an S corporation requires an extra step since the incorporators must first create a C corporation and then shareholders must elect the S corporation status.
b. Management Structure
Again, the flexibility for managing your company depends on the structure you choose. As already mentioned, with an LLC, the members can manipulate the management structure in a variety of ways, e.g., all members or some members may manage the entity. With an S corporation too the shareholders can directly manage the entity. With a C corporation, on the other hand, shareholders cannot manage the entity directly. Thus, the decision rests on your comfort level meaning do you prefer flexibility versus fixed management structure.
c. Taxation Issues
The decision to choose either one of these three structures depends on tax consequences for most business owners. The tax consequences for two out of these three structures depend on how they are structured for tax purposes since the IRS permits owners to self-select the tax treatment. If the owners choose “flow-through” then pays ordinary income taxes on profits of the business, and losses are offset against other income like sole proprietors and partnerships. If they do not choose the “flow-through” tax treatment then they are taxed twice meaning the shareholders pay taxes on their personal tax returns and the shareholders pay taxes as the owners (the term owner is used for simplicity purposes) of a corporation. In essence, two of these structures offer “flow-through” taxes with its own advantages and restrictions. In addition to pointing double versus single tax treatment, the author will point out other tax consequences such as (1) if the owners intend to borrow; (2) self-employment and Medicare taxes.
LLC—“flow-through”—whether an LLC is a “flow-through” depends on its federal tax classification. Federal tax classification permits an LLC owner to choose its classification as a disregarded entity or as a corporation (both chapters C or S). If an LLC is classified as a single-member LLC, or as an S corporation, it would likely be a “flow-through” entity. A multiple-member LLC too can choose its classification as a partnership or as a corporation.
Other tax consequences—an important consideration for some if they intend to borrow funds to run a company, they may or may not be able to increase or reduce their basis, which could have an impact on their tax liability. Because an LLC is taxed under Subchapter K, the members may increase their basis to the extent they guarantee debt of the LLC. The basis can also increase or decrease depending on the profits and losses allocated to each member. Certain LLC’s members would be able to increase their basis by a proportionate amount of the non-recourse debt incurred by the entity, even though the members will not be per se liable for this debt. In addition, members of LLC can include the business debt even if members personally guaranteed the debt.
LLC members do pay self-employment taxes on all allocations of income or Medicare taxes on those portions of company earnings that are distributed.
C corporation—not a “flow-through,” which means double taxation. The shareholders pay taxes on distributed income. The shareholders of C corporation pay no taxes on retained earnings since shareholders of a C corporation cannot receive allocations of any corporate profits or losses. In simpler terms, profits and losses of the corporation belong to the corporation not the shareholders. In certain circumstances, however, shareholders of C corporation might have to pay additional taxes on accumulated earnings.
Other tax consequences—in a C corporation, shareholders cannot increase the basis in their stock by guaranteeing corporate debt.
S corporation—could be a “flow-through”—whether an S corporation is a “flow-through” depends on its federal tax classification since the IRS permits self-classification. As a result, the shareholders of an S corporation do not pay double taxes on profit distribution and do not pay Social Security or Medicare taxes on non-wage (anything that is not wages) income. The shareholders of S corporation pay taxes on proportionate share of income, deductions and credits of the entity even if they do not actually receive distributions.
Other tax consequences—in an S corporation, shareholders cannot increase the basis in their stock by guaranteeing corporate debt.
Another factor to consider regarding an S corporation is that it provides less flexibility in attracting key employees than entities taxed under Subchapter K (LLC) or Subchapter C because an S corporation can only issue single class of stock.
d. Liability Issues
In the interest of keeping it interesting, the author will simply remind the reader to compare the extent of liability protection permitted under each structure and to review the extent of liability protection permitted by foreign jurisdictions for those considering expanding into foreign markets (meaning another state if you intend to expand your business).
LLC —for analysis of liability protection under LLC, see infra.
C corporation—this form offers the most liability protection because no shareholder, as an owner, is exposed to personal liability for the debts and obligations of the Corporation. But the limited liability protection is not absolute since shareholders of a C corporation are liable for their own tortuous acts, omissions, or contract guarantees undertaken on behalf of the entity.
Even though the liability is not absolute, two factors make this form more attractive to businesses: one, because all jurisdictions offer this form of business structure, it is easier to compare the level of liability protection provide under each jurisdiction. Another, because this is the oldest form of business entity, there is well established case law that can assist a business owner in predicting with some certainty the outcome in multi-state transaction in case of a dispute. To translate that rule into a business language means that a business owner can predict and hedge against the business risks in advance.
S corporation—because an S corporation is simply a status for tax purposes, the same rules apply to an S corporation as they apply to a C corporation. Thus, the extent of liability protection is same under this structure.
3. Comparison between an LLC, a PLLC (Professional
Limited Liability Company), and a PC (Professional
Corporation): Three main differences between an LLC, a PLLC, and a PC are: (1) forming a PLLC and a PC require a professional license; (2) the professional may be required to obtain an approval from the state’s highest court or a bar association before forming a PLLC or a PC, e.g., lawyers; and (3) the loss of professional (meaning the member/shareholder leaves) or professional status (meaning the member/shareholder is disbarred) may dissolve the entity. However, these restrictions do not apply to all professions, e.g., landscape services. Otherwise, all other rules that apply to LLCs and corporations (chapter C and subchapter S) apply to a PLLC and/or a PC. In the interest maintaining consistency in structure, the author will very briefly remind the reader the four factors for comparison purposes.
a. Public Notice
Even though the benefit of forming an LLC over a PLLC or a PC is that the LLC organization is simpler, forming an LLC is generally not an option for many providing professional services. Otherwise, an LLC, a PLLC are identical just like a PC is identical to a chapter C corporation.
LLC Public Notice is required
PLLC Public Notice is required
PC Public Notice is required
b. Management Structure
To reiterate again, the choice of entity depends on whether you prefer flexibility for managing your company. As already mentioned, with an LLC, the members can manipulate the management structure in a variety of ways, e.g., all members or some members may manage the entity. With a PLLC too the members can manipulate the management structure so long no one other than a licensed professional is a member with one exception this rule does not apply in all states. With a PC, on the other hand, shareholders cannot manage the entity directly and if all the shareholders with a professional license leave, the corporation would likely be dissolved. In essence, in some states, the members/shareholders desire for a particular management structure may be irrelevant if state rules limit their options to choose between these structures.
c. Taxation Issues
The tax considerations for a PLLC or a PC are like any other LLC or a corporation.
LLC—“flow-through”—detailed explanation infra
PLLC—“flow-through”—detailed explanation infra
PC—“flow-through”—detailed explanation infra
d. Liability Issues
The extent liability protection under an LLC structure is the same as a PLLC. Similarly, the extent of liability protection is the same between a chapter C corporation and a PC. To refresh your memory, please refer back to the relevant sections in this article. Please remember, as far as liability is concerned, professionals are liable for their own malpractice, even if the business was incorporated.
4. Comparison between an LLC and LLP (Limited Liability
Partnership): The extent of liability protection is what caused of its popularity an LLC structure. However, when comparing an LLC and an LLP, the extent of liability protection is very similar. The protection is similar since even though an LLP is a form of general partnership that, by means of making an election with the state, the selection modifies the traditional rule of joint and several liability amongst the partners for partnership debts and obligations and substitutes either partial or full limited liability (see below for detailed explanation). There are very little differences in the other basic requirements as well.
a. Public Notice
Both entities require formal notice. The ease of organizing one over the other depends on state-specific requirements.
LLC Public Notice Required
LLP Public Notice Required
b. Management Structure
Like members of an LLC, all partners of an LLP can participate in the management of entity without losing the liability shield as well.
c. Taxation Issues
As previously discussed, LLCs can be “flow-through” depending on the members choice. They can choose their tax classification. Similarly, since LLPs are form general partnership, LLPs are “flow-through” entity but partners must file an informational return, which shows the proportionate share of partnership profits or losses allocated to each partner, but partners pay taxes on “allocated” profits, not just “distributed” profits.
LLC—“flow-through”—detailed explanation infra
LLP—“flow-through”—detailed explanation infra
d. Liability Issues
For discussions about the extent of liability protection with an LLC structure, please refer to several preceding paragraphs. The focus of this paragraph will be an LLP form. The traditional rule of joint and several liabilities amongst the partners for partnership debts and obligations do not apply under this structure because this statute substitutes either partial or full limited liability. As a result, one, all partners avoid individual liability for the debts and obligations of the entire partnership including judgments that arise from errors, omissions, or negligence committed in the course of a partnership; another, LLP partners cannot compel each other to contribute, in case, the LLP does not have sufficient funds to pay the judgment.
However, the analysis of the extent of protection under the LLP Act does not end there. Still is important to note that the extent of protection depends on whether the jurisdiction has adopted a full-shield LLP Act as opposed to a partial-shield LLP Act. In the full-shield LLP Act states, partners are not per se liable for the debts and obligations of the partnership, irrespective of the legal theory under which those claims are raised. By way of contrast, a number of states have partial-shield LLP Acts, and in those jurisdictions, partners, as partners, have limited liability from certain claims made against the partnership, but remain per se liable for other claims made against the partnership. Consequently, exactly what is the extent of the liability protection afforded (or not) by a partial-shield jurisdiction must be assessed based upon the statute in question. Finally, for some business owner, how a foreign jurisdiction might treat the entity may have bearing on their decision-making process as well. Even though the experts speculate that the foreign state will respect the liability permitted in the jurisdiction in which the entity was organized, which has many practical implications, e.g., what debts will be discharged in bankruptcy but that is just a guess. It is, thus, important to analyze how the states in question might treat organizational issues from the internal affairs issues of a business.
Like Raj and Shanty, limited liability issues for the business debts looms on every entrepreneur’s mind. Most entrepreneurs borrow to some extent, and they all want and need to know how to plan for catastrophe so they do not have to sell their personal assets. However, because no one form of entity provides protection from all types of liability, good understanding the investment goals, the risk capacity of the investors, and the characteristics of an entity could guide an entrepreneur and his team (an attorney and a CPA) during the planning stages in how to minimize the risk. Again, it is also crucial to remember that although taking advantage of the limited liability afforded by certain forms of business organization is important, entrepreneurs should consider other risk-shifting mechanisms, such insurance or borrowing from only those trade creditors that do not require personal guarantees.
Finally, there are three points to take away from this article. One, one form does not fit all was the point of the illustrations here. It is extremely important to evaluate all the options before selecting an entity that fits your needs and goals. Another, incorporating alone does not protect against all types of liabilities. Rather, entrepreneurs must add layers of protection, e.g., obtaining various types of insurances would be adding layer of liability protection. Finally, there is no substitute for forming a team that is experienced to guide you through this process, which is why the author selected two attorneys, Raj and Shanty, to make this point. These attorneys had the education but lacked the experience.
