Starting a business involves many issues, not the least of which is what entity will operate the business. Many of the same concerns arise when dealing with a business. Taxation and liability are usually the primary issues.
Many businesses, and perhaps a majority of start-ups, are sole proprietorships. When the operation is effectively a one-man band, the business starts with an individual’s effort.
The sole proprietorship is the easiest business entity to start, as it does not require any filing or formality. An individual simply conducts a business and files taxes as an individual. Profit and loss from the business is reported on the individual’s personal income tax return.
The major drawback to a sole proprietorship is that the individual is also fully liable for any business debt or liability. That means the individual can be sued and if the plaintiff is successful, the plaintiff can reach the individual’s assets and not merely those in the business. The sole proprietor is not only liable for his or her sins, but also those of employees and possibly agents.
As business grows, many sole proprietors bring in new owners for financing and/or extra manpower. Multiple owners means the business is no longer a sole proprietorship, but these entrepreneurs do not consider liability or taxes so they operate as a general partnership. They may prepare a partnership agreement outlining responsibilities and benefits of each partner, but many do not even get to that level of documentation.
The partnership files informational tax returns and the partners each end up paying the taxes on partnership income on their individual tax returns. Each partner is also liable for all of the partnership’s actions, including another partner’s negligence. Someone suing the partnership can go after the partnership assets and the personal assets of all partners, one at a time or jointly, until paid.
An entity which sounds like a partnership but is more like a corporation is the limited partnership. A limited partnership requires filing documents with the State and formal paperwork to create the entity. A limited partnership is most often used to raise funds, as it brings with it protection from liability for the investor owners.
A limited partnership has two types of members. One, the general partner, is personally responsible for the business’ liabilities. Limited partners invest, and are only liable to the extent of their investment. The general partner controls the business.
Creating a limited partnership is relatively complicated and requires legal and tax assistance to structure correctly. Many investors in small businesses want more than an investment – they want a say on how the business is run. For these reasons, limited partnerships are not often the choice of entity for small businesses.
As business grows for proprietors and partners, and for many others at inception, liability for business, debts and mistakes is considered important. First stop in limiting liability is often consideration of incorporating. The very essence of incorporation is limited liability, with its roots in 17th Century chartered companies. Chartered companies were monopolies chartered by the government with limited liability. Those chartered entities eventually transitioned into corporations created under a royal charter or by Parliament in England, both of which were granted a monopoly for trade. Ultimately, the government chartered monopolistic entity was replaced by the corporation platform which could be used by all businesses.
A corporation is created by filing articles of incorporation with the State and its internal operations are governed by bylaws. Owners of the corporation are shareholders who acquire their ownership interest in exchange for funds, services or as incentive or reward. The owners (shareholders) only have liability to the extent of their investment in the corporation. The corporation has liability for corporate debts and claims against the entity. The corporation is generally managed by a board of directors elected by the shareholders and its operations run by officers designated by the board. The structure is formal. A corporation can have one or more shareholders.
The formal structure of a corporation may not be attractive to a “seat of the pants” business operator, but even more unattractive is corporate taxation. A corporation files its own tax return and pays income taxes on its profit. If there is any profit left over after paying the bills and taxes, that profit may be distributed to the shareholders as dividends. The shareholders pay taxes on those dividends, which means the corporation’s income is taxed twice.
Double taxation of corporate income was such a burden for small businesses looking to attract investors that Congress changed the tax code to allow for creation of a small business or s-corporation in 1958. This new creature allowed incorporation but the corporation files an informational tax return and the shareholders pick up the income and pay the taxes on their individual returns. The structure avoids double taxation of a regular corporation.
The s-corporation is intended to benefit small businesses, and Congress meant small seriously. The original s-corporation statute limited the number of shareholders to 10. That limit was increased to 15 in 1976, 25 in 1981, 35 in 1982, 75 in 1986 and 100 in 2004. Shareholders must be individuals, certain trusts and estates and may not be partnerships, corporations or non-resident aliens. An s-corporation can only have one class of stock.
The prohibition on non-resident alien shareholders and limitation to one class of stock can make the s-corporation unattractive for investors. A regular corporation is not an attractive alternate, because of double taxation. Consequently, the limited liability company was invented when the State of Wyoming passed a statute allowing creation of that entity in 1977. The entity was not widely popularized and the IRS virtually ignored it for over a decade, until Delaware adopted legislation approving the entity. The IRS could no longer ignore the LLC and gave its blessings in 1993.
The LLC is somewhat of a Frankenstein, drawing from the limited liability of a corporation and the flexibility of a partnership. It is created by filing articles of organization with the State and in place of bylaws and a rigid corporate structure it has an operating agreement. With limited liability of owners and ability to tailor the operating agreement to the business arrangement between owners, the limited liability company has become the most common entity of choice for newly formed businesses. It can be member managed as a partnership or manager managed as a corporation. It can even adopt a corporate structure. There are no limits on the number of members and non-resident aliens can participate. It can elect to be taxed as a corporation or an s-corporation. It can also have members that are other than individuals.
Perhaps the biggest mistake in the choice of entity for a business is the temptation to “do-it-yourself.” Many of these entities can be created by filing with the State a bare bones document, which can often be obtained from the State’s website itself. Other “helpful” websites also provide additional forms for boilerplate bylaws, operating agreements and even partnerships. The do-it-yourselfer often fails to do anything more than file what is required by the State to create an entity and later discovers that failure to complete entity documentation creates tax problems and even allows third parties to claim that the entity is not really in existence. The do-it-yourselfer then finds that limited liability was not obtained or that unexpected tax problems endanger the business.
Choice of entity is an important issue that should be considered at inception of a new business. All too often, it is given little thought or left to chance.
William G. Morris is the principal of William G. Morris, P.A. William G. Morris and his firm have represented clients in Collier County for over 30 years. His practice includes litigation and divorce, business law, estate planning, associations and real estate. The information in this column is general in nature and not intended as legal advice.