Which Legal Structure To Choose? Comparison of forms of business organizations

Usa: Legal Forms Of Ownership

Sole Proprietorship. The majority of all small business start out as Sole Proprietorship. These firms are owned by one person, usually the individual who has day-to-day responsibility for running the business. Sole proprietors own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the view of the law and the public, you are one in the same with the business. Currently used by more than 75 percent of all businesses, it is often the suggested way for a new business that does not carry great personal liability threats. The owner simply needs to secure the necessary licenses, tax identification numbers, and certifications in his or her name, and you are now in business. Major advantages that differentiate the sole proprietorship from the other legal forms are (1) the ease with which it can be started, (2) the owner's freedom to make decisions, and (3) the distribution of profits (owner takes all).

Advantages. Easiest and least expensive form of ownership to organize. Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit. Sole proprietors receive all income generated by the business to keep or reinvest. Profits from the business flow-through directly to the owner's personal tax return. The business is easy to dissolve, if desired.

Disadvantages. Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk. May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans. May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a part of the business.

Some employee benefits such as owner's medical insurance premiums are not directly deductible from business income (only partially deductible as an adjustment to income). A corporation pays 15% federal income tax on taxable income up to $50,000; 25% tax on income from $50,001 - $75,000; 34% tax on income from $75,001 - $100,000; 39% tax on income from $100,001 - $335,000; and 34% tax on income over $335,000. A sole proprietor who filed a federal income tax return under the status of married, filing jointly, would pay 15% federal income tax on taxable income up to $35,800; 28% tax on income from $35,801 to 86,500; and 31% tax on income over $86,501. Sale/Transfer of All or Part of the Business. The sole proprietor can transfer the business only by the sale of business assets. This means it is more difficult to have someone buy into the business, and there are potential tax consequences of converting a sole proprietorship to a corporation or a Limited Liability Company rather than starting out with a durable form of business entity.

Federal Tax Forms for Sole Proprietorship: Form 1040: Individual Income Tax Return. Schedule C: Profit or Loss from Business (or Schedule C-EZ). Schedule SE: Self-Employment Tax. Form 1040-ES: Estimated Tax for Individuals. Form 4562: Depreciation and Amortization. Form 8829: Expenses for Business Use of your Home.

Types of Partnerships. In a Business Partnership, two or more people share ownership of a single business. Like sole proprietorships, the laws do not distinguish between the business and its owners. The Partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed;. Its difficult to think about a "break-up" when the business is just getting started, but many partnerships split up at crisis times and unless there is a defined process, there will be problems. They also must decide up front how much time and capital each will contribute.

Advantages of a Partnership. Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement. With more than one owner, the ability to raise funds may be increased. The profits from the business flow directly through to the partners' personal tax returns. Prospective employees may be attracted to the business if given the incentive to become a partner. The business usually will benefit from partners who have complementary skills.

Disadvantages of a Partnership. Partners are jointly and individually liable for the actions of the other partners. Profits must be shared with others. Since decisions are shared, disagreements can occur. Some employee benefits are not deductible from business income on tax returns. The partnership may have a limited life; it may end upon the withdrawal or death of a partner.

General Partnership. Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.

Advantages. Simple and inexpensive to create and operate Owners (partners) report their share of profit or loss on their personal tax returns.

Disadvantages. Owners (partners) personally liable for business debts.

Limited Partnership. Limited Partnership and Partnership with limited liability "Limited" means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decisions, which generally encourages investors for short-term projects, or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses.

Advantages. Limited partners have limited personal liability for business debts as long as they don't participate in management. General partners can raise cash without involving outside investors in management of business.

Disadvantages. General partners personally liable for business debts. More expensive to create than general partnership Suitable mainly for companies that invest in real estate.

Federal Tax Forms for Partnerships. Form 1065: Partnership Return of Income. Form 1065 K-1: Partner's Share of Income, Credit, Deductions. Form 4562: Depreciation. Form 1040: Individual Income Tax Return. Schedule E: Supplemental Income and Loss. Schedule SE: Self-Employment Tax. Form 1040-ES: Estimated Tax for Individuals.

Corporate Structures. Corporation. A corporation, chartered by the state in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it. A corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes.

Advantages. Shareholders have limited liability for the corporation's debts or judgments against the corporations. Generally, shareholders can only be held accountable for their investment in stock of the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.)

Corporations can raise additional funds through the sale of stock. A corporation may deduct the cost of benefits it provides to officers and employees. Can elect S Corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership.

A corporation pays 15% federal income tax on taxable income up to $50,000; 25% tax on income from $50,001 - $75,000; 34% tax on income from $75,001 - $100,000; 39% tax on income from $100,001 - $335,000; and 34% tax on income over $335,000. A sole proprietor who filed a federal income tax return under the status of married, filing jointly, would pay 15% federal income tax on taxable income up to $35,800; 28% tax on income from $35,801 to 86,500; and 31% tax on income over $86,501.

Disadvantages of a Corporation. The process of incorporation requires more time and money than other forms of organization. Corporations are monitored by federal, state and some local agencies, and as a result may have more paperwork to comply with regulations. Incorporating may result in higher overall taxes. Dividends paid to shareholders are not deductible form business income, thus this income can be taxed twice.

Federal Tax Forms for Regular or "C" Corporations. Form 1120 or 1120-A: Corporation Income Tax Return. Form 1120-W Estimated Tax for Corporation. Form 8109-B Deposit Coupon. Form 4625 Depreciation.

Subchapter S Corporation. A tax election only; this election enables the shareholder to treat the earnings and profits as distributions, and have them pass thru directly to their personal tax return. The catch here is that the shareholder, if working for the company, and if there is a profit, must pay herself wages, and it must meet standards of "reasonable compensation". This can vary by geographical region as well as occupation, but the basic rule is to pay yourself what you would have to pay someone to do your job, as long as there is enough profit. If you do not do this, the IRS can reclassify all of the earnings and profit as wages, and you will be liable for all of the payroll taxes on the total amount.

Advantages. Owners have limited personal liability for business debts. Owners report their share of corporate profit or loss on their personal tax returns. Owners can use corporate loss to offset income from other sources.

Disadvantages. More expensive to create than partnership or sole proprietorship. More paperwork than for a limited liability company, which offers similar advantages. Income must be allocated to owners according to their ownership interests. Fringe benefits limited for owners who own more than 2% of shares.

Federal Tax Forms for Subchapter S Corporations. Form 1120S: Income Tax Return for S Corporation. 1120S K-1: Shareholder's Share of Income, Credit, Deductions. Form 4625 Depreciation. Form 1040: Individual Income Tax Return. Schedule E: Supplemental Income and Loss. Schedule SE: Self-Employment Tax. Form 1040-ES: Estimated Tax for Individuals.

Professional Corporation. Advantages. Owners have no personal liability for malpractice of other owners.

Disadvantages. More expensive to create than partnership or sole proprietorship. Paperwork can seem burdensome to some owners. All owners must belong to the same profession.

Nonprofit Corporation. Advantages. Corporation doesn't pay income taxes. Contributions to charitable corporation are tax deductible. Fringe benefits can be deducted as business expense.

Disadvantages. Full tax advantages available only to groups organized for charitable, scientific, educational, literary, or religious purposes. Property transferred to corporation stays there; if corporation ends, property must go to another nonprofit.

Limited Liability Structures. Limited Liability Company (LLC). The LLC is a relatively new type of hybrid business structure that is now permissible in most states. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership.

The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. The time limit can be continued if desired by a vote of the members at the time of expiration. LLC's must not have more than two of the four characteristics that define corporations: Limited liability to the extent of assets; continuity of life; centralization of management; and free transferability of ownership interests.

Advantages. Owners have limited personal liability for business debts even if they participate in management. Profit and loss can be allocated differently than ownership interests. IRS rules now allow Limited Liability Corporation (LLC) to choose between being taxed as partnership or corporation.

Disadvantages. More expensive to create than partnership or sole proprietorship. State laws for creating Limited Liability Corporation (LLC) may not reflect latest federal tax changes.

Professional Limited Liability Company. Advantages. Same advantages as a regular limited liability company. Gives state-licensed professionals a way to enjoy those advantages.

Disadvantages. Same as for a regular limited liability company. Members must all belong to the same profession.

Corporation vs LLC

Let's assume that you've concluded it would be advantageous to operate your small business through an entity that limits the personal liability of all the owners - even if following this strategy involves a bit more paperwork, complexity and possible expense. You have too main choices - either the tried and true corporation or the new and streamlined limited liability company (LLC). Which is best? There's no answer to this question that applies to every business. Nevertheless, some general principles may be helpful.

For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice. This is especially true if your business will hold property, such as real estate, that's likely to increase in value. That's because regular corporations (sometimes called C corporations) and their shareholders are subject to a double tax (both the corporation and the shareholders are taxed) on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC owners (called members) avoid this double taxation because the business's tax liabilities are passed through to them; the LLC itself does not pay a tax on its income. But an LLC isn't always the best choice. Occasionally, other factors will be present that may tip the balance toward a corporation. Such factors include the following:

You expect to have multiple investors in your business or to raise money from the public. While an LLC works fine when you have just a few investors - especially those who will be active in the day-to-day operations of the business - it may get more awkward when the number of investors increases. For example, you'll likely run into resistance from potential investors if you can't offer them the corporate stock certificates that they perceive to be tangible evidence of their partial ownership of the business. Rather than wasting your time trying to overcome this resistance, it's probably better to structure your business as a corporation.

You would set up a single-member LLC but you live in Massachusetts, which requires two or more members. Of course, if you live in Massachusetts and are married, you can easily comply with the LLC rules by including your spouse as an LLC member. But if you can't - or don't want to - meet this two-member rule, you'll need to incorporate to limit your personal liability. (Every state allows one-person corporations.)

You'd like to provide extensive fringe benefits to owners. Often, when you form a corporation, you expect to be both a shareholder (owner) and an employee. The corporation can, for example, hire you to serve as its chief executive officer and pay you a tax-deductible salary as well as fringe benefits. These benefits can include the payment of health insurance premiums and direct reimbursement of medical expenses. The corporation can deduct the cost of these benefits and they are not treated as taxable income to the employees, which can be an attractive feature of doing business through a regular corporation. These opportunities for you to receive tax-favored fringe benefits are somewhat reduced if you do business as an LLC.

You want to entice or keep key employees by offering stock options and stock bonus incentives. Simply put, LLCs don't have stock; corporations do. While it's possible to reward an employee by offering a membership interest in an LLC, the process is awkward and likely to be less attractive to employees. Therefore, if you plan to offer ownership in your business as an employee incentive, it makes sense to incorporate rather than form an LLC.

Choosing Between an LLC and an S Corporation: Self-Employment Taxes Can Tip the Balance. You know that taxes are withheld from employees' paychecks. In 2002, for example, employers must withhold 7.65% of the first $84,900 of an employee's pay for Social Security and Medicare taxes, and 1.45% of earnings above that amount for Medicare taxes alone. The employer adds an equal amount and sends these funds to the IRS. (The total sent to the IRS is 15.3% on the first $84,900 of wages and 2.9% on anything above that.) You may not be aware that the IRS collects a similar 15.3% tax on the first $84,900 earned by a self-employed person and a 2.9% tax on earnings above that amount. This is called the self-employment tax.

For an S corporation, the rules on the self-employment tax are well established: as an S corporation shareholder, you pay the self-employment tax on money you receive as compensation for services, but not on profits that automatically pass through to you as a shareholder. For example, if your share of S corporation income is $100,000 in 2000 and you perform services for the corporation reasonably worth $65,000, you will owe the 15.3% self-employment tax on the $65,000 but not on the remaining $35,000.

By contrast, the rules for members of an LLC are murky. Proposed IRS regulations (which Congress has placed on hold) would impose the self-employment tax on an LLC owner's entire share of LLC profits in any of the following situations:

The owner participates in the business for more than 500 hours during the LLC's tax year. The LLC provides professional services in the fields of health, law, engineering, architecture, accounting, actuarial science or consulting (no matter how many hours the owner works). The owner is empowered to sign contracts on behalf of the LLC.

S Corporation vs LLC

S corporations and LLCs possess similarities: They offer their owners limited liability protection and are both pass-through tax entities. Pass-through taxation allows the income or loss generated by the business to be reflected on the personal income tax return of the owners. This special tax status eliminates any possibility of double taxation for S corporations and LLCs.

That's where the similarities end. The ownership of an S corporation is restricted to no more than 75 shareholders, whereas an LLC can have an unlimited number of members (owners). And while an S corporation can't have non-U.S. citizens as shareholders, an LLC can. In addition, S corporations cannot be owned by C corporations, other S corporations, many trusts, LLCs or partnerships. LLCs are not subject to these restrictions.

LLCs are also more flexible in distributing profits than S corporations, wherein the corporation can only have one class of stock and your percentage of ownership determines the percentage of pass-through income. On the other hand, an LLC can have many different classes of interest, and the percentage of pass-through income is not tied to ownership percentage. The pass-through percentage can be set by agreement of the members in the LLC's operating agreement.

S corporations aren't without their advantages, however. One person can form an S corporation, while in a few states at least two people are required to form an LLC. Existence is perpetual for S corporations. Conversely, LLCs typically have limited life spans. A few states require LLCs to list dissolution dates in their articles of organization, and certain events such as the withdrawal or death of a member can cause LLCs to automatically dissolve.

The stock of S corporations is freely transferable, while the interest (ownership) of LLCs is not. This free transferability of interest means the shareholders of S corporations are able to sell their interest without obtaining the approval of the other shareholders. In contrast, member of LLCs would need the approval of the other members in order to sell their interest. Lastly, S corporations may be advantageous in terms of self-employment taxes in comparison to LLCs. For advice specific to your situation, contact an attorney.

S Corporations vs C Corporations

If you plan to remove significant profits above what would be considered a reasonable salary for you as President or CEO, you would favor an S corporation, because S corporation are pass-through tax devices. For S corporation there is generally no tax at the corporate level. This means that once a reasonable wage is paid, excess profits can be removed as distributions. If you chose a C corporation dividends will be doubly-taxed. If the expected profit you remove is comparable to a reasonable wage, you might be OK with either a C corporation or an S corporation. Wages greatly in excess of reasonable salaries may be challenged by the IRS, who may view the wages as dividends in disguise.

Salary is subject to about a 15% self employment, but you do get more future Social Security benefit by paying more in employment tax. And, many retirement plan maximums are also based upon salary level. This somewhat offsets the negative of paying higher employment taxes. Many individuals choose S corporation over LLCs, C corporations Sole-Proprietorship, and partnerships to minimize employment taxes on wages. If you plan to remove large amounts of cash from a profitable company and you feel the amounts are larger than a reasonable wage, consider the S corporation.

If you plan to retain most of the income for corporate growth, either S corporations and C corporations can work well. A C corporation is probably preferable if you plan to offer employee stock options, which could be classified as a second class of stock. S corporation shareholders can also face phantom income, but that is easily remedied by paying small distributions to shareholders to offset individual tax liability.

This is the same basic "pass-through" treatment afforded partnerships and LLCs. The key distinction of the S corporation is that profits and losses are not taxed at the corporate/business level like they would be if the corporation remained as a C corporation.

If you have high-income investors, and you anticipate losing money for the first few years an S corporation losses pass through to the investors who can offset their other taxable income. This is fully allowed. The IRS is not enthused on tax shelters where losses exceeding an investor's original investment in a company are passed through, as some tax schemes in the past tried to achieve. If such losses in excess of original investment "basis" were allowed, an investor could offset tax deductions. That is not allowed. This is why entrepreneurs need a basic understanding of stock basis and passive losses.

If you have certain non-people shareholders, such as certain trusts, the IRS forbids to own S corporation shares. Or, there may be too many shareholders as allowed for S-corporation status. To qualify, generally, the corporation must have a maximum of 75 shareholders who are individuals. Once a corporation makes the Subchapter S election to be an S corporation profits and losses are passed through the corporation and are reported on the individual tax returns of the respective shareholders of the S corporation.