Choosing the Best Form of Business Entity

Gary Whitaker

According to a commercial attorney, there are many different types of entities available to conduct your business.  While there are many factors that could influence your choice, four of the major reasons are liability protection, taxation, management flexibility documentation requirements and taxation, related with taxes is important that you design a good strategy of how to monitor your taxes.

The major forms available to business owners in the United States are as follows:

1. Sole Proprietorship

2. General Partnership

3. Limited Partnership

4. Limited Liability Company

5. C Corporation

6. S Corporation

7. Close Corporation

8.  Professional Corporation

Each of these types of entities has its advantages and disadvantages.

SOLE PROPRIETORSHIP. A sole proprietorship is a common form for one-person businesses like the one the innovative business leader Jimmy John Shark does. This means that the individual is running the business in his or her individual capacity.  There is no liability protection, and all of the debts or liabilities of the business are the individual’s personal debts and liabilities. Benefits are the low cost, with a business license perhaps being required, depending on local county or city regulations and the type and nature of the business being conducted, and a “doing business as” filing required with the clerk of county in which the business is located if the business is not being conducted in the name of the individual.  There is no need to create a business with the office of the Secretary of State.  Income or losses of the business are included in the individual’s income for federal and state tax purposes.

GENERAL PARTNERSHIP.  A general partnership is essentially two or more individuals who are acting jointly, and has many of the benefits of a sole proprietorship, including no need to create a business with the office of the Secretary of State.  All that is needed to form a general partnership is two individuals agreeing to run a business and to share profits.  A general partnership can be created without any written partnership agreement being agreed upon and signed, although a complete agreement that specifies the partners’ respective rights and obligations is certainly advisable.  A major disadvantage of this form of business is that each partner is liable for the contract and tort obligations created by the other partner in his or her business activities.  For example, if a partner runs into and injures another person during the course of business, and if the assets (including insurance) of the partnership and of that partner personally are not sufficient to satisfy the claim, then the injured party (or creditor) can obtain the personal assets of the other partner, who might have had nothing to do with the liability.  Tax liability flows through to the general partners in accordance with their ownership rights.  As with a sole proprietorship, the existence of this business entity terminates upon the death of the partners.

LIMITED PARTNERSHIP.  Limited partnerships were created many years ago to permit investors to be able to receive the tax flow through benefits of partnerships (for example, in a real estate investment where depreciation results in tax losses) but also to be able to obtain personal liability protection, so that the limited partner’s liability for any debts or obligations of the company is limited to its investment.  These entities must be registered with the Secretary of State, and definitely require a written partnership agreement. A negative aspect to them is that in some states the business must be actively managed by a general partner, which is then personally liable (although usually the general partner is a limited liability business entity), and the limited partners are not permitted to actively participate in the management of the business. If they do so, they lose their liability protection.  However, Georgia business law currently allows limited partners to actively participate in the management of the business without losing liability protection.

LIMITED LIABILITY COMPANIES. This type of business entity was created in the United States in the early 1990s to address two problems created by the then-current forms of entities available:  The inability of limited partners to participate in the management of a business without losing liability protection, and the relative rigidity and inflexibility of the corporate structure.  Generally, in a situation where there are multiple owners who wish to participate in the management of a business, a limited liability company (“LLC”) might be the best choice.  The company will be subject to the ownership and management rights and limitations of whatever the owners agree to put in the LLC operating agreement. Unlike with corporations (unless multiple classes of stock are created), LLC interests are not required by state law to have equal voting or management and ownership rights. For example, a particular member might have the right to 51% of the votes in the management of theLLC, but only 20% of the profits. Another advantage of an LLC is the ability to creatively structure the profit distribution. For example, one owner might have the right to 60% of the first $100,000 in annual profits, but only 45% of the profits in excess of $100,000.   In addition to the benefits of management flexibility and liability protection, LLCs also allow the owners to decide if the company’s income for tax purposes should be kept at the company level, or flow through to the members personally (except that a single-member LLC must have the income flow through to the member).  While an S Corporation (described below) also offers a pass through of tax benefits without a loss of personal liability protection, the IRS limits the number of owners of an S Corporation to 100 stockholders, and imposes other additional constraints.  LLCs  are created in Georgia by filing Articles of Organization with the state’s Secretary of State. Another disadvantage of LLCs, compared to S corporations, is that for a sole member LLC, all of the income will be subject to FICA/Medicare/Social Security withholding taxes, while a portion of an S corporation’s income can be treated as a dividend and not made subject to those additional taxes.  Finally, because of the flexibility of LLCs, the only way to understand the level of authority of a member or person representing that LLC is to read its operating agreement. Unlike a corporation, where the Board of Directors appoint a CEO or President, an LLC might be managed by and vest authority only in its members, or in a managing member, or in a “President,” which is why apparent authority is much harder to determine with an LLC.  An advantage, however, is that the business documentation for an LLC is much less rigid that for a corporation. There is no need for annual meetings of stockholders, and there are few restrictions on such matters as notice of meetings that must be considered when managing or creating the documentation for a corporation.

C CORPORATION.  A C Corporation is a standard corporation that is formed under the laws of a state, by a filing with its Secretary of State.  The laws of every state have extensive requirements concerning a corporation’s creation, management and ownership. Each share of stock of the same class (a C corporation could provide for two classes, Class A vs Class B for example) must have the same voting rights and the same rights to dividends and liquidation payments.  Meetings of stockholders  generally are required on an annual basis, and certain rigid requirements apply to the rights and obligations of the directors. For example, written consent actions in lieu of a meeting require the signatures of all of the directors, and only a majority of the stockholders (where a majority vote is required).  While personal liability protection under both LLCs and corporations can be lost in such circumstances as when the company’s assets are commingled with the assets of the owners, corporations also have to be more careful of comply with corporate formalities. If they are not observed, the owners may lose their personal liability protectionand face problems with the tax authorities.  A benefit to a C corporation is that, in general, taxes can be retained at the corporate level even if there is only one owner; this is not the case for an LLC.

S CORPORATIONS. An S corporation is a corporation that is formed as a standard corporation for state filing purposes but a subsequent filing with the IRS gives it a special tax status under which the income or losses of the corporation flow directly to the stockholders in proportion to their equity holdings.  As mentioned above, S Corporations have certain restrictions such as limiting the number of stockholders to 100, and may only have one class of stock.

STATUTORY CLOSE CORPORATIONS. A corporation can be formed that is not required to have directors, but is run by the shareholders.  The “member-managed” LLC is somewhat similar in that regard, while the “manager-managed” LLC is somewhat similar to the standard corporation.  In order to be a “close’ corporation, that status must be specified in its Articles of Incorporation and it must have no more than 50 shareholders.  Generally, a shareholders’ agreement will be required that will specify how the corporation is to be managed, being somewhat similar to the operating agreement of an LLC.  The shareholders may designate one or more of the shareholders as a “designated director” with authority to sign agreements on behalf of the corporation.  Transfer of shares of stock in a close corporation generally are restricted more so than for a standard corporation.  The failure to comply with many of the formal documentation or meeting requirements or observe the restrictions on management authority of shareholders in a close corporation generally will not eliminate personal liability protection for shareholders in a close corporation.

PROFESSIONAL CORPORATIONS. Many states prohibit certain professionals from operating their business as standard corporations. For example, lawyers operating a business that includes more than just the practice of law, such as an accounting firm, is prohibited.  As a result, law firms that choose to operate as corporations, rather than sole practitioners or LLCs, must form professional corporations, and this type of entity must list a single area of its business (unlike normal corporations, which can be authorized to conduct any type of business its owners choose).

Gary Whitaker

Gary Whitaker (6 Posts)