July 1, 2008
Editor’s note: Gary contributed this article and we’re posting it through the new “contribute” idea/feature on TECHcocktail.com. Check out techcocktail.com/home/contribute for more details on how you can submit articles to TECH cocktail. It is our hope that more people will start sharing their expertise with the community via TECH cocktail’s contribute feature.
Now, back to Gary who outlines the pros and cons of various legal structures you should consider as you look to form your new company.
By Gary Barron, CPA: founding member of the tax department of Frost, Ruttenberg & Rothblatt, P.C.
There are numerous considerations in determining the type of entity to be used when starting a new business. The form or structure chosen will determine a number of the business’s features, such as the taxability of the business and its owners, control, legal liability, transferability, as well as countless other aspects. No form is perfect, and the decision usually comes down to weighing the advantages and disadvantages of each type of entity and then making an informed decision.
The five primary types of entity available for conducting a business include Sole Proprietorship, C corporation, S corporation, Partnership and Limited Liability Company (“LLC”). The following is a brief overview of each of these business structures:
Sole Proprietorship – A Sole Proprietorship is easily formed merely by opening a bank account. Some states or local authorities may also require some type of registration or license, depending on the nature of the business. As a result of the ease of formation, most legal and other professional fees associated with the creation of a new business can be avoided. Control of the business rests with the sole owner. Because of the structure, capitalization is limited to the assets and borrowing potential of the sole owner.
The owner of the Sole Proprietorship has unlimited personal liability. In many instances, some of the risk can be mitigated by insurance. Since the results of operations are reported directly on the owner’s individual income tax return, there is only one level of taxation. Although payroll tax filings for the earnings of the owner are avoided, the results of operations are subject to self-employment tax. This form of business also has no continuity of existence beyond the life of the sole owner.
Because of its ease of form and operation and limited flexibility, the Sole Proprietorship may be perfect for a new entity before it really takes off. At that time, it might be necessary to consider one of the other, more sophisticated forms for doing business discussed below.
C & S Corporations – The formation of a C or S corporation usually requires the creation of formal articles of incorporation and other necessary documentation. A corporation wishing to elect S corporation status must file with the IRS a signed form indicating that intention. A corporation must also register with the state, and annual state filings and fees are usually required. As one can see, the initial startup costs are significantly greater for a corporation than those incurred for the creation of the Sole Proprietorship.
Corporate bylaws need to be created to set forth the rules governing the entity. The shareholders have the sole authority to approve articles of incorporation, merger and dissolution, and they are granted the authority to elect the directors of the company. C corporations may have more than one class of stock, and the various classes of stock may grant the holders different rights or preferences over other classes.
There is basically no limit on the number of shareholders that a C corporation may have. As a result, the C Corporation usually has the potential to raise or borrow significantly more capital than the Sole Proprietorship or any of the other business forms discussed. In contrast, an S corporation is limited to 100 shareholders, and certain individuals or entities are deemed to be ineligible S corporation shareholders. The S corporation may also have only one class of stock. Shareholders of both C & S corporations also have any potential liability limited to their investment in the corporation.
From an income tax point of view, the C corporation is a separate entity that pays tax on its net earnings. Those earnings, once distributed as dividends, are taxed again to the shareholders. The S corporation, while a separate entity, is not subject to federal tax. The shareholders are subject to tax on their distributive share of the corporate earnings, whether distributed or not. The S corporation shareholder can also deduct their distributive share of any losses recognized by the corporation. The ability to deduct an S corporation loss is limited to the shareholder’s basis in his or her stock, plus the balance of any shareholder loans to the corporation.
There are a number of other significant differences between the C & S corporate structures which are beyond the scope of this article. It should be noted that as a separate entity, the corporate structure provides a continuity of existence that extends beyond the life of any individual shareholder.
Partnership & LLC – The formation of a partnership can be accomplished on the most basic level through a mere handshake, although a signed partnership agreement is definitely advisable. The agreement is needed in order to establish such points as profit and loss ratios, control, admission and withdrawal of partners, and other necessary factors. An LLC is created through the drafting of articles of organization and an operating agreement.
With respect to control in a General Partnership, each of the partners usually has the ability to transact business and sign contacts or loan documents in the name of the partnership. In a Limited Partnership or an LLC, the agreement designates certain individuals as having sole responsibility for the decision-making authority for the partnership.
Like the C corporation, there is usually no limit for the number of potential investors in the entity. Therefore, the partnership form usually affords the entity with a greater opportunity to raise capital or borrow funds. Limited partners or non-managing members of an LLC have their liability limited to their investments in the entity. General partners can be fully liable for the liabilities of the partnership. Neither the partnership nor LLC format is subject to federal tax. Each of the partners/members is taxed on their distributive share of the entity’s earnings. Losses of the partnership or LLC can be deducted by the investors to the extent of their partnership basis, which in certain circumstances can include the partnership or LLC’s debt.
The above information provides a very brief overview of the basic factors that need to be considered when determining the appropriate structure for a new business. This information is by no means a complete analysis of the topic. If additional information is desired, please email me at the address indicated below and I’ll be happy to forward on to you a copy of a tabular analysis of “Choice of Business Entity Issues” prepared by a leading tax research service, BNA
TECH cocktail Community Contributed Knowledge
Gary Barron CPA, is the founding member of the tax department of Frost, Ruttenberg & Rothblatt, P.C. of Chicago. His humorous articles regarding tax, the accounting industry and business have been printed in the Chicago Tribune, Crain Chicago Business and various other local news publications in the Chicago metropolitan area. (See – www.frronline.com/tax-articles/ ) Gary can be reached at gbarron [at] frronline [dot] com.
Did you like this article?
Get more delivered to your inbox just like it!