February 5, 2007
Karen A. Monroe
In starting a business, a primary consideration is the legal structure of the entity to operate the business. There are several options to choose from, each of which has practical as well as legal advantages and disadvantages that should be carefully considered in light of your particular circumstances.
The first type of business structure to consider is a sole proprietorship. This is the simplest form of business structure and costs the least to maintain. This structure is largely informal and consists of one individual who functions as owner and operator of the business. From a tax perspective, the advantage of a sole proprietorship is that business expenses and income are included in the sole proprietor’s personal income tax, thereby allowing business losses to offset other income. This type of business structure is also less expensive when it comes to preparing tax returns because the business itself does not need to file separate tax returns. However, other business structures have, too, this advantage as will be discussed below. It is uncommon in the U.S. for businesses to use sole proprietorships.
A corporation is a more complex form of business structure that must be formally incorporated by filing various forms such as articles of incorporation and paying specified fees to the state of incorporation. The distinguishing feature of a corporation is that it is a separate legal entity from its owner.
Another significant feature of corporations is that income earned by corporations is potentially subject to a double tax: once for the corporation and once for its stockholders. There are, however, several ways to soften the impact and manage double taxation. One way is to elect to have the corporation taxed under Subchapter S of the Internal Revenue Code. The C corporation is the regular corporate form that results in double taxation, allows an unlimited number of shareholders, and has all of the other characteristics of a corporation. The S corporation has much more restrictive ownership and structuring rules, but offers significant tax benefits because the corporation itself is not subject to federal income taxation on its profits. Instead its income flows through to shareholders in the same percentage as each shareholder’s ownership interest, and each shareholder reports it on an individual return. That means income is taxed once rather than twice. However, ownership of an S corporation is restricted to no more than 100 shareholders; and non-U.S. citizens may not be shareholders of an S corporation. Also, the taxation of S corporations varies among the different states and cities.
Limited Liability Company
An LLC is a somewhat flexible form of business structure that offers many of the advantages of a corporation, such as protection from individual liability, while avoiding the ownership restrictions imposed on S corporations. Thus, the LLC form may be attractive to businesses that would prefer to form an S corporation but are not able to meet the requirements because they have too many shareholders or are not U.S. citizens. It is advisable, however, for non-US members of an LLC to hold the interest in the LLC through a C corporation to avoid subjecting the holder of the interest to federal and state income tax.
Like a corporation, an LLC is a formal business entity that must be formed by filing forms and paying fees to the state of formation and is subject to rules and regulations regarding its formation and operation. The costs involved in forming and operating an LLC may be comparable or exceed that of a corporation. In addition, some states require formal publication of the formation of the LLC.
Similar to S corporations, the income of an LLC is passed through to its members who report it on their personal income tax returns. The LLC does not pay taxes on its own. For tax purposes, a single member LLC (which is allowed in some states) is treated as a sole proprietorship and a multiple member LLC is treated as a partnership. The members of an LLC can allocate income and losses among themselves in any way that they agree, not necessarily based on their ownership interest.
A general partnership requires an agreement (express or implied) between two or more individuals or entities to own and operate a business. The partnership agreement does not have to be written or formal, although it is good business practice to document the terms of such an arrangement properly. Profit, loss, and management of the business are shared equally by the partners (unless otherwise agreed); and each partner is personally liable for the partnership’s liabilities. A partnership is taxed in much the same way as a multiple member LLC or an S corporation: individual partners report their share of profits and losses on their individual tax returns and the partnership itself does not pay taxes.
A limited partnership is very similar to a general partnership, except with respect to the personal liability exposure of the limited partner. While a general partner in a limited partnership has no protection from personal liability, the limited partner’s liability is limited to the amount of his or her investment in the company. This business structure is attractive for an investor who does not play an active role in the partnership’s operation because he can share in the company’s profits without exposure to the company’s liabilities. Every limited partnership requires at least one general partner. Because a general partner is exposed to unlimited personal liability, often the general partner of a limited partnership is a corporation or an LLC. Like a corporation or an LLC, a limited partnership is a product of state law and must be formally formed by filing forms and paying fees to the state of formation. As in a general partnership, absent an election to the contrary, a limited partnership has pass–through taxation, meaning that income is taxed only once.
Limited Liability Partnership
A limited liability partnership is similar to that of a limited partnership except that it allows all partners to take an active role in the business of the partnership while enjoying limited liability. Limited liability partnerships offer the pass-through taxation of a partnership and the limited liability of a corporation or LLC. This type of business structure is common among professionals such as law and accounting firms which are not allowed to use the corporate form to limit personal liability.
Please note that special tax rules apply to non-U.S. persons that own a Limited Liability Company, Limited Partnership or General Partnership entities and accordingly, these entities may not be appropriate for non-U.S. persons.
The United States has special complex reporting rules that apply to transactions between U.S. entities and their non-U.S. affiliates. These rules are beyond the scope of this article.