Six Basic Legal Structures for Business
Sole proprietor, partnership or corporation – What form will you do business in?
From Debra Bruce, JD, CPCC
When you start up a new business you will need to select the business form to operate under. Because there are a number of complex issues involved in determining the form most suitable for your business and your personal situation, it is important to consult a lawyer and a tax advisor. Do this before you do any kind of business, including acquiring property or equipment, hiring employees, leasing space, getting investors, borrowing money, acquiring a license or franchise, etc.
This article describes the differences among the six basic business forms used by for-profit businesses in the U.S. (You are in it to make a profit, right?) This subject may not be tantalizing, but the knowledge is useful. You may want to clip this article and save it in a file. If you study this a few minutes before meeting with your lawyer or tax advisor it may help you better understand the legalese and tax gobbledy-gook. Then you can better ask the kinds of questions you need answers for. If you have already visited your lawyer and CPA, maybe this can help you sort out and remember some of the complicated principles they may have rattled off.
This article speaks in general terms for ease of understanding, and does not address many exceptions and details. It is not intended to be legal or tax advice or to be used in substitution for consulting qualified legal and tax advisors.
1. Sole Proprietorship. A single owner of an unincorporated business essentially operates the business as an extension of herself. For tax purposes, profits and losses of the business flow through to the tax return of the owner. Liabilities of the business also flow through to the owner. For example, if someone slips and falls on the business premises, the company damages the property of a customer, or the company is unable to pay its debts, successful claims against the company may be levied against the bank account or lake house of the owner.
2. General Partnership. Two or more persons own the business jointly and share profits and losses of the business in accordance with their partnership agreement. Each partner is exposed to the public for the full amount of all liabilities of the business, regardless of the agreement between the partners. In other words, a creditor may collect the full amount of a debt of the partnership from the partner that is the easiest to collect from. Profits and losses of the partnership flow through to the tax returns of the partners in accordance with their ownership percentages as determined in the partnership agreement. The partnership itself is not subject to any income or franchise tax. The authority to control aspects of the business is determined by the partnership agreement, but unless stated otherwise, the partners control the business jointly. Each partner has one vote.
3. Limited Partnership. The partnership must have at least one general partner and one limited partner. The general partner has personal liability for all liabilities of the partnership. The limited partner does not have personal liability for the business and cannot take part in the management of the business. She is what is sometimes referred to as a “silent partner.” Profits and losses are distributed and flow through to the tax returns of all partners in accordance with the percentages the partners determine in the partnership agreement. Profits and losses may be distributed (and reported for tax purposes) in percentages differing from the ownership percentages. The voting power of the partners is determined by the agreement. A limited partnership is not subject to state franchise tax.
4. Limited Liability Partnership. The LLP is taxed and controlled like an ordinary general partnership, except that the partners are not liable for the liabilities of the partnership or for the negligence of other partners. A partner is still liable for her own negligence.
5. Corporation. A corporation is owned by one or more stockholders and managed by a board of directors (which may consist of only one person) elected by the stockholders. The directors appoint officers who run the day-to-day business of the company. The stockholders, directors and officers of the company are protected from the liabilities of the company, including liabilities for their own negligence in operation of the business (except in certain extraordinary circumstances). In an ordinary corporation (a “C Corporation”) the profits and losses of the corporation do not flow through to the tax returns of the owners. The corporation is a separate entity filing its own tax return and paying its own taxes. Corporate federal income tax rates are not set in graduated tax brackets, and corporations are also subject to franchise taxes in many states (in essences a state corporate income tax). The stockholders may choose, however, to elect “S Corporation” status by making a filing with the IRS. In that case the corporation is taxed like a partnership and the profits and losses of S Corporations flow through to the federal tax returns of the owners in accordance with their stock ownership. They are still protected from the liabilities of the company.
6. Limited Liability Company. An “LLC” is a hybrid of a corporation and a partnership. The ownership percentages, profit and loss distributions, and voting powers of each member are determined by the agreement, rather than by a pre-set corporate legal structure. At the formation of the company an election is made as to whether the company will be taxed like a partnership with profits and losses flowing through to the owners’ tax returns, or taxed like a corporation. The owners and any officers and directors are protected from the liabilities of the company, including for their own negligence in operating the business. An LLC is generally subject to franchise tax.
7. Others. You may also hear of Professional Corporations (PC’s) and Professional Associations (PA’s). Those are special entity forms created for lawyers, doctors, CPA’s, and other professionals subject to licensing requirements and malpractice liability. There is also a separate body of law relating to non-profit corporations.
Debra Bruce practiced business law for 18 years, and is a Certified Professional Co-Active Coach, specializing in coaching business owners and lawyers.