Choosing a Legal Form of Business
What Business Structure is Right for You?
by MIKE O'DONNELL

Introduction

A business or non-profit entity may be structured in a variety of ways; each with its own advantages and disadvantages. Selecting the structure under which you will operate the enterprise involves decisions about tax treatment and liabilities. The purpose of this paper is to describe the legal forms of business available to you and help identify the pros and cons of choosing one form over another. It is strongly recommend that you consult with an attorney, accountant, financial adviser, and/or banker to help you determine which structure best suits your needs.

The federal and state governments generally recognize six types of legal entities. They are:

1.  Sole Proprietorship (SP)
2.  General Partnership (GP)
3.  Limited Partnership (LP)

• Limited Liability Company (LLC)

• Professional Limited Liability Company (PLLC)

4.  Limited Liability Partnership (LLP)
5.  Corporation (Corp)

• For Profit "C" Corp

• For Profit "S" Corp

• Close Corp

• Non-Profit Corp

6.  Professional Corp

Which legal structure is best for your enterprise will depend upon these and other considerations:

• Will you be the sole owner, or have partners or other owners?

• Will you have employees?

• Will you set up operations in other states?

• Will you raise money from institutional investors?

• Will you operate as a small, lifestyle enterprise, or as a large, growing company?

The answers to these and other questions will help you choose the right form. The laws, filing requirements and business licensing procedures vary from state-to-state. The following is a general overview of the most common forms of business.

Sole Proprietorship (SP)

A sole proprietorship is owned and operated by an individual or a married couple acting as one. It does not have a separate existence apart from its owner. No filing with the State is usually necessary to form a sole proprietorship, but if the sole proprietorship is operating under a fictitious or assumed name, filing with the state, county or city may be required. The individual owner is personally responsible for the debts of the business.

A sole proprietor has total control of and responsibility for his or her business, receives all profits, and can make important decisions quickly. The sole proprietor is also responsible for all taxes and liabilities of the business, as well as for obtaining any necessary state and local business licenses.
Most business owners choose sole proprietorship for simplicity. It is easy to set up and easy to manage. A sole proprietorship is owned by, and benefits, one person. As a sole proprietor, you alone are responsible for the business's liabilities. You (and your spouse) profit from its endeavors. This money is considered personal income and is taxed as such. Tax losses, if any, are applied against any other taxable income you may have.
Many businesses start out as Sole Proprietorships, but convert to a corporation or another form of business after reaching a certain size.

General Partnership (GP)

A general partnership is an association of two or more persons, or entities, to carry on as co-owners of a business for profit. In a business partnership, the parties that join forces could be individuals, corporations, trusts, other partnerships, or a combination of all of the above. No filing with the State is usually necessary to form a general partnership, but if the general partnership is doing business under a fictitious or assumed name, filing with the state, county or city may be required. Generally, every partner is an agent of the partnership and is personally responsible for the debts of the partnership, as well as shares all profits and losses.

Individuals may create a partnership by oral or written agreement. Profits are taxed as personal income for each individual partner at their respective tax rates. A partnership agreement is generally maintained by the partnership itself. Some states allow you to file a partnership agreement with the Secretary of State’s Office for a nominal fee.

Next to Sole Proprietorships, general partnerships are the simplest legal structure to establish. It is advisable to have an attorney draw up an agreement that outlines the rights and responsibilities of each partner, the management structure, profit-sharing arrangements, and provisions for ending the partnership's affairs and distributing the assets upon dissolution. Each partner in a general partnership is individually liable for all of the partnership's liabilities. Even though you agree to split the debt 50-50 with your partner, from the creditor's perspective you are 100 percent liable if your partner doesn't pay his or her share of the debts. The liabilities are not limited to the amount a partner has invested, but may extend to non-partnership properties as well.

Any one general partner may bind the partnership (and fellow general partners) to a contractual obligation. For this reason, there are no true "silent partners" in a general partnership. Each is liable for the consequences of the other’s actions and decisions. Partnerships are not separate legal entities; they have a limited life. They are tied to the individual partners. Upon death or withdrawal of a partner, or the addition of a new partner, the partnership is terminated. For this reason, as well as residual liability, it is difficult to step out of or sell a partial interest in the business.

Limited Partnership (LP)

A limited partnership is an association of two or more persons with one or more limited partners and one or more general partners. Limited partners are not personally responsible for the debts of the limited partnership unless they participate in management of the partnership. General partners are responsible for managing the business of the partnership and are personally responsible for the debts of the partnership. A limited partnership is usually formed by filing a Certificate of Limited Partnership with the State.

A limited partnership is more closely regulated than a general partnership. There must be at least one general partner who manages the business and who is fully and personally responsible for claims against the business. In addition, there are investors who play no part in the management of the business and whose liability for the business is limited to the extent of their investment. A partner is designated "limited" because he or she signs an agreement limiting his or her control over the partnership's affairs. In return, a limited partner's liability is usually limited to the amount of his or her original capital investment. In this instance, the limited partner is a "silent partner" in the popular notion of the term. The general partner still has unlimited liability, just as in the general partnership.

Formation of a limited partnership is usually governed by the state in which it is formed. For a limited partnership to exist there must be a written limited partnership agreement and a certificate of limited partnership filed with the state. In some states, if the appropriate certificate is not filed, the business is considered a general partnership.

Limited Liability Company (LLC)

A limited liability company is an unincorporated business. The LLC is a hybrid between a partnership and a corporation, providing the liability protection of a corporation, with the favorable tax treatment and other advantages of a partnership. It is typically formed by filing Articles (or Certificate) of Organization with the State. An LLC may be managed by members or managers. The members and managers are not personally responsible for debts of the company. The main advantage to choosing a limited liability company over a corporation is that LLC members enjoy limited liability, but the entity can be taxed as a partnership, which is a more favorable tax treatment. For this reason, the LLC has become the most popular form of business for most start-ups.

An LLC provides for flexibility in the contribution and distribution of assets. Under this type of structure, you need not hold annual meetings, but you typically need to file Articles of Organization and, in some states, annual reports with the state in which you have organized the LLC.

Another flavor of LLC is the Professional Limited Liability Company. A PLLC generally has the same requirements as professional corporations. (See the Corporations section for more information.)

Limited Liability Partnership (LLP)

A limited liability partnership is a partnership that is registered with the State. Each partner is personally responsible for the debts of the partnership, except for the debts of the partnership arising from negligence or misconduct committed by another partner or employee. A limited liability partnership is typically formed by filing a Statement of Registration with the State in which it is doing business.

The advantage of an LLP is liability protection for all partners. The LLP provides the same limited liability enjoyed by a corporation, but at the same time, it is a flow-through entity for federal and state tax purposes. A limited liability partnership operates much like a general partnership, except none of the partners can be held personally liable for claims against the business. As with a general partnership, profits are taxed as personal income for each individual partner.

Corporation (Corp)

A Corporation is a business organization that is separate from its owners. A corporation has the same powers as an individual to do all things necessary to carry out its business. A corporation can make its own contracts, raise capital, assume liability, and, just like the rest of us, pay taxes. Corporations are usually formed by the authority of a state government. A board of directors manages the corporation and officers are responsible for the daily operations of the corporation. Shareholders are not personally responsible for the debts of the corporation. A corporation is typically formed by filing Articles of Incorporation with the State.

A corporation is a more complex form of business organization. It exists apart from its owners or shareholders and is a legal entity in its own right. As a separate entity, it has its own rights, privileges, and liabilities apart from the individuals who form it.

A corporation has shareholders who invest money in the business and therefore own it. The shareholders hold an annual meeting at which they elect a board of directors. The board makes policy decisions for the company and selects the corporate officers who manage the company’s daily affairs.

A corporation affords limited liability to its shareholders and can continue on after the death of or transfer of shares by one or more of the owners. A corporation pays taxes on its profits, and its shareholders pay taxes on dividends and/or sale of its stock at a profit.  There are various flavors of corporations; some operate for profit and others are not for profit. An attorney can advise you as to which type best suits your needs.

S corporations. These generally do not pay taxes. Profits or losses are passed on to the individual shareholders’ and declared on their personal tax returns. You must apply to the Internal Revenue Service to get S corporation status. The IRS places limits on who can be a shareholder. Other corporations (nor most institutional investment funds) can be shareholders, so if you are planning to raise money from these types of investors, an "S" corp is NOT a good choice.

The issue of double taxation might be a concern to you if you are contemplating forming a corporation. Double taxation may occur when the corporation has a profit. Just as you pay income tax when you make money, so does the corporation. For the corporation, however, the tax rate may be even higher than the current maximum rate for individuals. To pass on the benefit of its profits to those who own stock, the corporation declares a dividend and distributes the profits to the shareholders. The individual shareholders receive these profits as investment income. Even though the corporation paid taxes on the profit, the shareholders are now liable for taxes on their additional income.... voila! double taxation.

Corporations with thirty-five or fewer share holders and which meet certain other requirements may elect Sub-Chapter S status. This permits the corporation to have its shareholders assume the business's tax liabilities, based on their share of the corporate income, rather than to be taxed itself. The corporation still files a tax return for information purposes, much like a partnership does. Although profits can be distributed to the shareholders, who then include them with their individual tax returns, often there may be taxable income and no "profit." As in partnerships, the Internal Revenue Service may limit losses that maybe claimed for tax purposes by individual investors.

Businesses that intend to elect "S" corporation status must do so using Form 2553, which is available from the IRS. Generally, you must elect "S" status within 2 1/2 months from the date of incorporation. This filing procedure to elect "S" status is critical. Failure on your part to properly file could cause your request to be disallowed. We urge you to use professional legal and accounting assistance in all "S" corporation filings.
Statutory close corporations. This type of structure allows a business to eliminate many of the formalities of a standard corporation. For example, the business can elect to operate without a board of directors. A shareholder of a statutory close corporation may not sell his shares in the business without the approval of the other shareholders. Articles of Incorporation are filed with the state where the business is incorporated.
Nonprofit corporations. These are established solely for the benefit of charitable, religious, educational, or scientific purposes. No earnings are distributed to members, trustees, officers, or other individuals, except for compensation for services rendered. A nonprofit corporation is exempt from income tax. You must apply to the IRS for nonprofit status, and you must file Articles of Incorporation with the state where the business is incorporated.

A nonprofit corporation may take one of three forms:

1.  A public benefit corporation operates for public or charitable purposes. Members may not sell their interests or receive distributions from the organization.

2.  A mutual benefit corporation exists to serve its members. Trade associations, social clubs, and fraternal organizations are examples of this type of nonprofit. Members are given broader voting rights and, while not entitled to receive distributions while the organization is operating, they are entitled to sell their memberships and receive distributions when the organization dissolves.

3.  A religious corporation is treated much like a public benefit corporation.  Incorporating as a non-profit corporation does not immediately qualify donations to your organization as tax-deductible, charitable contributions. For that, you must obtain recognition from the I.R.S. as a charitable organization under Section 501,(C),(3) of the I.R.S. Code, using Form 1023.

Professional corporations

Individuals who are licensed in certain professions may form a professional corporation. This provides them with the benefits of a corporate structure for the business aspects of their practices while preserving the personal and professional relationship between them and the clients they serve. In most states, these professions include, but are not limited to, certified public accountants, registered public accountants, chiropractors, optometrists, dentists, osteopaths, podiatrists, architects, veterinarians, doctors of medicine, physicians, surgeons, attorneys, and life insurance agents. Shareholders in a professional corporation are subject to both the regulations of their respective licensing board and the state incorporation agency. Shareholders may only be people who are licensed to render the specific professional service; at least half of the officers and directors must also be licensed.

Misc. Business Licensing Requirements

In addition to establishing the legal form for your business, there are often a host of other registration applications and reports a company of any type must file. These requirements vary from jurisdiction-to-jurisdiction, and often depend upon the type of business being conducted. The state, county and city in which the business is located may all require separate forms to be filed. First, they want to know how to tax you. Second, they want to know how to regulate you. Most of these requirements are for the public good. Don’t be daunted by the requirements. Check with your state and local business licensing authorities, and then just knock them down one at a time. It’s the price of owning your piece of the American Capitalist Society! The price of admission is well worth it.

A few important filings you should not neglect:

Federal Compliance – Tax ID Number (required if you expect to have employees)

A new business first registers with the Internal Revenue Service by obtaining and completing Form SS4 (Application for Employer Identification Number), and returning it to the regional IRS office in your area.
The business will then receive a Federal Identification Number, which will be used on all tax forms and documents filed by the company. The IRS will automatically send most of the forms your business needs to file including:

• Business income tax

• employee income tax

• unemployment tax

• and other taxes to which the company may be subject.

Download form SS4. Application for Employer Identification Number.  

To order the Tax Guide for Small Business or other publications, call the IRS at 1-800-829-3676, or visit http://www.irs.gov/smallbiz/index.html.

Register a Tradename, Trademark, or Servicemark

Every state supplies a form that you can submit to reserve or register the name of your business. Most states also supply a web site where you can conduct a search to see if your name is available. You may register a name even if it is not the name of your company. For example, the name of your company might be "Horizon Enterprises," but you are doing business as (or your product name is) "Horizon Trail Rides."

Forms of Business Organization: Comparison Chart

Legal Entities	Advantages	Disadvantages	Compliance Requirements
Sole Proprietorship	Ease of formation; ease of discontinuation.	Unlimited liability for all debts, legal infractions, law suits, etc.	File with the state if using an assumed or fictitious name.
	Sole ownership, control, and decision making.	Difficult access to capital and financing.	File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
	Flexibility in responding to business requirements.	May be difficult to attract highly skilled, entrepreneurial employees (no stock options).	Declare income and expenses on your federal and state tax forms, using your social security number.
	Minimal compliance requirements; less paperwork.	Continuity of business difficult upon illness or death of owner.
	Minimal legal restrictions.	Limited input from others; restricted viewpoint.
	Minimal start-up and continuation costs.
General Partnership	Ease of formation.	Unlimited liability of partners; any partner can commit the others to obligations.	File with the state if using an assumed or fictitious name.
	Flexibility in management still possible.	Financing may be difficult to access.	File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
	Broader management base; may draw upon the financial and management strength of all the partners.	Continuity of business difficult upon death or withdrawal of partner.	Declare income and expenses on each partner’s federal and state tax forms, using your respective social security numbers.
	Direct share of profits by partners; profits are not directly taxed.	Disposition of partnership interest difficult.
	Minimal legal constraints and compliance paperwork.	Potential for conflict over authority and decision making.
Limited Partnership	Obtain equity without surrendering control to investors.	Unlimited liability for general partner(s); jointly and individually.	File a Certificate of Partnership with the state.
	Good structure to raise investment capital.	Decisions and participation may be restricted by limited partner agreement.	File with the state if using an assumed or fictitious name.
	Direct participation in profits.	Partnership may dissolve upon death, withdrawal, or bankruptcy of a general partner.	File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
	Limited partners' risk is limited.	Disposition of partnership interest may be difficult, since its sale must comply with state and federal securities laws.	Some states require the LP to publish a "Notice of formation" in the newspaper and Affidavits of Publication with the state.
	May have multiple general partners.		Declare income and expenses on each partner’s federal and state tax forms, using your respective social security numbers.
	A limited partnership is not treated as a separate taxable entity; business income is taxed through each partner's personal tax return.
Limited Liability Company	Personal liability is generally limited, although the Articles of Organization can specify that member(s) will be liable for company debts, etc.	May require annual reports and a registered agent in some states.	File Articles (or Certificate) of Organization with the state.
	Easier to discontinue an LLC than a corporation.	Filing fees are required by most states.	File with the state if using an assumed or fictitious name.
	Less legal compliance and paperwork than a corporation.		File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
	For purposes of taxation, an LLC can elect its classification for federal tax purposes. It may file as a separate legal entity, or its owner may file on his or her tax return.		File tax return for the LLC, or declare income and expenses on the owner’s federal and state tax forms.
	Flexibility in the contribution and distribution of assets.
Limited Liability Partnership	Partners are not responsible for debts or liabilities arising from negligence or misconduct committed by another partner or employee.	Each partner is personally responsible for the business debts of the partnership.	File a "Statement (or Application) of Registration" with the state.
	Protection for all partners, not just limited partners.	Profits are taxed as personal income for each individual partner.	File with the state if using an assumed or fictitious name.
			File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
			Declare income and expenses on each partner’s federal and state tax forms according to each partner’s share.
Corporation	Limited investor liability; only the funds invested are at risk.	Complexity of formation and higher costs.	File "Articles of Incorporation" with the state. Many states also require a separate application.
	Transferability of ownership. A corporation is a "perpetual" form of business.	Double taxation; the corp is taxed as well as the gains of the shareholders.	Some states require a "Certificate of Authority."
	Separate legal "person."	More difficult and costly to maintain and dissolve; more administrative overhead.	File with the state if using an assumed or fictitious name.
	Continuity of existence.	Charter limitations and government regulations.	File form SS-4 (Application for Employer Identification Number) with the IRS, if the business has employees.
	Access to investment capital; most favorable structure for attracting institutional investors.	More and tighter regulations and governmental oversight.	Some states require an annual report filing.
	Delegated authority to hired management		If shares are to be sold to the public, a variety of reports and filing are required by the IRS and SEC.
	Legitimacy and credibility; corps often carry more weight with customers, suppliers, employees and partners.