Multiple variables can impact the selection of the optimal entity (or entities) for your business, including, tax considerations, limitations on liability, management concerns and asset protection. Generally, forming the correct entity for your business involves (1) filing the requisite forms with a State’s Secretary of State, (2) selecting an appropriate income tax regime to apply to your business and (3) drafting contracts (e.g. operating agreements, shareholder agreements, etc.) to govern the management and operation of the business. Furthermore, if you fail to take one of the foregoing steps, there are default choices that will automatically be applied to your business. Although these default choices may be desirable, you should be aware of the ramifications of your actions.
Entity Types recognized by state law
When forming an entity under state law, below are the choices most frequently allowed by state law:
Sole Proprietorship – this is a business owned by one person that has not registered with the State. The sole proprietorship is treated as the same as the owner. This means that all of the owner’s assets are available to satisfy the businesses creditors.
Partnership –This is a business owned by two or more people that has not registered with the State. Like a sole proprietorship, all of the assets of all partners are at risk. Furthermore, each partner is liable for the acts of the other partners taken in furtherance of the partnership.
Corporation – to form a corporation, the owner must file articles of incorporation with the State. A corporation separates ownership and management by creating a board of directors that are elected by the shareholders but are responsible for the management of the corporation. A corporation’s shareholders are not vicariously liable for the acts of the corporation.
Limited Liability Company – to form a corporation, articles of formation must be filed with the State. Limited liability companies can be owned by one or more persons and can be operated like a partnership (with the owners directly management the affairs of the company) or like a corporation (with a separation between ownership and management). Because of their flexibility, limited liability companies have become the most popular form legal entity.
Limited Partnerships – To form a limited partnership, a notice must be filed with the State. Limited Partnerships have at least one general partner who is charge of operating the limited partnership and is liable for the actions of the partnership, and at least one limited partner who is not liable for the actions of the partnership but who must also not participate in the management of the limited partnership.
In addition to the foregoing, different states allow for various combinations and modifications of the foregoing entities, such as limited liability limited partnerships, professional corporations and benefit corporations. Finally, each state also allows for the creation of non-profit corporations which, unlike every other entity listed above, are not required to have owners.
Once you have formed the correct entity under state law, the next step is to select an appropriate tax regime. There are four regimes of the Internal Revenue Code that can apply to your business. They are:
Personal Income – The business is not separately taxed. Instead, all of the profits and losses from the business are included in the business owner’s annual personal income tax return.
Partnership Taxation (Subchapter K of the Internal Revenue Code) – The business is not separately taxed; instead, all of the profits and losses from the business are allocated among two or more partners and included in the partners’ annual personal income tax return.
Corporate Taxation (Subchapter C of the Internal Revenue Code) – The entity is separately taxed on its profits. Furthermore, to the extent the entity distributes assets to its shareholders, the shareholders generally will have to include the value of these distributions in their personal income tax returns. Because there are two separate taxes at play here (one on the entity’s profits and a second on the distributions), selecting corporate taxation is usually a poor choice unless there are separate compelling reasons to do so.
S Corporation Taxation (Subchapter S of the Internal Revenue Code) – The entity elects to pass profits and losses directly to its shareholders for income tax purposes. There are numerous restrictions on S corporations, but probably the most noteworthy is that the entity being taxed as an S corporation can only have one class of equity. As a result, there cannot be “preferred” shareholders.
Not all state entities can be taxed under each tax regime listed above (for example a sole proprietorship cannot be taxed as a partnership). Furthermore, the above discussion focuses solely on income tax. In addition, you may have other types of taxes to consider, such as employment taxes, property taxes and excise taxes.
Probably the most important step in setting up your entity (and a step that is too often ignored) is the drafting of appropriate contracts. Provisions regarding management of the company, restrictions on transfers of equity and similar provisions should always be in writing. These documents are the foundation for your business, and you should make sure they address as many contingencies as possible.