Choice of Business Entity
SOLE PROPRIETORSHIP CHARACTERISTICS
- Business that is capitalized by the assets of an individual.
- Usually minimal start-up costs and start-up requirements.
- Sole proprietor is personally liable for all debts of the business.
- There is no distinction made between the individual and business so that they are treated as one entity for all purposes.
- Sole proprietorship is dissolved upon the death of the owner.
- Sole proprietorship is free to sell or transfer all or any part of the business.
- The sole proprietor has total authority to run the business since there are no formalities limiting his or her control.
- Since the sole proprietorship is not a separate taxable entity, all business income is taxed as personal income to the business owner.
SOLE PROPRIETORSHIP ADVANTAGES
- Few formalities required for organization and hence organizational costs are minimal.
- Absence of statutory or other formalities required for decision-making and action.
- Freedom to do business anywhere without elaborate formalities to qualify.
- Minimal reporting requirements to government entities.
- Control is centered in one person, thus avoiding the inconvenience of collective decision-making and the risks arising when broad powers to manage or obligate the business are granted to several persons.
- Income is taxed at individual tax rates.
- Losses are available on the owner’s personal income tax return and can offset other income.
SOLE PROPRIETORSHIP DISADVANTAGES
- The owner is subject to unlimited personal liability for obligations and liabilities of the business.
- The business is subject to termination upon the death or disability of the owner.
- Transfer of the business through sale or otherwise requires transfer of the individual assets of the business.
- Risk of equity capital is limited only to resources of the individual owner, which may limit borrowing ability as well.
- Business profits are taxed as income to the owner at individual tax rates.
GENERAL PARTNERSHIP CHARACTERISTICS
- The pooling of the capital and skills of two or more persons as co-owners in order to run a business for profit.
- No official registration is needed except for the filing of a trade name certificate with the local Town Clerk.
- Although no written partnership agreement is required, it is highly advisable.
- Partnership liabilities extend to the personal assets of the partners since the partnership is not a separate entity.
- Partnership is legally dissolved at the death or withdrawal of a partner, in the absence of a partnership agreement stating otherwise.
- In the absence of a partnership agreement to the contrary, a partner cannot sell or assign his or her interest in the partnership without the consent of all the other partners.
- Unless the partnership agreement states otherwise, majority rules in a partnership.
GENERAL PARTNERSHIP ADVANTAGES
- Minimal formalities are required for organization, and hence organization costs are limited.
- Since a partnership involves more than one person, it permits a combination of individual resources and talents, and authority to act is not limited to one person.
- Few formalities are required by law for decision-making and action.
- The business may operate where it wishes without extensive formalities to qualify.
- Minimal reporting to government entities is required.
- If the partnership agreement so provides, a partnership may continue in existence after the death or withdrawal of a partner.
- Business profits are taxed to the partners.
- Business losses are available on partner’s personal income tax returns and can offset other income.
GENERAL PARTNERSHIP DISADVANTAGES
- Each partner has unlimited personal liability for all debts and liabilities of the partnership.
- The general power of every partner to act on behalf of the business requires caution in the selection of partners.
- A partnership is dissolved upon the death or withdrawal of any one partner, if not otherwise provided for by partnership agreement.
- Partnership profits are taxed as income to the individual partners.
LIMITED PARTNERSHIP CHARACTERISTICS
1.A refinement of the general partnership form.
2. To form a limited partnership, you must comply with the following statutory requirements:
a. Two lists – one of general partners and one of limited partners;
b. A written limited partnership agreement; and
c. A certificate filed with the Secretary of the State which sets out the rights and duties of the partners between each other.
3. A limited partner’s liability is limited to the amount of capital he or she has invested in the limited partnership.
4. To insure limited liability for the limited partners, all limited partnerships must have at least one general partner who is personally liable (a corporation may be a general partner).
5. The general partners manage and control the business activities of the limited partnership.
6. Where a limited partner participates in the management of the limited partnership, he/she loses his/her limited liability status and becomes liable as a general partner.
7. Limited partnerships are dissolved by the death or withdrawal of a general partner unless the limited partnership agreement specifically provides to the contrary or there is unanimous consent of the remaining members to continue.
8. The death or withdrawal of a limited partner does not dissolve the limited partnership and the limited partnership agreement can provide for the transfer of limited partnership interests.
9. A limited partner can sell his/her limited partnership interest with the consent of all other partners.
10. Limited partnerships are taxed like general partnerships.
LIMITED PARTNERSHIP ADVANTAGES
- Additional resources for financing are available from limited partners, without the need for the general partners to surrender control.
- For limited partners, a limited partnership provides the opportunity to invest and receive partnership profits without the risk of liability or loss beyond the amount invested.
- The business continues in existence without interruption upon the death of a limited partner or the transfer of a limited partner’s interest.
- Relatively free transferability is available for limited partnership interests.
- The tax advantages are the same as those for a general partnership including the ability to take partnership losses on partner’s personal income tax returns and reporting of partnership income on individual partner’s returns.
LIMITED PARTNERSHIP DISADVANTAGES
- Organization requires greater formality, which increases organizational costs.
- Operating in states other than the state of organization will require qualifying to do business in those states.
- There are greater reporting requirements to governmental entities.
- Limited partners are required to make a financial or property investment without the right to participate in the operation of the partnership.
- At least one general partner is required to assume responsibility for unlimited exposure for debts and liabilities of the business.
- Transfer of interest may be subject to securities law regulation.
- The limited partnership is dissolved upon the death, insanity or withdrawal of a general partner.
- The same tax disadvantages apply as for general partnerships, including income being taxed to the individual partners.
1. Separate legal entitles created pursuant to state statute.
2. Formal filings are required pursuant to state law.
3. Ownership interests are evidenced by stock certificates which are held by shareholders (who may be individuals, partnerships, limited liability companies, limited liability partnerships, other corporations or other forms of legal entities).
4. The policy-making decisions are made by the Board of Directors (who must be individuals and are elected by the shareholders).
5. Day-to-day management is by the corporate officers (who must be individuals and are elected by the Board of Directors).
6. Since a corporation is a separate legal entity, the financial risk to the owners is limited to the amount of their investment.
7. Centralized management (see 4 & 5).
8. Neither the death of a director nor the death of a shareholder will affect the legal existence of the corporation.
9. Corporations are taxed as separate entities.
10. Corporate earnings are distributed to shareholders through non-deductible dividends.
11. Income is subject to double taxation:
a. First at the corporate level; and
b. Then at the shareholder level.
12. Corporate tax rates differ from individual tax rates.
13. The corporation is required to file tax return – Form 1120.
14. Freely transferable (stock can be sold if marketable, given or bequeathed) except where restricted by shareholders’ agreement.
- Limited liability of the shareholders for the debts and liabilities of the corporation.
- Free and easy transferability of ownership by sale and transfer of stock, without affecting the continuing existence of the business or title to its assets.
- Perpetual existence of the corporation which is unaffected by the death of its shareholders or the transfer of corporate stock.
- The ability to transact business without each shareholder participating in every decision.
- Availability of S corporation election which substantially eliminates many of the tax disadvantages.
- Flexibility of financing through the sale of various types of securities to many investors.
- The availability of tax-favored fringe benefits unavailable to other forms of business entities.
- Easiest form of doing business since greater historical acceptability for dealing with other parties.
- Relatively high costs to organize.
- Burdensome reporting requirements.
- Statutory formalities must be adhered to for corporate decision-making and actions.
- Control is held by the Board of Directors, not the individual shareholders.
- Stock transfers are subject to state and federal securities law regulation.
- Limited liability limits the assets available to establish credit. The result is that individual shareholders are frequently required to personally guaranty corporate debt, which defeats much of the value of the limited liability characteristics.
- Must qualify to do business in states other than the state of incorporation.
- Double taxation for federal income tax purposes of business income which is taxable initially at the corporate level and again upon distribution to the shareholders.
- Losses of corporation may not be deducted by individual shareholders unless the corporation elects to be taxed as an S corporation.
LIMITED LIABILITY COMPANY CHARACTERISTICS
- Separate legal entity created pursuant to state statute.
- Formal filings are required pursuant to state law.
- The policy-making decisions are made by either members or managers.
- No written operating agreement required, but is highly advisable (However, New York State requires written operating agreements for New York limited liability companies).
- Formal filing of Articles of Organization with the Secretary of the State.
- Profit interest may be transferred, however, transfer of voting interest must be approved by a majority of the remaining members.
- Day-to-day management is by either the members or managers.
- The entity is dissolved upon the end of the term stated in the Articles of Organization or operating agreement or by the death or withdrawal of a member unless the majority of remaining members vote to continue.
LIMITED LIABILITY COMPANY ADVANTAGES
- Limited liability of the members for the debts and liabilities of the limited liability company.
- The ability to transact business without each member participating in each decision.
- Flexible financing through the sale of multiple classes of membership interests.
- No restriction on membership participation in management.
- Ownership of membership interests has no restrictions.
- There is no taxation on property transferred to the limited liability company upon formation by members.
- Liquidation is a non-taxable event unless the actual or deemed cash distribution exceeds the member’s tax basis in his/her membership interest.
- Relatively free transferability is available for limited liability company membership economic interests. Transfer of voting interests must be approved by a majority of the remaining members.
- Business profits are taxed to the members.
- Business losses are taxed to the members.
- The entity permits a combination of individual resources and talents while authority to act is not limited to one person.
- Few formalities are required by law for decision making and action, BUT potential problem of piercing the LLC veil.
LIMITED LIABILITY COMPANY DISADVANTAGES
- No uniform LLC statutes. Therefore, treatment of LLC’s in some states may differ.
- Transfer of membership interests may be subject to state and federal securities law regulation.
- Voting interests cannot be transferred without the approval of a majority of the other continuing members.
- Organization requires greater formality, which increases organizational costs.
- Operating in those states that have enacted limited liability company acts other than the state of organization will require qualifying to do business in such states.
- Little established body of law on which to rely, including protections of minority owners’ rights. Also, although few formalities are required, piercing the LLC veil has been found.
- More difficult to go public.
- The advantages of incentive stock option are not available. Issuing equity interests to management results in current taxation.
- Bankruptcy treatment is new and may create uncertainties for both members and creditors.
- Tax-free reorganizations are not available to LLC’s not electing to be taxed as corporations.