May 8, 2018

This piece is presented by Woods, Fuller, Shultz & Smith PC.

Business owners and entrepreneurs often inquire about what is the most appropriate legal entity structure for their business and differences between the various options.

Choosing a legal entity structure requires careful consideration of many factors. For example: Does the business need financing? Are other businesses allowed to be an owner? What about taxes? Can owners be sued personally for the actions or omissions made by or on behalf of the business? Can one owner be held responsible and liable for the actions of another owner? If the business defaults on an obligation, is an owner personally liable?

To choose correctly, it is important to know the basic differences between the most common types of entities. The breakdown below summarizes some of the important differences.

Sole proprietorships

• Single owner.
• Simplest business structure, generally the quickest and least costly to set up.
• Is not a distinct, independent legal entity.
• The owner is responsible for business operations and has full financial control.
• The owner is personally responsible and liable for debts, obligations and actions of the business.
• Income and losses are “passed through” to the owner’s personal income tax return.
• Business losses may offset other income.
• Requires the payment of quarterly estimated income taxes and self-employment taxes. 

Partnerships

• An association between two or more persons carrying on as co-owners of a business and sharing profits.
• Easy to form.
• Should have a written partnership agreement but not required. An agreement helps protect each partner by clearly defining ownership, partner responsibilities, partnership interest transfers, non-compete arrangements and other important partnership matters.
• No requirement that certain formalities be followed, such as holding annual meetings of the partners.
• Individual partners are personally responsible and liable for debts and obligations of the partnership and actions of other partners.
• The profits and losses of the partnership are “passed through” to each partner’s individual income tax returns based on his or her share of the income and losses from the partnership.
• The partnership structure can be organized to have limited partners — investors only, without control or personal liability, as well as limited liability partnerships, which can limit personal liability for business debts.

Corporation (C corporation)

• Is a separate, independent legal entity incorporated under the laws of a particular state.
• More complex than sole proprietorships and partnerships, resulting in increased legal and accounting costs.
• Shareholders (owners) are not personally responsible or liable for debts, obligations and actions of the corporation unless the shareholders fail to follow certain corporate formalities.
• Is taxed separate and independent from its shareholder owners.
• Shareholders are taxed upon the issuance and receipt of dividends from the corporation.
• No limit on the number of shareholders.
• No restriction on the type of shareholders — can be individuals, partnerships, corporations, LLCs and other organizations.
• Corporate formalities must be followed, including creating articles of incorporation and bylaws, holding regular shareholder and board meetings, and maintaining separate financial accounts.

Subchapter S corporation (S corporation)

• Is generally a corporation or an LLC that has elected to be taxed as a S corp.
• Is a separate, independent legal entity (corporation or LLC) incorporated under the laws of a particular state.
• More complex than sole proprietorships and partnerships, resulting in increased legal and accounting costs.
• Is not taxed separately and independent from its owners.
• Income and losses are “passed through” to owners’ personal income tax returns.
• Limited to 100 shareholders.
• Restriction on type of shareholders — must be individuals, estates or certain trusts, and all must be U.S. persons.
• Shareholders are not personally responsible or liable for the debts, obligations or actions of the business unless the business is a C corporation and certain corporate formalities are not followed.
• Must follow corporate formalities if a C corporation.

Limited liability company (LLC)

• Is a hybrid of a partnership and corporation.
• Is a separate, independent legal entity organized under the laws of a particular state.
• Is governed by an operating agreement, which lists and describes a member’s (owner’s) rights and responsibilities in the business.
• Is not taxed separately and independent from its members.
• Similar to partnerships and S corporations, income and losses are “passed through” to the members and taxed on their personal income tax returns.
• No limit on the number of members.
• No restriction on type of members — can be individuals, partnerships, corporations, LLCs and other organizations.
• Are either member managed (managed directly by the members) or manager managed (managed by a created board of managers).
• Fewer and more flexible business formalities to be followed.
• Because fewer business formalities must be followed, members are less likely to be personally responsible or liable for the debts, obligations or actions of the business.

Choosing initially a legal entity structure for a business requires careful consideration. In addition, as a business grows and state and federal laws and regulations change, business owners should review and reconsider whether their business’ existing legal structure remains appropriate.

Woods Fuller’s business organization attorneys have the expertise to advise business owners on the most beneficial structures based on their unique needs and goals. Visit woodsfuller.com to learn more.