Choosing the Form of Entity for Your Business - Business Law Legal Blogs Posted by Ms. Kara K. Martin - Lawyers.com

Choosing the Form of Entity for Your Business

Choosing the form of entity by which to conduct business is one of the
first, and often most important, questions faced by someone starting a
business. Several factors determine which form of business entity is
most appropriate for a particular business, including protection of the
owners of the business from debts, obligations and liabilities of the
business, and achieving favorable tax treatment. This article will help
you understand the basic differences in business entities and the
advantages and disadvantages of the several options from which to
choose. In making your ultimate choice, you should discuss these and
other factors with your legal and tax advisors.

In Utah, you have several options when choosing the form of entity for
your business. The entities discussed in this article are: A) Sole
Proprietorships, B) General Partnerships, C) Limited Partnerships, D)
Corporations, E) S-Corporations and F) Limited Liability Companies. Not
discussed are more specialized entities such as professional
corporations, non-profit corporations, limited liability partnerships
and business trusts.

A. SOLE PROPRIETORSHIPS: A sole proprietorship is a single
individual who owns and operates a business typically using his or her
own assets. The sole proprietorship is the simplest form of business
entity, with little distinction between the owner and the business.

1. Advantages. A sole proprietorship is simple and requires no
formalities or state filings. A sole proprietorship avoids the double
taxation disadvantage of corporations. The owner may deduct business
expenses and losses from his or her personal income.

2. Disadvantages. An owner is personally liable for all obligations of
the business. Creditors of the business can seek recovery from the
owner’s personal assets, as well as business assets. Also, all profit
may be subject to self-employment tax, even if part of the profit is
attributable to a return of capital.

B. GENERAL PARTNERSHIPS: A general partnership is an association
of two or more persons formed for the purpose of conducting a business
for profit. A partnership may be created by a formal agreement or
merely by the parties’ actions.

1. Advantages. The biggest advantage of a partnership is its relatively
favorable tax treatment. There is no separate tax at the partnership
level and individual partners get the benefit of business expenses and
deductions to offset income from other sources. Partners may also
specially allocate income and losses, thus allowing them to shift tax
benefits and burdens. A partnership can be formed and operated with
minimal formality and no filings or agreements are necessary.
Partnerships are relatively easy to manage.

2. Disadvantages. Each partner is jointly and severally liable for all
obligations of the partnership. On dissolution of a partnership, a
creditor of the partnership can sue any of the partners personally for
unpaid partnership debts. In the absence of any agreement to the
contrary, the death or withdrawal of one partner dissolves the
partnership. Management of a partnership can be difficult if many
partners are involved or if partners do not get along well. Interests
in partnerships are not freely transferable. There is no centralized
management in a partnership, and any partner can bid the partnership and
the other partners in any matter of partnership business. Raising
capital is difficult in the partnership form since the partnership
cannot obtain funds through broad ownership distribution. It takes at
least two persons to form a partnership.

C. LIMITED PARTNERSHIPS: A limited partnership is a partnership
comprised of one or more general partners who operate and manage the
business, and one or more limited partners who do not actively operate
or manage the business. Articles of limited partnership must be filed
with the state. A partnership agreement would normally describe the
rights and duties of the partners.

1. Advantages. A limited partnership enjoys the same basic tax
advantages as a general partnership, subject to the passive income and
loss rules, and except that limited partnerships may be more limited in
how they can specially allocate income and losses. The limited
partnership affords investors limited liability, much like a
corporation, so long as they do manage the business.

2. Disadvantages. The general partners of a limited partnership are
liable for all partnership obligations. As with a general partnership,
the death or withdrawal of a general partner will dissolve a limited
partnership, absent a partnership agreement provision to the contrary.
Although more freely transferable than general partnership interests,
limited partnership interests are still not as freely transferable as
corporate interests.

D. CORPORATIONS: A regular corporation, or “C Corporation” to
the IRS, is the most common form of entity for doing business. A
corporation is a legal entity, formed pursuant to state law that exists
separately from its owners. Articles of incorporation must be filed
with the state. The management structure and financial and voting
rights of the shareholders are typically embodied by bylaws or
shareholder agreements.

1. Advantages. It is difficult to “pierce the corporate veil” to hold
shareholders, officers or directors personally liable for corporate
obligations. Protection from liability is the principal reason a
corporation is preferred as a form of business entity. Also, with a
long history of use in this country, corporate law is well developed and
fairly standard throughout the states, and therefore legal issues are
more predictable and more readily settled. Ownership interests (stock)
in a corporation are freely transferable.

2. Disadvantages. A C corporation’s income is subject to double
taxation: first on the net income when it is earned by the business, and
again on the dividends when paid to the shareholders out of the
corporation’s remaining income. Also, a corporation requires more
formalities and is somewhat more complex than a sole proprietorship, a
general partnership or a limited liability company. Annual reports must
be filed and corporate formalities, such as keeping proper corporate
minutes, should be followed to maintain the separate identity of the
corporation. Also, corporations are less flexible from a tax standpoint
than other entities.

E. S-CORPORATIONS: An S-corporation is a corporation that, by
complying with IRS requirements, avoids the double taxation of C
corporation, and is taxed more like a partnership than like a C
corporation. Articles of incorporation must be filed with the state and
a form must be filed with the IRS indicating the corporation’s election
to be treated as an S-corporation.

1. Advantages. Shareholders enjoy the same protection from liability
for the obligations of the business as shareholders of a regular
corporation. The primary advantage of an S-corporation over a C
corporation is the avoidance of double taxation. Another advantage is
that, to the extent there are losses in the corporation, those losses
may be passed through to shareholders to be offset against shareholders’
income from other sources, subject to certain limitations.

2. Disadvantages. An S-corporation is limited by the number (100 or
less) and type of shareholders it can have. It is also limited to one
class of stock. These limitations may make it more difficult for an
S-corporation to raise capital. Also, unlike a partnership, income and
losses cannot be specially allocated to shareholders.

F. LIMITED LIABILITY COMPANIES: A limited liability company
(LLC) is a relatively new form of business entity in Utah combining
features of partnerships and corporations. An LLC has the tax
advantages and operational flexibility of general partnerships, together
with the limited liability protection of a corporation. The LLC is a
separate legal entity which is organized by one or more persons or
entities. Articles of organization must be filed with the state. The
rights of the owners or “members” with respect to management and
financial matters may be set forth in an operating agreement.

1. Advantages. Members of an LLC are not personally liable for the
obligations of the company. LLCs enjoy favorably flow-through tax
treatment without double taxation. LLCs can specially allocate income
and losses among members. There is no limit on the number or type of
members, and an operating agreement can, in effect, create different
classes of ownership interests. There are relatively few formal
requirements to create and operate an LLC. Finally, LLCs also offer
certain other tax advantages of an S- corporation.

2. Disadvantages. One disadvantage of an LLC is that it is still the
newest form of business entity and as such, is still somewhat untested
in court cases. There still remains some uncertainty with respect to
issues such as piercing the veil of an LLC, the treatment of the LLC and
its members in bankruptcy, and the like. However, each year adds more
experience so these concerns are becoming less disadvantageous. Another
area of disadvantage of the LLC is that there still is no strong
uniformity of state laws governing LLCs. An LLC entity conducting
multi-state business may find it difficult to comply with the laws in
all the various states. Also, to the extent an LLC engages in business
in a state which has not passed LLC legislation, there is a risk that a
court might not recognize the limited liability of members, and might
hold the members personally liable in that state for the obligations of
the business. However, most every state now recognizes LLCs as a type
of business entity.

Each business is different, but determining which factors are most
important to your business will help you better determine which type of
entity will work best for you.

View Attorney Profile

Ms. Kara K. Martin

Licensed since 2009

Member at firm The Franchise Business Law Group

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