Understanding and Choosing a
Legal Structure
Based on Peri Pakroo’s The Women’s Small Business Start-Up Kit: A
Step-by-Step Legal Guide (USA, NOLO: 2010). Chapter 5
The basic entities are
- sole proprietorships
- partnerships (general and limited)
- limited liability companies (LLCs)
- corporations (including C and S types)
The most important differences cover how taxes are paid and who is
liable for the business.
Type of Entity
Sole Proprietorships
Partnerships
Limited Liability
Companies
Corporations
Personal Liability
Owners are personally
liable for business
debts
Owners are personally
liable for business
debts
Owners are shielded
from personal liability
for business debts
Owners are shielded
from personal liability
for business debts
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Taxation
Profits/losses taxed
on personal tax
returns
Profits/losses taxed
on personal tax
returns
Profits/losses taxed
on personal tax
returns (unless the
LLC chooses corporate
tax treatment)
Corporation files its
own tax return and is
taxed as its own entity
Sole Proprietorships – any one-person business that has not
filed papers to become a corporation or an LLC. About 3/4ths of all
businesses operate as sole proprietorships.
Being a sole proprietor does not mean you are the only person who
works at the business. It means that you are the only person who owns
the business.
Just because you are a sole proprietor, you are still subject to local
registration requirements and rules.
Pass-Through Taxation – The sole proprietorship is not legally
separate from the person who owns it.
With respect to taxation, a sole proprietor simply reports all business
income or losses on her individual income tax return. This is called
“pass-through” taxation, because business profits pass through the
business to be taxed on the business owner’s tax return.
When filing, report income from the business just like wages from a job
and include Schedule C along with Form 1040.
This form of taxation will help if business losses offset any taxable
income you have earned from other sources.
Make sure you have a separate business bank account and keep
accurate records of all income and expenses.
Self-employment taxes and payroll taxes are essentially the same tax:
Social Security and Medicare taxes, totaling 15.3% of income/wages up
to $106,800 (for tax year 2009), and 2.9% on income/wages above that.
Doing business with your spouse –
Two unmarried people working at a business that’s not an LLC or a
corporation would be considered one of 2 things: (1) partners in a
partnership, or (2) one would be a sole proprietor and the other an
employee.
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If the two are considered to be business partners, they will need to file a
partnership tax return and each person would have to pay selfemployment taxes on their share of business income. If one person is
considered to be a sole proprietor, then she would owe selfemployment taxes on her business income, and payroll taxes would
apply to the employee’s wages.
The IRS typically allows a spouse to work without pay without being
classified as an owner or an employee of the other spouse’s business.
The IRS loosely terms this as a “husband-wife sole proprietorship.” The
upside of this arrangement is that you do not have to pay payroll taxes
for your spouse. The down side is that your spouse will not get Social
Security or Medicare account credit.
If the spouses want to be co-owners of the business, the IRS now allows
husband and wife co-owners to file as “co-sole proprietors,” with each
spouse filing his own Schedule C reporting of his and her share of profits
and losses. Here, both spouses will receive Social Security and Medicare
credits.
If you use your spouse as a volunteer, the IRS might find your business
to be a partnership and charge your spouse with back self-employment
taxes.
The sole-proprietor can be held personally liable for businessrelated obligations. “This means that if your business doesn’t pay a
supplier, defaults on a debt, loses a lawsuit, or otherwise finds
itself in financial hot water, you, personally, can be forced to pay
up.” (p. 158)
Insurance is an important tool for the sole proprietor. Insurance
will help with a slip-and-fall lawsuit, for example. But it might not
help your business if you fail to make a profit and fall into debt.
Take a step back and ask yourself: What are the risks in my
business?
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(i.e. – using hazardous materials; manufacturing or selling edible goods;
driving as a part of your job; building or repairing structures or
vehicles; caring for children or animals; providing or allowing access to
alcohol; conducting or allowing activities that may result in injury, such
as personal training or skateboarding; and repairing or working on
items of value, such as cars or antiques)
Partnerships – a business owned by two or more people
designed to make a profit.
When two or more people engage in business activity and they have not
filed papers with the state to become a corporation or an LLC (or other
less common business form), by default the business is considered a
partnership.
General partnership – 1) The partners are personally liable for all
business debts, including court judgments. In addition, each individual
partner can be sued for the full amount of any business debt. 2) Any
individual partner can bind the whole business to a contract or business
deal. Each partner has “agency authority.”
Limited partnership – A limited partnership requires at least one
general partner and at least one limited partner. The general partner
plays the same role of controlling day-to-day operations and is
personally liable for business debts. The limited partner contributes
financially to the partnership but has minimal control over business
decisions or operations, and normally cannot bind the partnership to
business deals. In return for giving up management power, a limited
partner gets the benefit of protection from personal liability. But the
limited partner MUST stay out of management activity, otherwise the
limited partner can be liable to third parties who reasonably believed,
based on the limited partner’s conduct, that the limited partner was a
general partner.
Limited Liability Partnership – all the owners have limited personal
liability. New York States has LLPs; however, they are only available to
professionals like lawyers and accountants.
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Pass-Through Taxation
A partnership is also a “pass-through entity” and income passes through
the business to each partner who pays taxes on his share of profit on his
individual income tax returns with Schedule E.
The partnership, itself though, must also file what the IRS calls an
“informational return”, Form 1065 (U.S. Return of Partnership Income),
to let the government know how much the business earned or lost that
year. No tax is paid along with this return.
Personal Liability for Business Debts
General partners are personally liable for business-related obligations.
In a general partnership, the business actions of any one partner bind
the other partners, who can be held personally liable for those actions.
“Marie and Ivy are general partners in a profitable plant nursery
specializing in native and drought-tolerant plants for sustainable
landscapes. They’ve been in business for five years and have earned
healthy profits, allowing them each to buy a collection of garden
sculptures and Ivy’s roomful of vintage musical instruments. One day
Marie finds a website offering fertile marijuana seeds that she knows
would be a hit with their customers. She orders two cases of the seeds,
without telling Ivy. But when the shipment arrives, so do agents of the
federal drug enforcement agency, who confiscate the seeds which, as it
turns out, violate U.S. drug laws. Soon thereafter, criminal charges are
filed against Marie and Ivy. Though the partners are ultimately cleared,
their attorney fees come to $50,000 and they lose several key accounts,
putting the business into serious debt.” As a general partner, is Ivy
liable for any of these debts even though she had nothing to do with the
ill-fated marijuana seed purchase?
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Partnership Agreements – you can structure your relationship with
your partners in practically any manner you want.
However, it is not legally necessary for a partnership to have a written
agreement; the act of two or more people doing business together
creates a partnership. In the absence of a partnership agreement, your
state’s version of the Uniform Partnership Act (UPA) or Revised
Uniform Partnership Act (RUPA) is the standard.
WHAT A PARTNERSHIP AGREEMENT CANNOT DO
1) free the partners from personal liability for business debts
2) restrict an partner’s right to inspect the business books and records
3) affect the rights of 3rd parties in relation to the partnership – i.e. – if a
partner signs a contract with a 3rd party even if the partner cannot do so
4) eliminate or weaken the duty of trust (the fiduciary duty) each partner
owes to the other partners
Partnership agreements usually include:
- name of the partnership and partnership business
- date of partnership creation
- purpose of the partnership
- contributions (cash, property, and work) of each partner to the
partnership
- each partner’s share of profits and losses
- provisions for taking profits out of the company (often called partners’
draws)
- each partner’s management power and duties, such as what
departments they will manage and specific responsibilities such as
hiring or budgeting
- how the partnership will handle departure of a partner, including
buyout terms
- provisions for adding or expelling a partner
- dispute resolution procedures.
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Limited Liability Companies (LLCs)
The LLC offers the simplicity and tax benefits of pass-through taxation
(as with sole proprietorships and partnerships) without the exposure to
personal liability. LLCs are less complex and costly to start and operate
than corporations.
Limited Personal Liability
Owners of an LLC are not personally liable for the LLC’s debts. Creditors
can take all of the LLC’s assets, but they generally can’t get at the
personal assets of the LLC’s owners.
Like a general partner, any member of a member-managed LLC can
legally bind the entire LLC to a contract or business transaction.
In a manager-managed LLC, any manager can bind the LLC to a business
contract or deal.
Protection from personal liability is not absolute and there are several
situations where an LLC owner can still be personally liable for debts:
1) Personal Guarantees – If you give a personal guarantee on a loan to
the LLC, then you are personally liable for repaying that loan. Banks
and other lenders often require this personal guarantee.
2) Taxes – The IRS or the state tax agency may go after the personal
assets of LLC owners for overdue federal and state business tax debts,
particularly overdue payroll taxes.
3) Negligent or intentional acts – An LLC owner who intentionally or
even carelessly hurts someone will usually face personal liability. (i.e. –
an LLC owner who drunkenly crashes with a client as a passenger)
4) Breach of fiduciary duty – LLC owners have a legal duty to act in the
best interest of their company and its members. This is a fiduciary duty
or a duty of care. The business judgment rule protects LLC owners
when they act with reasonably good faith. Thus, there is only a breach
of duty due some type of fraud, gross negligence, or other illegal
behavior.
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5) Blurring the boundaries between the LLC and its owners. An LLC
owner can be found liable when the LLC looks like an extension of the
owner’s personal affairs. Avoid this by opening a separate LLC checking
account, getting a federal identification number, keeping separate
accounting books for your LLC, and funding your LLC adequately
enough to be able to meet foreseeable expenses.
Because of all these considerations, insurance is still an
important option to explore.
LLCs v. S Corporations –
Before LLCs, people used S Corporations as ways to conveniently limit
liability. An S Corporation is like an LLC except for the fact that business
profits pass through to the owner, rather than being taxed to the
corporation at corporate tax rates.
Why not S Corporations?
LLCs are not bound by the many
regulations that govern S corporations.
Ownership restrictions – An S corporation may not have more than 75
shareholders, all of whom must be U.S. citizens or residents. (So you
really don’t have the option of making any large public offers.) Any
person can be a member of an LLC.
Allocation of profits and losses – Shareholders of an S corporation must
allocate profits according to the percentage of stock each owner has.
Subject to a few IRS rules, LLC owners can allocate membership freely.
Corporate meeting and record-keeping rules – Corporate rules are more
stringent than how LLC owners just have to make sure that their
management team is in agreement on major decisions about business.
Tax treatment of losses – An S Corporation’s business debt cannot be
passed along to its shareholders unless they have personally cosigned
and guaranteed the debt. LLC owners can normally real the tax benefits
of any business debt, cosigned or not.
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LLC Taxation –
An LLC is also a “pass-through entity.” On the individual income tax
return, this is Form 1040 with Schedule E, Supplemental Income and
Loss. A multi-owned LLC, like a partnership, does have to file Form
1065, “an informational return”.
By filing a form with the IRS (Form 8832, Entity Classification Election),
you can choose to have your LLC taxed like a corporation rather than a
pass-through entity. “For example, if the owners of an LLC become
successful enough to keep some profits in the business at the end of the
year (or regularly need to keep significant profits in the business for
upcoming expenses), paying tax at corporate tax rates can save them
money. That’s because federal income tax rates for corporations start at
a lower rate than the rates for individuals.” (p. 174)
Forming an LLC
To form an LLC, you must file Articles of Organization with your
secretary of state or other LLC filing office.
You should also execute an operating agreement, which governs the
internal working of your LLC.
It might be more expensive to form an LLC because of state filing fees.
LLCs that have owners who do not actively participate in the business
may have to register their membership interests as securities, or more
likely, qualify for an exemption to the registration requirements. See
the Securities and Exchange Commission’s website – www.sec.gov
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Corporations
A corporation is simply a specific legal structure that imposes certain
legal and tax rules on its owners (shareholders). A corporation is a
separate legal entity from its owners.
Shareholders are normally protected from personal liability for
business debts and the corporation itself – not just the shareholders – is
subject to income tax.
Limited Personal Liability
Limited Personal Liability also allows owners to protect themselves
from legal and financial responsibility in case their business flounders
or loses an expensive lawsuit and can’t pay its debts. Creditors can take
all of the corporation’s assets but they generally cannot get at the
personal assets of the shareholders.
However, when corporate owners ignore corporate formalities and
treat the corporation like an unincorporated business, a court may
ignore the existence of the corporation (“pierce the corporate veil”) and
rule that the owners are personally liable for business debts and
liabilities.
Corporate Taxation
Corporate Taxation is a bit more complicated and demands the help of
an accountant and an attorney.
After deductions for employee compensation, fringe benefits, and all
other reasonable and necessary business expenses have been
subtracted from its earnings, a corporation pays tax on whatever profit
remains.
TAX ADVANTAGE OF A CORPORATION – If a corporation pays for
benefits such as health and disability insurance for its employees and
owners/employees, the cost can usually be deducted from the corporate
income, reducing a possible tax bill. As a general rule, owners of sole
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proprietorships, partnerships, and LLCs can deduct the cost of
providing these benefits for employees, but not for themselves. The fact
that fringe benefits for owners are deductible for corporations may
make incorporating a wise choice. But the business must have enough
capital to underwrite these expenses.
Since initial rates of corporate taxation are comparatively low,
corporations that keep some profits in the business from one year to
another rather than paying out all profits as salaries and bonuses can
take advantage of 15% to 25% tax brackets.
Marginal Tax Rates for Corporations
Taxable Income
0 to $50,000
$50,001 to $75,000
$75,001 to $100,000
$100,001 to $335,000
$335,001 to $10,000,000
$10,000,001 to $15,000,000
$15,000,001 to $18,333,333
Over $18,333,333
Tax Rate
15%
25%
34%
39%
34%
35%
38%
35%
Professional corporations are subject to a flat tax of 35% on all
corporate income.
The double taxation problem – Unlike salaries and bonuses, dividends
paid to shareholders cannot be deducted as business expenses from
corporate earnings. These dividends are taxed as a part of corporate
profits and then double taxed as a part of the shareholder’s individual
tax rate.
Double taxation can be avoided by not paying dividends. This is easy if
all shareholders are employees, but probably more difficult if some
shareholders are passive investors waiting for a return on their
investments.
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Forming and Running a Corporation
Forming a corporation takes major time and expense. To incorporate,
you must file articles of incorporation with the secretary of state along
with paying hefty filing fees and minimum annual taxes.
If a corporation sells public shares, the corporation has to comply with
lots of complex federal and state securities laws.
To limit your personal liability, the corporation must adopt bylaws,
issue stock to shareholders, maintain records of various meetings of
directors and shareholders, and keep records and transactions of the
business separate from those of the owners.
As a Whole
The LLC is more popular than ever because it offers protection
from personal liability along with the simplicity of pass-through
taxation.
If risks are so low as to be nonexistent, or if you don’t have any personal
assets worth protecting, you might want to wait on forming an LLC or
corporation until your circumstances change.
An LLC or a corporation? Incorporation normally makes sense only if
a business needs to take advantage of the corporate stock structure to
attract key employees and investment capital. The ability to issue
employee stock options is a key to retaining key employees.
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