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Choice Of Entity

December 2004


The determination of a business structure may be the single most important decision when one is forming a business. This decision proves exceedingly difficult due to the fact that one must demonstrate vision in anticipating the future tax, membership, management, investment, liability, sale and transfer issues that may arise. Each of these factors will be determined fundamentally by the laws supporting such entity's formation. Therefore, it is important that a professional be consulted in order to highlight and clarify common pitfalls.

There are essentially four formats for conducting business, with subtle variations within each of the four. These four entities are the sole proprietorship, the partnership, the limited liability company and the corporation. Within the partnership context, two or more individuals or entities may form either a general partnership, a limited partnership or a limited liability partnership. Within the corporation context, one may form either a C corporation or an S corporation. Collectively, there are essentially seven (7) choices of entity. Each entity type has unique requirements, with both positive aspects and negative aspects.

After deciding what the purpose, focus and goal of the entity are intended to be, it is time to determine the choice of entity. It may be best to contact a qualified professional to consult and help ensure the best fit.

Sole Proprietorship

A sole proprietorship is the most basic way in which to conduct business. Most small businesses are conducted as sole proprietorships. The sole proprietorship is the intermingling of the individual non-business and business assets. This is beneficial because no formalities are required and all taxes are reported on the individual's tax return. However, the lack of separate identity of the individual and the business places the individual personally at risk for any liabilities incurred in the pursuit of the business, including the acts of such individual's agents or employees. Because of the liability aspects, this is the least desirable method of operating a business. A single member limited liability company (discussed below) should be considered as an alternative.

General Partnership

A general partnership is like a sole proprietorship except that there are two (2) or more persons conducting business under one name. No filing or agreement is necessary when forming a general partnership, but the partners typically enter into a partnership agreement that will outline the operations of the partnership. While no papers have to be filed to form a general partnership, a fictitious name statement should be filed with the county. The greatest concern with a general partnership is that each partner remains jointly and severally liable for the actions and debts of the partnership. Additionally, since either partner may bind the partnership, as well as an agent or employee with apparent authority binding the partnership "by estoppel," a partner may be liable for actions, contracts or debts that such partner did not realize existed. Partnerships are typically referred to as "flow-through" entities because the income flows through to the partners. Consequently, a partnership files a separate return, but the partners report their proportionate share of the income and losses on each of their respective tax returns.

Limited Partnership

A limited partnership has at least one general partner and one or more limited partners. A limited partnership is a hybrid between a partnership and a corporation. The general partner is like a partner in a general partnership. The general partner runs the business of the partnership, similar to a manager, and remains personally liable for the debts and obligations of the partnership. A limited partner generally does not get involved in the business of the partnership and is only liable for the amount contributed by the limited partner to the partnership. A limited partnership is formed by filing a certificate of limited partnership with the secretary of state's office in the state of formation. Limited partnership statues require that the limited partnership must maintain a principal office in the United States and a registered office in the state of formation. Additionally, the partners must enter into a limited partnership agreement. This agreement will generally set forth the terms upon which profits and losses will be split, define the relative responsibilities of the partners, discuss transferability, withdrawal and discharge of partners and partnership interests, and in some cases, define or limit the duties of care, loyalty and good faith (especially with regard to limited partners). Like a general partnership, the income and losses "flow through" to the general and limited partners. Generally, limited partners will only have liability up to the amount of their initial capital. A corporation may be used as the general partner, and therefore limit the general partner’s liability (as long as corporate formalities have been followed). The primary differences between a limited partnership and a general partnership are the limited liability of the limited partner and the additional required filing and documentation formalities.

Limited Liability Partnership

A limited liability partnership is a general partnership that has filed a certificate of limited partnership or other registration with the secretary of state's office in the state of formation. This type of entity is not limited to, but is primarily used by, professionals. In short, if the statement is filed and the partnership provides "security" in the form of insurance covering omissions, malfeasance and malpractice, no partners will be liable for the obligations of the limited liability partnership except to the extent of the security. However, individuals are not exempted from their own errors, omissions, negligence, incompetence or malfeasance.

Limited Liability Company

A limited liability company ("LLC") is a relatively new form of entity used in the United States and is derived from a form of entity commonly used in other countries. An LLC is commonly used because it provides liability protection to all owners, similar to shareholders in a corporation, but still allows the flow-through of income and losses for tax purposes, like a partnership. Additionally, the more burdensome requirements of a corporation, such as annual meetings, are not required with an LLC. An LLC is formed by filing articles of organization or a certificate of formation with the secretary of state's office. A written agreement, called the operating agreement or limited liability company agreement, is typically entered into among members to provide for the operations and the conduct of the business of the LLC. LLCs have the most flexibility of any entity, and therefore are frequently chosen by new business owners. Some states, like Illinois and Delaware, permit the formation of a single member LLC.

Corporation

Corporations are still the most common form of limited liability entity. The corporation shields the shareholder from the liabilities incurred by the corporation. For tax purposes, the corporation is treated and taxed separately. Thus, the corporation, and not the shareholders, pay taxes on its income. However, when the corporation distributes the income to shareholders as dividends, the shareholder is taxed on the dividends. This is commonly referred to as "double taxation" because both the corporation and shareholder are paying taxes on the same income. Likewise, losses remain with the corporation and do not flow-through to the individual to be used on such individual's tax return. A corporation is formed by filing either articles of incorporation or a certificate of incorporation with the secretary of state's office. Bylaws, which are the governing document of the corporation, must also be adopted. Unlike the entities discussed above, corporations are more structured in how they operate. A board of directors is the governing body. Officers are elected by the board of directors to run the day-to-day operations of the business. The board of directors and the officers owe duties of good faith, loyalty and care to the company.

S Corporation

An S corporation is a creature of federal income tax laws. For all purposes other than taxes, an S corporation is the same as any other corporation. To be treated as an S corporation, shareholders can elect S corporation status under the Internal Revenue Code. Generally, the income and losses flow-through to the shareholders. S corporations have limited liability similar to other corporations. There are several limitations on what types of corporations may qualify as S corporations. For example, S corporations are limited to a certain number of shareholders.

Most recently there has been a major influx in the number of LLCs being used for anything from a single member entity to protect assets, to complex multi-investor transactions. Because of their flexibility, flow-through tax aspects and limitation on liability, LLCs are quickly becoming the entity of choice for companies that are not looking to become publicly traded companies in the near future.

As should be apparent from the discussion above, choice of entity is one of the most important decisions that a business can make. Therefore, it is imperative to get counsel when such a decision is necessary. The use of entities in estate planning, as tax shelters or deferral mechanisms, as investment vehicles or just to run the family business, requires intimate knowledge of state statutes and the tax code.

If you should have any questions, or would like the attorneys at Pedersen & Houpt to help you select a business form for the function that you desire, our Corporate and Business Counseling professionals are ready to help.

This communication is provided as a general informational service to clients and friends of Pedersen & Houpt. It should not be construed as and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship. This material may be considered Attorney Advertising in some states. Please note that any prior results discussed in this material do not guarantee similar outcomes.

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