There are many issues to consider when deciding which business type will be best for your business model. In my last post, I wrote about the ease of formation and the liability of owners of each of the four types of business entities:
- Sole Proprietorship
- Partnership
- Limited Liability Company
- Corporation
In this post, I’d like to discuss the tax issues and the management and control issues of each type.
TAX ISSUES
Sole Proprietorship
A sole proprietorship is an unincorporated business that is owned by one person. The business has no separate legal existence apart from the owner. Therefore, any income or loss the business experiences, is included on the owner’s personal tax return. The business’ income and expenses are reported on Schedule C then the net profit or loss is transferred to the owner’s Form 1040 and taxed at the owner’s then current tax rate.
In addition, because income is not usually paid out as wages, the sole proprietor is responsible for paying self-employment tax on the amount of net income. This requires that a Schedule SE also be filed along with the 1040.
Partnerships
There are three types of partnerships: general, limited and limited liability. Like a sole proprietorship, a partnership (regardless of the type) is an unincorporated business. Therefore, any income or loss experienced by the partnership flows through to the partners’ personal tax returns. However, the partnership entity is required to file an informational return, known as Form 1065, with the IRS. Therefore, the partnership will need to obtain its own taxpayer identification number and should also file a Form SS-4.
Typically, profits and losses are shared in proportion to each partner’s capital contribution unless the partners agree otherwise. Data from the Form 1065 is split between the partners and reported to each partner on a form called Schedule K-1. The individual partner then reports the information on their tax return. In the case of a person, this would be on a Schedule E. The Schedule E income or loss is then transferred to the Form 1040. If the partner is an entity, such as a corporation or another partnership, the proportional share of income or loss is reported on that entity’s specific tax return.
Limited Liability Company
The limited liability company is the newest entity type to be recognized. Members of an LLC can choose to be taxed as a corporation or as a partnership. If they choose to be taxed as a C corporation, the entity would file Form 1120 and pay any tax that is due. If the LLC elects to be taxed as an S corporation, it should file Form 1120S and each owner then would receive a K-1.
If the LLC chooses to be taxed as a partnership, the partnership would be responsible for filing Form 1065 and then providing a Schedule K-1 to each member.
Corporation
The corporate entity structure gives rise to the issue of “double taxation.” Because a corporation is a separate legal entity, it is responsible for paying taxes on any profits; not the owners. But when those profits are paid out as dividends to the owners, each owner will pay tax on the income received. Corporations are responsible for reporting income and expenses to the IRS on Form 1120. They then send a form 1099-DIV to each owner who received a dividend payment.
An S corporation is not a separate type of entity. Every S corporation started out as a C corporation. The S signifies only different tax treatment for the corporation. The shareholders of a C corporation elect to become an S corporation by filing the appropriate forms with the IRS. The S designation then allows the corporation to be taxed as a partnership which means that the income and deductions of the corporation will flow through to the shareholders; thus, income is only taxed once at the shareholder level and not also at the corporate level. State taxation of S corporations varies. Some states do not allow S corporations this special tax treatment.
An S Corporation files Form 1120S with the IRS and provides a K-1 to each shareholder. The shareholder then reports the information from the K-1 on their separate tax return.
MANAGEMENT AND CONTROL
There are single-owner entities and multiple-owner entities. A sole proprietorship is naturally, a single-owner entity. Partnerships are always multi-owner entities. Corporations and LLCs are generally multiple-owner entities; however, they can also be single-owner entities.
Management refers to the level of involvement one has in the day to day running of a company. Control is about voting power – who has the right to make decisions regarding major business activities such as borrowing money, paying out profits, or dissolution of the company.
Single-Owner Entities
If you want to be in control of your business and have ultimate responsibility for managing it whether or not you decide to hire employees or other agents to assist in running the business, a sole proprietorship may work for you. You can also retain control and responsibility for management of the business with a corporation or an LLC.
Multiple-Owner Entities
If you’re going to operate a business with more than one owner, the issues involved in deciding which business entity to choose include whether or not a particular owner wants to be actively involved in the management of the company and who will actually control the company.
Partnerships
Partnerships can be ideal for business models that involve only a few individuals who want to control the company and be actively involved in the day to day operations. In a general partnership, the partners typically share these responsibilities equally; each one having an equal amount of voting power (or control) and management responsibility. But if your business model is a partnership in which all of the partners want to have a share of control in decision making but one or more aren’t interested in participating in the day to day operations of the business, then a limited partnership could be appropriate.
However, the limited partners must remain “passive” investors. As soon as they become actively involved in managing the business, they could lose their limited partner status and then become personally liable for the debts and obligations of the partnership.
A limited liability partnership allows each partner equal control and an equal right to participate in the management of the business. However, in most states, this type of partnership is restricted to professional occupations such as lawyers, doctors and accountants.
Limited Liability Company
In a limited liability company, all members have an equal right to control of the organization. At the same time, a limited liability company provides the most flexibility in deciding who will manage the business. An LLC can be managed by some, all or none of its members.
The members of the LLC are free to allocate control through voting rights as they see fit. Typically, each member would have one vote. However, it is possible to assign control based on each individual’s capital contribution – where each member is given votes proportional to their ownership interest in the company.
There are two types of limited liability companies when it comes to management: those that are managed by its members and those that are managed by managers. The organization’s management structure is generally outlined in its Articles of Organization. In a member-managed company, each member will have equal rights in the management of the company unless agreed otherwise.
If the company is going to be managed by managers, then a member would have no right to participate in the day to day management of the company unless he serves as a manager. A business is then free to establish criteria by which the managers will run the business. But be aware that managers of an LLC have the legal authority to enter into binding agreements on behalf of the company. Therefore, your operating agreement should be very specific about what powers are granted to the managers and you should make sure that your managers fully understand the limitations you wish to impose upon them.
Corporation
Corporation owners are referred to as shareholders. The shareholders are responsible for electing a board of directors who will have control over the decision making functions of the company. Thus, it is the board that has overall responsibility for the management of the corporation. The board of directors then, is responsible for hiring the corporate officers who will be responsible for the day to day management of the company.
The corporate officers are generally given broad powers to set policies and procedures for the running of the company and then report the company’s financial performance to the board. Board members do not participate in the management of the company.
In a large corporation, the shareholders are like limited partners; passive investors who have no involvement in the day to day workings of the company and limited control over decision making. Their control rests in being able to dismiss any one or more of the directors at any time for any reason if the company’s financial performance is not to their liking.
In a small or single-owner corporation, the shareholder(s) generally are also the directors and the corporate officers. Almost all states allow a single owner to assume the title of each of the required corporate officers (i.e. president, vice president, secretary and treasurer). Often, the shareholders elect non-shareholder directors and/or officers, such as family members, to fill the roles and help with the management of the company.
FINAL THOUGHTS
Today, there are more choices than ever in selecting the appropriate business entity. Personal liability, tax advantages, ease of formation and retention of control are just some of the issues that should be discussed when determining which entity type will be best for your business model.
I encourage you to post questions if you have them. And, as always, consult a knowledgeable CPA – and maybe also an attorney in this case – prior to making your final decision.