There are eight primary factors that define how a business is structured:
- Creation – how the business is started
- Management – how it is managed and operates on a daily basis
- Ownership – who owns property and assets
- Profit – how profits and losses are distributed
- Liability – who is accountable for legal responsibilities
- Taxation – how the business is taxed
- Continuity – the length of the Firm’s life
- Termination – how the business can be terminated
Owners of a closely held business face numerous problems. Some are inherent in the organizational structure of the small business and others exist in enterprises of all sizes. Many problems facing the business owner, such as survival in the marketplace, are obvious. The business owner may not recognize other problems, such as the reduction in business income resulting from loss of a key employee due to death or disability, until the incident occurs. Many problems facing the business owner can be avoided, or at least mitigated, through proper planning. Planning intelligently to avoid or handle future problems is necessary to identify potential problems and form objectives.
Business owners are faced with a number of choices when selecting the form of enterprise. They may elect to operate unincorporated, as a sole proprietorship, a partnership, or a limited-liability company (LLC); or they may incorporate as a regular C corporation or as an S corporation. The choice of ownership form is not irrevocable, and owners of existing businesses often decide to change the form as circumstances dictate. For example, the sole proprietor might wonder if the benefits of switching to the corporate form of ownership are worth the costs of incorporation. Or perhaps the owners of an existing closely held corporation are considering what the tax advantages would be if they switched to a subchapter S form of business. The choice of organizational structure is a complex decision facing all business owners because it will have a significant impact on the initial start-up cost, the control and flexibility in management, the taxation of the business and individual owners, the ability of the Firm to raise capital, and business risks absorbed by the individual owners. Owners often have several objectives when selecting a form of ownership under which the business will operate:
- Start-up costs and formalities of operation
- Control of the business and management
- Flexibility in business operations
- Ability of the business to raise funds
- Limiting the liability of owners from business operations
- Overall tax burden
- Business continuity and termination
- Compensation and fringe benefits
The priority ranking of these goals will differ from one individual to the next, but the typical business owner or professional will face troubleshooting all of these issues. The following discussion of forms of business organization will examine how each impacts these objectives.
For entrepreneurs establishing a new business, oftentimes a Sole Proprietorship is the most common and simplest form of business entity for a few reasons:
- Ease to establish
- A sole proprietor has complete control and decision-making power over the business
- Sale or transfer can take place at the discretion of the sole proprietor
- No corporate tax payments
- Minimal legal costs to form
- Few formal business requirements
It is not uncommon for the business to outgrow the original entity structure and therefore, may not meet an entrepreneur’s long-term objectives. This may result in disadvantages that begin to outweigh the advantages of remaining in the present form. Most of these disadvantages spring from the very feature that makes the sole proprietorship form of business so attractive – the complete identity of the business with its owner. Disadvantages of a Sole Proprietorship structure can be summarized as follows:
Unlimited and Unshared Liability: One of the main disadvantages of a sole proprietorship is that it opens the owner up to personal liability. Because a sole proprietorship is essentially a business being run in the name of the owner, the individual is liable for any action against the company. In the eyes of the law, there is no wall of protection between the owner and the business. They are one and the same. The liabilities of a sole proprietor include liability for the negligent or willful acts of employees and agents. Therefore, if an employee negligently injures someone in the course of the employee’s duties, you may be personally liable for damages. If there is no insurance or insufficient insurance to cover the damages, the individual’s other assets (home, car, or stock portfolio) could be seized to pay the damages. Therefore, as you reflect upon your present situation, ask yourself that while it was simple to establish, is a Sole Proprietorship in your best interest?
Also, should the business fail, debts and liabilities are completely the responsibility of the owner. It is possible that the creditors could come after the owner seeking personal property or finances to repay the debts of the business. In addition, if filing bankruptcy is necessary to clear the debts of the business, that bankruptcy will be a personal bankruptcy affecting the owner and his or her personal credit report.
No Stock: A sole proprietorship has only one owner and, as a result, cannot sell “equity interests” (stock or partnership interests) as is typically done by corporations and other forms of business. Therefore, should you ever desire to sell an ownership interest in your Firm to an investor, employee, or third-party, in part or in whole, you are precluded.
Death: Since a sole proprietorship is connected only with the sole proprietor, if you die, the existence of the sole proprietorship ends upon the death of the owner and the property of the business will be disposed of according to the terms of the owner’s will. All assets of the sole proprietorship are owned by the owner as personal property.
Limited Resources: The amount of capital available to a sole proprietorship is limited to personal financial resources of the owner and the ability to obtain credit and borrow money. You have no way to raise funds from outside investors without ceasing to be a sole proprietorship. For this reason, sole proprietorships generally are not practical in large business ventures that demand outside capital inputs. The sole proprietorship form is also limited in terms of business talent and ability. The success of the business generally is tied to the ingenuity, initiative, resourcefulness, and managerial abilities of the sole owner. Even if a sole proprietor is a skilled manager, the business will probably decline any time this person is sick or disabled. In addition, a sole proprietor typically would be reluctant to undertake projects that require a variety of specialized technical skills.
There are two basic types of partnerships – General Partnerships and Limited Partnerships. A general partnership is the most common type of partnership. Each partner is fully active in the Firm with a voice in its management. Each is an agent of the other partner (or partners) with full authority to act for the Firm within the scope of its business activities. Each is fully liable for the debts of the business, and each shares in the profits.
Every limited partnership has at least one limited partner and one general partner. The limited partner is not legally liable for all the financial obligations of the Firm. Instead, this partner’s liability is limited to the amount of his or her investment in the venture. A limited partner has no voice in management, no involvement in the day-to-day running of the business. In
essence, the limited partner is largely an investor in the Firm. A general partner is one who has unlimited liability and is active in managing the partnership.
Advantages of a general partnership can be summarized as follows:
- Partners get all the profits. Unlike corporations there are no stockholders with whom to share the earnings of the business;
- Unlike corporations the partnership itself is free from federal income tax. Also, partnerships are not subject to the accumulated earnings tax, as are some C corporations. Any losses or profits of the partnership pass directly to the partners as personal income for federal income tax purposes. This means that any partnership losses can be used by the partners to offset income from other sources, thereby reducing their individual federal income tax bill. This is unlike a corporation, where corporate losses can be used only to offset the past or future profits of the company. This treatment of partnership losses can be particularly important to partners who have significant income from other sources;
- Finally, as contrasted with sole proprietorships, partnerships permit a pooling of capital and talent and a sharing of risk. For example, two people may decide to open a wholesale distributorship. They pool their financial resources to lease space and purchase inventory. One partner may have a knack for dealing effectively with people. The other is more detail oriented and excels at the bookkeeping.
Disadvantages of a general partnership can be summarized as follows:
- The death of a partner may automatically end the partnership—with serious consequences to all concerned. These consequences can be avoided if an ownership transfer plan (buy-sell agreement) is implemented and funded;
- Unlimited personal liability of the partners. Business debts can devour all of the business assets. If the debts cannot be satisfied out of partnership assets, creditors can go after personal assets of every partner.
The Uniform Limited Partnership Act defines a limited partnership as “a partnership formed by two or more persons having as members one or more general partners and one or more limited partners. The limited partners as such shall not be bound by the [financial] obligations of the partnership beyond the extent of their investment.”
To grasp the concept of limited partnership, think of limited partners as investors. This is, in fact, what they are—namely, investment vehicles, as opposed to regular business partnerships. They put their money into the partnership as a financial investment, taking none of the day-to-day responsibilities for managing the business. In addition, their limited liability keeps them from losing more than they invest. The general partners conduct the day to day business for the entire partnership and have unlimited liability for the Firm’s obligations. Most limited partnerships deal in investment ventures such as oil and gas drilling, cattle breeding, and real estate.
The purpose of the limited partnership is to enable a person who has money to enter into a partnership with others, without being exposed to the unlimited liabilities of a general partner. If the business fails, the limited partner can lose no more than the capital invested in the Firm. Additional facts can be summarized as follows:
- The limited partner cannot be active in the management of the Firm;
- Usually the limited partner receives a specified share of the profits. The partnership interest of a limited partner may be reached (attached) by any of his or her creditors;
- Upon dissolution of the partnership, the limited partner’s share has priority over funds due the general partners, but is subordinate to claims of the Firm’s creditors;
- Upon death, the limited partner’s personal representative is entitled to the deceased’s portion of assets and deferred profits in order to settle the estate. Death of the limited partner does not dissolve the partnership. However, the death of a general partner can end the business unless the partnership agreement stipulates otherwise.
If a limited partnership develops too many characteristics of a corporation—even though it calls itself a partnership—it will be taxed as a corporation. Four major corporation characteristics are considered in determining whether or not a limited partnership will be classified by the IRS as a corporation for tax purposes. If the limited partnership has more than two of the following characteristics, it probably will be taxed as a corporation:
- Freely transferable ownership interests;
- Continuity of life;
- Participation of limited partners in management of the partnership;
- Limited liability of the limited partners for debts of the partnership.
There are many gray areas concerning what constitutes each of these four characteristics. Thus, the limited partnership agreement must be carefully drawn – and followed – to avoid corporate tax status.
Limited Liability Company
An important innovation in forms of business organizations is the limited liability company (LLC). All states now allow LLCs, and their numbers are mushrooming nationally into the hundreds of thousands. LLCs are very similar to limited liability partnerships (LLPs are partnerships in which all partners are sheltered from liability for partnership activities). A limited liability company combines some basic concepts of partnerships, C corporations, and S corporations. Owners of LLCs are called members. In many respects, a limited liability company is like an S corporation, but has some additional advantages, and fewer disadvantages.
Limited liability companies combine the personal liability protection of a corporation with the tax benefits and simplicity of a partnership. In other words, LLCs have the benefit of being taxed only once on their profits, and the owners of the LLC, or “members,” are not personally liable for the LLC’s debts and liabilities. In addition, LLCs are more flexible and require less on-going paperwork than an S corporation.
Here are some of the characteristics that make LLCs so popular:
- Unlimited Membership: Unlike S corporations, which have a limit of 100 owners, limited liability companies have no limit on the number of members. Members may be individuals or entities. Generally, start-up costs will exceed those of a simple partnership or corporation due to the more complex nature of the operating agreement.
- Foreign Members: Unlike S corporations, which prohibit non-resident aliens as owners, limited liability companies have no restrictions on foreign ownership.
- Classes of Ownership: Unlike S corporations, which allow only one class of ownership, limited liability companies allow different classes of ownership.
- Ownership Transfer: LLCs are attractive to family businesses that want to keep control in the family. How is this accomplished? Generally, ownership interests cannot be transferred without the consent of other members.
- Limited Liability: Unlike general partners who have unlimited liability for debts of the partnership, the financial liability of LLC members is limited in the same way that shareholders of C and S corporations are limited. That is, a member’s financial liability for debts of the business is limited to his or her contribution to the LLC. Unlike limited partners, LLC members can be active in the management of the business. A limited liability company is valuable for professionals because it protects the assets of each member against the negligence of the other members. There is no shelter from liability for an individual’s own actions.
- Taxed as Sole Proprietor, Partnership, or Corporation: For federal income tax purposes, LLCs may be treated as a sole proprietorship, partnership, or corporation. Tax regulations provide rules to determine how a business entity is classified for tax purposes. If a business has a preponderance of the characteristics of a regular (C) corporation, it will be treated for federal income tax purposes as a corporation. A business with only one owner can elect to be taxed as a sole proprietorship or as a corporation. Businesses with two or more owners can elect a partnership or corporate tax status. The tax filing status will determine other characteristics, benefits and disadvantages of the business entity as described throughout this chapter. Most of the discussion on LLCs in this section assumes the use of the corporate form of organization.
- Membership interests of LLCs can be assigned, and the economic benefits of those interests can be separated and assigned, providing the assignee with the economic benefits of distributions of profits/losses (like a partnership), without transferring the title to the membership interest.
As a general rule, corporations provide a “veil” of liability protection for owners that partnerships and sole proprietorships do not. Because a private company is a separate legal and taxable entity, some shareholders value the separation (tax and otherwise) from their personal affairs afforded by this structure. Also known as closed corporations and close corporations, closely held corporations constitute the vast majority of all corporations. They are seldom owned by more than a handful of people, each of whom is engaged actively in the day-to-day management of the business. The stock is not listed on the stock exchanges and rarely changes hands except at death, retirement, or a major realignment within the Firm.
There is a tendency to view corporations as formal business organizations – rigidly structured, managed, and administered. The fact is that many closely held corporations are not this way at all. Some corporations are little more than sole proprietor ships with “incorporated” added to the name. Although a sole proprietor might have become president by incorporating, nothing substantial has changed in the day-to-day operation of the business. He or she is the sole stockholder and therefore continues to make all of the decisions just as before.
The general characteristics of a corporation apply to both closely held and publicly traded corporations. However, the personal structure and the methods of operation of the typical closely held corporation bring about some important differences. Understanding these distinguishing characteristics will help you come to know the subtleties of a closely held corporation:
- Union of Ownership and Management: In closely held corporations, each stockholder usually has a three-fold role as a director, an officer, and an employee. The owners are the managers. Therefore, death of an owner means death of a key employee of the corporation;
- No Ready Market for the Stock: A characteristic of a public corporation is that its shares may be bought and sold on the stock exchanges. In closely held corporations, however, a few employees are the major stockholders. Ordinarily, the only persons interested in buying the shares of a deceased closely held stockholder are the surviving stockholders or possibly a competitor. The stock owned by the deceased stockholder’s family generally is worthless to them unless it is sold or unless they own enough of the stock that they can use their influence to hire themselves as paid employees. In and of itself, stock of a closely held corporation generally provides no income for the family. As will be discussed later, this is a key reason why having a buy-sell agreement is so important for all stockholders of closely held corporations. Here is where your “sale” will be made, and funding the buy-sell is where insurance enters the picture;
- Limited Liability – Theory Versus Reality: Many creditors will insist that loan notes be signed not only by the appropriate corporate officer of a closely held corporation, but also by the corporate owners personally. If the corporation cannot repay the loan, the owners are personally responsible to repay it. Thus, the legal limit of a shareholder’s liability is meaningless in such cases. Insurance to cover these personal notes is just as important to the stockholder’s family as is insurance on a homeowner’s life to cover the mortgage;
Dividends and Unreasonable Compensation: In virtually all closely held C corporations, the owners are also salaried employees of the corporation. In theory and in practice, they can set their own salaries at whatever levels they wish. If given free choice, it would be foolish for owners to pay themselves dividends instead of salaries because salaries are tax deductible by the corporation while dividends are not. Closely held corporations generally pay no dividends. Were it not for a provision of the law dealing with reasonableness of compensation, the owner-employees of a corporation could reduce or even eliminate corporate taxable income simply by paying themselves extremely large (and tax-deductible) salaries. The reasonable compensation provision allows the government, in effect, to force the corporation to treat a portion of the owner’s salary as a dividend.
S corporations get their name from that part of the Internal Revenue Code that gave them birth, namely, Subchapter S of Chapter 1 of the Internal Revenue Code. Although 1982 legislation officially designated them as “S corporations,” you might run into their older names of Subchapter S corporations, Sub S corporations, or simply Sub S. The form used by S corporations for reporting their income is Form 1120S (C corps use Form 1120).
Although S corporations have some of the important features of closely held corporations, they are taxed in part like partnerships and in part like corporations. Here’s how they resemble a partnership:
As with partnerships, there is generally no federal income tax levied on S corporations. Certain levels of capital gain and passive income such as interest are taxable if certain conditions exist;
As with partnerships, S corporations are pass-through forms of business. Owners of S corporations are taxed on their proportionate share of the earnings of the corporation. It doesn’t matter whether the earnings are actually distributed to the owners or remain with the corporation as undistributed earnings. Either way, the owners must report earnings personally. Expenses and losses are passed through directly to the shareholders.
The popularity of S corporations fluctuates with changes in income tax law and the tax status of individuals and their businesses. Corporate tax rates can sometimes exceed individual rates, and individual rates can exceed corporate rates at different income levels. Decisions to incorporate as a C or S corporation will often vary based on the relative income tax brackets of the individual owner(s) and the corporation. At certain income levels, business owners would rather have income taxed to a C corporation, rather than have it passed through to their individual taxes via an S corporation structure. For example, if there are good business tax deductions, such as in the start-up phase of the business, an S corporation can be a more favorable organization from a tax standpoint during the early loss years. An S election allows corporate losses to be deducted on the returns of individual shareholders. When the business becomes more profitable, the S election may be changed to a C corporation to have profits taxed to the Firm rather than the individual owner(s). Additionally, losses of an S corporation may be used to offset income earned outside the business if this is desirable from an income tax perspective.
S corporations resemble closely held corporations in the following ways:
- Both S corporations and closely held corporations have continuity of life. They can legally continue as going concerns despite death of a shareholder;
- Each shareholder’s liability is limited to the amount of his or her investment. This is true in both closely held corporations and S corporations;
- Legally, shares of ownership are readily transferable. In practice, however, since S corporations cannot have more than 100 shareholders, their shares lack marketability as do those in most other closely held corporations;
- Some states impose corporate taxes on S corporations just as if they were regular corporations.
S corporations differ from closely held corporations and partnerships in the following ways:
- Number of shareholders legally allowed in an S corporation is limited to 100 shareholders. In C corps the number is unlimited;
- Shareholders of S corporations may be any individuals except non-resident aliens. (This prohibition against nonresident aliens exists because non-resident aliens pay no income tax to the U.S. Government). In addition to individuals, estates and certain trusts also are eligible to be shareholders;
- Amounts contributed by the S corporation to qualified retirement plans are generally deductible. This is true regardless of whether or not the employee is a shareholder. Amounts paid by the corporation for other fringe benefits such as group term life insurance or disability income insurance are deductible by the corporation for coverage on all employees except those employees owning more than 2% of the corporation. In addition, such over 2% shareholder-employees must report these corporate payments as taxable income. This is not the case with C corporations.
Regular corporations are generally referred to as C corporations, taken from the Internal Revenue Code subchapter that establishes them. This terminology is useful, especially to distinguish S corporations from C corporations:
- To become an S corporation, all the shareholders of a corporation must vote in favor of it;
- Revoking the status of an S corporation requires consent of one or more shareholders owning 50 percent or more of the voting stock;
- The corporation must be domestic;
- There can be only a single class of stock;
- Certain events cause the S status of a corporation to be terminated. These disqualifying events include having more than 100 shareholders or having an ineligible shareholder.