I often get questions asking about entity selection when someone is considering incorporating. Here is a summary of some general ownership structure issues.
What do all these entities do?
This introduction will make it easier for you to come up with questions that will help you select the best alternative for your specific situation. There are almost always other issues that will come up if someone makes a three-year plan, for example. These issues could include financing, compensation, control (which doesn’t have to be the same as management or splitting profits), and long-term capital gains. Some other sticky issues involve getting someone out of the company, voluntarily or involuntarily, as well as a process for cashing out their interest. That question is partly answered by the corporate form you choose, but it can be modified by a separate agreement.
Partnerships
1. Partnerships fall into three general categories: general, limited, and limited liability partnerships. The third, the LLP, is usually reserved for professional firms such as law, accounting, or medical practice firms. It’s probably not relevant for most people. General partnerships are structures in which each partner is personally liable for all the debts of the partnership. That’s often not a good idea if the partners want to keep their house, etc. Limited partnerships, which protect the limited partners from personal liability, aren’t as good an option as they may seem in most cases because a general partner is still required. To prevent personal liability in this situation, an entity is usually the general partner. For most typical businesses, if you’re going to form an entity so you can use an LP, there’s little need to complicate the structure when the entity can simply own/run the business in the first place. The one advantage of a general partnership is that it requires no formalities to set up or administer except for an additional filing at tax time.
Verdict:
Not a great choice; last alternative unless there are special circumstances such as investment partnerships where the management is making investment decisions with the investor funds. Examples: real estate, venture capital, or hedge funds.
Corporation
2. The next choice to consider is a corporation. In part to achieve the substantially valuable goal of insulating shareholders from corporate liabilities, corporations require a fair amount of corporate formalities, including regular board and shareholder meetings, separate bank accounts, formal salaries, and separate tax returns. While the corporation can elect Subchapter S treatment, so that its income flows to the shareholders directly and is taxed on their returns, like a partnership, whether the added formalities are worth the effort depends on the size and structure of the business’s ownership. When outside investors are involved, a corporation becomes a better choice.
Also: depending on the size of the business, there may be tax advantages to the traditional corporation tax structure (which means regular corporate tax reporting). If the shareholders/managers want to load up on benefits, e.g., health care and retirement plans, through the business, it needs to be explicitly discussed with the accountants as well to confirm the specific requirements. However, even if they decide that corporate taxation is preferable, it is often possible to achieve the same results through an LLC.
Verdict:
Best choice when outside investors are involved. The difference between this outside money and that of an investment partnership is that investors in a corporation expect their money to be used by the corporation to pursue its business plan, not to make investments in other companies.
Limited Liability Companies
3. LLCs, or limited liability companies, are a hybrid form of corporate structure that combines the best aspects of partnerships and corporations with few of their disadvantages. It provides corporate-type insulation from personal liability for owners with the opportunity for pass-through taxation. Each owner of an LLC is called a member and if the formalities are observed (namely, LLC meetings, separation of business and personal funds, and sufficient capitalization or insurance to meet normal/expected liabilities), the members will not be personally liable for debts of the business. In terms of taxes, an LLC can choose to be taxed as a partnership or as a corporation. This provides a great deal of flexibility, especially if the members’ needs change over the course of the business.
Verdict:
Flexible entity that is expanding to cover most small businesses that used to be partnerships or sole proprietorships.
Finally, you should note that regardless of what corporate form you choose, if bank financing is required, for example, there is almost no way that a bank will lend money without personal guarantees and collateral. So, even though picking a different corporate form might protect against many of the debts of the company, perhaps the most substantial liabilities, at least in the beginning, are likely to remain with the principal individuals involved.
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