Table of Contents
Background on Business Entities
Ancient societies punished with slavery those who lost money for investors in business ventures. Eventually the law allowed for limited liability companies which permitted investors to back a venture and risk a fixed amount of money. This helped fuel the industrial revolution. Even the pilgrims made use of a limited liability company to raise funds to travel to America. Under early English law, the charter of limited liability companies were obtained from the King or Parliament. In the American colonies, often it was obtained from the state legislative branch as a privilege. Now obtaining a corporate charter is a routine clerical matter.
There are now several types of entities which are commonly used by businesses. The choice of entity depends on your objectives and the tax and legal aspects of the entity. All entities except Proprietorship and Partnership require a filing and fee paid to a state. The federal government does not create entities for private businesses (except a few rare exceptions). If you fail to continue to pay the fee and update filings, the entity will be dissolved.
A proprietorship is the name given for one-owner businesses that are not using another business entity form. A proprietorship is required to obtain city, county, and/or state licenses. It pays taxes on its income which is attributed to the proprietor (owner of the business). The IRS usually requires proprietors to schedule income and expenses on Schedule C of their individual 1040 forms.
A partnership is two or more people in business together. A partnership can be implied in law so it is often a legally risky form of business entity. It is usually better to form an entity to define the business relationship. A partnership is required to obtain city, county, and/or state licenses. It pays taxes on its income which is attributed to the partners according to the terms of their written or oral partnership agreement. The IRS has tax forms for partnerships (Form 1065). Individual partners receive K-1 forms declaring their share of the income which is reported on 1040 Schedule E.
A limited partnership is a partnership consisting of one or more general partners and one or more limited partners. The limited partners and general partners may be entities (e.g. corporations). The general partners run the business and have general liability. The limited partners are only liable to the extent of their promised capital contribution. If limited partners are active in the business, they assume general liability. The limited partnership was popular before the federal tax code amendments in 1986. Its function has for most purposes been taken over by the limited liability company. The IRS has tax forms for partnerships (Form 1065). Individual partners receive K-1 forms declaring their share of the income which is reported on 1040 Schedule E.
The corporation is considered to be a separate legal person under the law. It is run by a board of directors who appoint officers to run the day to day business affairs. It is owed by shareholders. Shareholders are either common or preferred. Preferred shareholders usually have more rights than common shareholders. Preferred shareholder rights are specified by the corporate charter and director’s resolution. It is the most common entity used by public companies. Standard corporations are often referred to a “C corporations,” a reference to Section C of the Internal Revenue Code where their tax treatment is defined. The IRS has tax forms for corporations (Form 1120). Individual shareholders receive K-1 forms declaring their share of dividend income (if any) which is reported on 1040 Schedule E. This results in a “double tax.” The income is taxed at the corporate level and then on the individual level. Except for the rare federal charter, all corporations exist under the authority of state law and federal law generally defers to the state statute to determine the power and rights of corporations.
A Subchapter S Corporation is exactly the same entity as a corporation or a “C” corporation. The entity is defined by state law. The “S” and “C” designations are for federal tax law purposes only. The “S” designation comes from the name of the subchapter of the Internal Revenue Code which defines its tax treatment. An S corporation was the first entity designed to help small business avoid the double tax C corporations must pay (at the corporate level and then at the shareholder level if dividends are paid). Because it has been in existence for over 50 years, the rules and regulations enacted by Congress and the IRS are complex.
The S corporation election taxes the shareholders for the profits of the corporation even if no dividends are paid. Losses are passed on to the shareholder but can only be deducted to the extent of the amount paid for the stock (called “basis”). Generally S corporations are complicated and have hidden risks. Limited liability companies are a better choice for most small businesses. The IRS has tax forms for S corporations (Form 1120S). Individual shareholders receive K-1 forms declaring their share of all income which is reported on 1040 Schedule E. If the S corporation had income, the shareholders must pay tax even if they received no distribution from the corporations. This is called “phantom income.”
Limited Liability Company
The best form of business entity is usually the limited liability company. It is taxed like a partnership (no double taxation – see above), is very flexible, and has legal advantages that are not available to corporations (e.g. no “piercing of the corporate veil”). A good transactional lawyer is required to set up LLCs properly if there is more than one owner. The operating agreement needs to cover all possibilities (e.g. death, retirement, divorce, and conflict). The LLC has the disadvantage that it is generally not as well-known as corporations and some investors are suspicious of LLCs.
If there is only one owner, or if the spouse is active (500 hours per year), the entity can be disregarded for federal tax purposes and the income and expenses scheduled on 1040 Schedule C (like a proprietorship).
A benefit corporation allows business owners to pursue and consider social and environmental goals in their for-profit ventures. B-Corps allow directors and officers to prioritize people and the environment, by considering and making decisions based on environmental and social concerns, along with the traditional objective of maximizing shareholder profits. B-corps allow businesses to prioritize social values and provide accountability and transparency to shareholders and the public. The procedure for incorporating a B-corp is the same as a traditional corporation, and the B-corp may list its specific public benefit in its Articles of Incorporation (please note – a benefit corporation is a for-profit entity and is distinguished from a non-profit “public benefit corporation.”).
Business trusts are a fairly rare form of business entity which exists under some state laws. For most purposes it is taxed and treated like a C corporation. It has some advantages because the rules and regulations governing business trusts are minimal.