The past two weeks I have introduced the basic structures for forming a business- sole proprietorships, partnerships, corporations and limited liability corporations. Here I will summarize the key differences to consider when choosing a business structure.

Limited Liability

The biggest concern most people have when starting a business is how they can limit their personal liability from business related issues. For example, a workplace accident may result in a lawsuit against the business. A person’s personal assets could be at risk if the business was not using a structure that legally limits liability to the business assets. There is no such limitation on liability for a sole proprietor, a general partnership or the general partner of a limited partnership. Liability is limited to the investment contributed to the business for limited partnerships’ limited partners, LLC, S corporations and C corporations.

Taxation

Another major issue is the tax treatment of profits and losses- will it be retained by the business or ‘pass through’ to the owner. If profits are retained by the business they may be subject to double taxation upon distribution to the owners as was explained in the post of corporations. A ‘pass through’ tax structure allows profits and losses to be reported directed on the owners personal taxes. There is no ‘pass through’ of profits and losses for LLC (election possible), LLP (election possible), or C corporations. There is pass-through treatment for sole proprietorship, general partnership, limited partnership. LLC and S corporations.

Management

Sometimes it is important to have a division of management and investors. Often this relates to taxation issues because an investor may be taxed differently depending on whether they have a managerial role. There is a division between management and investors for LP, LLC, S corporations and C corporations.

Lifespan

A business entity may continue to exist even after an investor dies or terminates their investment. A sole proprietorship and general partnership, however, will cease to exist on the death of the sole proprietor or general partner. A business can exist for perpetuity if it is a limited partnership, LLC, S corporation or C corporation.

Stock Issuance

The issuance of stock is the primary way business attract investors, but not every business structure can issue stock. In fact, only the S corporation and C corporation can issue stock. This is a key advantage for a business needing to attract outside investors.

Size Limit

Some business structures are limited in size- either by minimums or maximums. A S corporation is limited to 75 shareholders, a sole proprietorship can only be one person, a general partnership must be two or more partners, and in some states a LLC must have at least two members.

Limited Liability Company

In 1994 New York created a new type of corporation called the Limited Liability Company (‘LLC’). The Limited Liability Company is like a new hybrid created by combining the best of the corporate structure and the partnership structure. Limited Liability Company laws do vary significantly in certain states. This discussion will focus on New York. The New York law is much more comprehensive than most other states. The New York Department of State has a good page on LLCs (here) and is among the resource links at the end of this post.

A LLC is formed by 1- preparing the articles of organization, 2- properly executing such articles and 3- properly filing such articles. (NY LLCL 203) The LLC filing and notice requirements are similar to a LP. A LLC is required to have a written operating agreement. The operating agreement is akin to a shareholder agreement and by-laws combined. If any issue is not covered by the operating agreement it will be governed by NY LLCL. New York claims it is a LLC friendly state and helpful information, including model forms on its website www.dos.ny.us.

The Limited Liability Company has certain advantages to partnerships or corporations. All members of a LLC are protected from full personal liability. At the same time the LLC can be treated as a taw conduit just like a partnership for tax purposes. There are no minimum requirements for number of shareholders or members (unlike s-corporations) Members may also fully engage in management activities without jeopardizing their limited liability. All members have a right to manage the Limited Liability Company unless the articles of organization provide for management by a manager. Unless there is a manager every member is an agent of the LLC.

This combination of limited liability and being a tax conduit makes the Limited Liability Company very appealing with very few disadvantages. One big disadvantage is that if it does business in a state with different LLC laws or in countries without LLC laws it will probably not be treated as a LLC. LLC laws do vary significantly between states and many countries do not recognize a LLC. Also, the expenses to create a LLC are significantly higher and more complicated.

Prior to 1997, for a LLC to be tax as a partnership the LLC had to prove it did not have corporate characteristics. This created a lot of uncertainty. However, starting in 1997 the IRS adopted a ‘check box rule’ for non-publicly traded LLC businesses with two or more members. The rule treats LLCs as partnership for tax purposes by default unless the Limited Liability Company elects to be taxed as corporation. New York has adopted the same system. (Treas Reg 301.7701-3(a) and NY Tax Law 658) If there is only one member of the Limited Liability Company it is not treated as a separate tax entity.

Fees: The fee schedule is at NY LLCL 1101 although some fees are listed elsewhere, primarily Executive Law 96. New York requires an annual fee of $50 per member with a minimum fee of $325. This fee changes often! There is also a 4% Unincorporated business tax on any New York sourced income and possible rent tax.

Conclusion:

A LLC offers many of the advantages of the corporation, providing limited liability for the owners while offering the tax advantages of a partnership without the restrictions of the limited partnership where there must be at least one general partner who has full unlimited liability. The limited liability company also provides advantages that are preferable to an s-corporation, as the LLC is not subject to the restrictions relating to the number and type of shareholders in an S-corporation.

LLC still retains advantages over s-corporations. LLC has no limitations on its organization as do s-corporations. For example, s-corporations have limits on who can be a shareholder and how many shareholders exist. S-corporations have one class of stock resulting in all distributions being made pro-rata. A LLC may have different classes of members with different allocations for income and loss and be based on something other than capital contributions. LLC members can include certain LLC debt in the tax basis of their LLC membership interest. This results in less amount of distributions being considered taxable gains and allow larger amounts of losses to be used for deductions.

———————–

Resources:

New York Office of the Attorney General memo on corporations and limited liability companies

IRS Publication 542 IRS Corporation

IRS Publication 541 IRS Partnerships

New York State Publication 16 New York Tax Status of Limited Liability Companies and Limited Liability Partnerships

New York State Publication 20 New York State Tax Guide for New Businesses

New York State Publication 35 New York Tax Treatment of S Corporations and Shareholders

IRS S Corporation Requirements and forms

New York State Taxation S Corporation Rules and Forms

Corporations

The corporation is the most common legal structure for doing business in the United States. This is because it creates a completely independent legal person. Recently, this issue has been in the news because it has been pushed into the debate regarding a corporations right to make campaign donations. (Update: this issue continues to be debated.) Liability is detached from individuals investing and managing the business. This provides a great incentive for people to invest in corporations. There is also great flexibility in setting up management and control. Corporations are sometimes called c-corporations because they fall under IRS Chapter C. The corporation does require more compliance work, but the benefits are usually worth the effort. The requirements should be done diligently, even for small corporations, to maintain the benefits of a corporation. If the formalities are not met you may find that you are personally liable. A corporation can continue to exist even if the owners change or some of them die. (NY BCL Section 202(a)) Management is controlled by the board of directors who are elected by the shareholders. (NY BCL 701 and 703) New York does not, unlike many other states, have a minimum capital requirement. However, capital levels are an important factor if the existence of a corporation is questioned. This is referred to as a ‘piercing the veil’ and will be the focus of a future article. Finally, the creation of an S-corporation can address certain tax disadvantages of a corporation.
Read the rest of this entry »

Limited Partnership

A limited partnership is a partnership of two or more persons where one or more are designated general partners and others are designated limited partners. The agreement must be written. General partners have unlimited liability and control of the partnership management. Limited partners are only liable to the extent of their capital contribution and have no management power. This is much more flexible than the general partnership because it protects the limited partner. However, the limited partner must be willing to contribute capital without having managerial powers. The limited partner could lose its protection if in actuality it partakes in management of the partnership business.

In New York, the Revised Limited Partnership Act “RLPA” (New York Partnership Law 121-101 – 121-1300) made the limited partnership an easier structure to form and manage. The RLPA, for example, has safe harbor designations for certain acts a limited partner make take and maintain its limited partnership status. Previously you often had to take your best guess based on prior case-law. All filings are made with the Department of State rather that the county clerk. There are still filing fees of course which change (upwards, of course). (New York Partnership Law 121-1300)
Read the rest of this entry »

General Partnerships: “we’re in this together, right?”

A partnership is an association of two or more persons to carry on as co-owners a business for profit. (New York Partnership Law Section 10, IRS definition) A corporation, as a legal person, may act as a partner. (New York Bus Law 202(a)(15) ) A general partnership can be formed without any formal procedures but the partners to agree to work together. This agreement can be oral or written. However, like everything in the law, it is much better to have a written agreement. If there is a dispute regarding whether a partnership existed the presence of a written agreement would be an important factor. The partners do not have to contribute the same amount of even the same kind of contribution to the partnership. For example, one partner could contribute cash whereas anther partner contributes services. The New York Partnership law requires a general partnership to file a certificate in every county where business is conducted. (General Business Law 130) On the other hand, agreements to work together, even if profits are shared, do not necessarily create a partnership. (New York Partnership Law Section 11)
Read the rest of this entry »