CORPORATIONS, LIMITED LIABILITY, AND OTHER BUSINESS ENTITIES
Types of Organizations
Choosing which type of entity to use is among the most important decisions a business can make. Ultimately, a businessperson must analyze the level of legal protection and flexibility needed, as well as tax concerns.
Proprietorships and partnerships, both general and limited, are the most basic forms of entities and offer the least amount of protection from liabilities. Corporations offer more protection against liability, but are expensive and can be more complicated to operate. S-corporations are a specialized version of the corporation with unique advantages and drawbacks. Limited liability companies have become increasingly popular as a replacement for partnerships and S-corporations due to their flexible nature from both a tax and management standpoint.
C-Corporations. A corporation is created by filing articles of incorporation with the Secretary of State which set identify the purpose of the corporation, the amount of authorized stock to be issued, and other basic information about the corporation. Stock is issued to shareholders to signify their interests in the company. A major advantage for corporations lies in the fact that, assuming corporate formalities are followed, shareholders are not liable for the debts of the corporation.
One disadvantage of corporations stems from their tax treatment. Income from business operations is first subject to taxation at the corporate level. Dividends distributed to individual shareholders are not deductible by the corporation, but constitute income subject to tax in the hands of the shareholders. Thus, income is taxed twice – once when the corporation makes money and again when shareholders receive that money.
S-Corporations. A subchapter s-corporation has many of the same characteristics as a C-corporation. It is a regular corporation for state law purposes so all corporate formalities must be followed. The primary difference involves taxation. S-corporations were in part created to permit smaller enterprises to use the corporate vehicle without the C-corporation’s onus of double taxation. There are no dollar limits on the size of an S-corporation, and some are quite sizable. For all practical purposes, an S-corporation does not pay federal income tax. Instead, corporate profits (or losses) are divided among and “passed through” to its stockholders, who must then report the income and expenses on their individual income tax returns. In this way, both the income and expense benefits of an S-corporation are treated much like a partnership with each shareholder receiving his eligible share.
To be entitled to make the S-election the corporation cannot: (1) have more than 75 shareholders; (2) have anyone other than an individual, an estate or certain trusts, or certain tax-exempt entities (including pension plans) as shareholders; (3) have a non-resident alien as a shareholder; (4) have more than one class of stock (differences in voting rights are permitted); (5) be a financial institution; or (6) or be an insurance company.
Limited Liability Companies. The limited liability company (“LLC”) is a hybrid entity that has the corporate attribute of limited liability for all owners, but is often classified as a partnership for federal tax purposes. All states, including Kansas, have adopted LLC legislation and it is becoming increasingly popular as the preferred entity for most new businesses. As is the case with corporate shareholders, members are normally not liable for the obligations of the LLC, except to the extent they personally guarantee the debts. There is presumably no more risk of member liability for LLC obligations than there is for corporate shareholder liability. The LLC also has an important advantage over a limited partnership in that all members of an LLC may enjoy limited liability and still participate in the management of the entity. Perhaps the most important benefit of an LLC is that it has the tax advantages of a partnership, while commonly offering the relative simplicity of an S-corporation.
Sole Proprietorships. A sole proprietorship has a single owner and is not a separate business entity. The proprietor need not follow legal formalities such as a written agreement defining the responsibilities of others. Necessary licenses are filed in his or her name and a separate tax identification number is suggested but not required. The proprietor may take all proceeds of the business when he or she wants – the business account may be treated as a personal checking account – so long as payroll and tax reporting obligations are met. In short, every responsibility is upon the proprietor and all profits inure to his or her benefit. As may be expected, less formality equals less protection. The proprietor is personally liable for all reports and all debts of the enterprise. This liability extends to amounts arising from any injury caused as a result of the business operation. Because of these concerns, a proprietorship is not ordinarily recommended.
General Partnerships. The partnership is formed by two or more parties entering into a partnership agreement. In a general partnership, all the partners are joint and severally liable for the obligations of the partnership. This means one partner can be liable for all partnership debt with only the right to contribution from other partners. A partner has the power to do any act within the usual course of the partnership’s business. While this right can be limited among the partners by contract, the contractual limitation is not binding on unadvised third parties. A partner acting within the scope of his apparent authority can enter into an agreement that binds the partnership and exposes the other partners to liability, although he was not actually authorized to enter into the agreement. While a right of contribution may exist among the partners, other partners could be insolvent, leaving the remaining partners disproportionately liable for partnership obligations. For this reason, businesspeople generally avoid general partnerships in favor of a limited partnership or LLC.
Another disadvantage of general partnerships is that a partner’s interest is generally not transferable without the consent of the other partners. This limitation on liquidity is often a significant impediment to the use of general partnerships. Moreover, the disassociation of a general partner – by withdrawal, death or bankruptcy – causes dissolution of the partnership. Dissolution may be avoided by unanimous consent of the remaining partners, but in a two-person partnership, the withdrawal of one partner terminates the partnership for state law and federal income tax purposes.
Partnerships are not subject to income taxation. Although the partnership is required to file a partnership return, the partnership itself is not taxed. Rather, income and losses flow through and are taxed to or deducted by the partner, normally retaining the character they had to the partnership. Thus, partnership debt can be used to ease personal tax burdens. A partner’s share of partnership debt is considered a contribution of money to the partnership, thereby increasing the partner’s basis therein. Conversely, if a partner’s share of debt is decreased then the decrease is treated as a distribution of money to the partner, thereby decreasing the partner’s basis.
With the advent of limited partnerships and limited liability companies that limit the personal liability of a partner or member, it is difficult to imagine a circumstance where it would make sense to use a general partnership. Thus, despite the potential advantages, general partnerships are generally disfavored.
Limited Partnerships. A limited partnership is a partnership where one or more general partners operate the business while one or more limited partners have an investment interest in the partnership. Although they can accommodate other business types, limited partner statutes are often adopted with lawyers, accountants, doctors and other professionals in mind. A limited partnership is still a partnership and thus has all of tax advantages of a general partnership, with the added benefit of limited liability. For example, only general partners are liable for partnership obligations. Limited partners, like shareholders in a corporation or members of an LLC, are not liable for the debts of the partnership unless they specifically agree otherwise.
Generally, the limited partners have little right to control the operations of the partnership. Control is centered in the general partner or partners. Limited partners cannot act as agents (and therefore enter into binding contracts on behalf) of a limited partnership. A withdrawal, bankruptcy or other event of disassociation of a limited partner, unlike that of a general partner, cannot cause dissolution of a limited partnership. Additionally, in Kansas and most other states limited partnership interests are freely transferable without causing dissolution of the partnership. Any restrictions on transferability must be specifically provided for in the partnership agreement.
With the exception of reduced liability exposure, the disadvantages of limited liability partnerships are the same as those of a general partnership. This includes the ability of any general partner acting within his apparent authority to bind the partnership to agreements with third parties that have no knowledge of any limitation on that authority. Also, greater care must be exercised with limited partnerships than with many other entities. The liability shield of the limited partnership will be lost for limited partners who participate in the partnership’s management. A limited partner who in his capacity as a limited partner becomes involved in the management of the limited partnership can lose the limited partner status and be treated as a general partner with full liability exposure.
Conclusion. There is no single answer to choice of entity questions. Although most operating businesses lend themselves well to a corporate structure with officers holding certain inherent authority, the use of S-corporations and partnerships are on the decline. When compared to LLCs, S-corporations have few advantages and several distinct disadvantages. LLCs have replaced S-corporations as the presumptive entities of choice, particularly for more passive activities such as owning real estate or other investment interests. The combination of potential simplicity and the benefits of partnership taxation often will be hard to beat. However, the LLC form solves the partnership liability issue but is by no means the default. Choosing the correct business entity depends on the specific business. Needless to say, this is the most important decision a new business can make.
THESE MATERIALS WERE PREPARED BY EVANS & MULLINIX, P.A., 7225 RENNER ROAD, SUITE 200, SHAWNEE, KANSAS 66217 (913) 962-8700. THESE MATERIALS WERE PREPARED SOLELY FOR THE GENERAL INFORMATION AND REFERENCE OF OUR CLIENTS AND FRIENDS. BUSINESS AND TAX LAWS ARE COMPLEX AND SUBJECT TO CHANGE. THIS OUTLINE SETS FORTH ONLY GENERAL RULES THAT MAY NOT BE APPLICABLE IN SPECIFIC SITUATIONS. ACCORDINGLY, AN ATTORNEY SHOULD BE CONSULTED TO INSURE THAT THE DESIRED RESULTS ARE OBTAINED.