Legal Entities | Choosing Between Different Forms of Business
There are a number of reasons why a business should form a legal entity, including tax benefits, limiting personal liability, receiving investment, and business succession. Because there are a number of legal entities to choose from, businesses must evaluate several factors before determining which form of business they will choose.
For an overview of the key considerations when choosing between various legal entities, see Want To Start A Business? Entity Choice is One of the First Steps.
Limited Liability Companies (LLC) as Legal Entities
Because of its extreme flexibility, ease of use and favorable tax characteristics, the LLC has become the most popular legal entity for small to medium businesses (and in a lot of cases, even large businesses). With a few exceptions, most startup businesses or small businesses should begin using an LLC as an entity type.
For more information on some of the general characteristics and benefits of choosing an LLC as a legal entity for your business, read The Limited Liability Company – An Overview.
Partnerships as the Legal Entities of Choice for Business
Generally, there are two types of partnerships: General Partnerships and Limited Partnerships.
General partnerships are contractual arrangements that are not filed with the state and consist of one or more partners that share all of the liabilities and obligations of the general partnership. There are few instances where a general partnership (also sometimes referred to as joint ventures) make sense as a structure and I would strongly advise consulting with a transactional attorney before entering into a general partnership.
A limited partnership, on the other hand, is filed with a secretary of state in its state of formation and includes one or more general partners and one or more limited partners. Limited partnerships are prevalent in both the real estate and oil and gas industries and are good vehicles for certain business operations; however, in order to operate them correctly, the complexities of the limited partnership need to be understood and observed.
For a broader discussion of Limited Partnerships, read An Overview of Limited Partnerships.
Corporations as Legal Entities
The two types of corporations are C-Corporation and S-Corporations. Each, under state law, are simply corporations.
S-Corporations file an election with the Internal Revenue Service to be treated differently for tax purposes – which election triggers other unique characteristics/requirements. An S-Corporation elects to be treated by the IRS as a “pass-through” entity for tax purposes, which means it does not pay an entity level tax. Instead, the S-Corporation’s profits and losses generally pass-through to its stockholders who include their respective share of those items on their individual income tax returns. Based on making this election, S-Corporations have some limitations not applicable to C-Corporations.
C-Corporations pay what is called an “entity level tax,” meaning the entity itself is taxed on its operations. Any leftover funds can then be paid as a dividend to stockholders. The dividends paid by stockholders are then taxed again by the IRS, creating what is referred to as “double taxation” – two layers of tax imposed on the profits of a C-Corporation.
For a broader discussion of C-Corporation and S-Corporations, read An Overview of Corporations.
Drafting Ownership Agreements for Legal Entities
When you select your choice from the various types of legal entities, a next step in the formation process involves the negotiation and drafting of agreements between the owners. Depending on the type of legal entity, this may be a partnership agreement (for a partnership), a company agreement (for an LLC), or a shareholder agreement (for corporations).
Businesses often make a tragic mistake when they fail to formally document an agreement upon key terms at the outset of the business formation. If business owners wait until a dispute arises, it is often too late to adequately remedy disputes in a fair or expected manner to all business owners involved.
For a broader discussion of ownership agreements, see Is Your Ownership Agreement Leaving You in the Lurch? Drafting Ownership Agreements Properly.
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