Evolution of Your Business Entity

Knowing the right questions...

Many factors must be considered when choosing the best form of business ownership and structure because the choices you make impact future taxes, liability, and ownership succession. In making the decision on what entity type to use, you will want to take the following into account:

• Your vision regarding the size and nature of your business.
• The level of control you wish to have.
• The level of structure you are willing to deal with.
• The business' vulnerability to lawsuits.
• Tax implications of the different ownership structures.
• Expected profit (or loss) of the business.
• Whether or not you need to reinvest earnings into the business.
• Your need for access to cash out of the business for yourself.

Evolution of a business...

To explore the classic cycle of a business, from "rags to riches" so to speak, we just follow the business entity from simple to more complex. The simplest business entity is the Sole Proprietorship, which is simply "hanging out your shingle for business". A single individual is responsible for the business' operations, its liabilities, and for all intents and purposes, the individual and the business are one entity. In fact, all of the revenue and expenses are filed as part of the individual's tax return (Schedule C: Profit or Loss from Business). Except for occupational licenses, no further registration is required in almost every locale (See http://www.business.gov/register/licenses-and-permits/ for further information on this).

ADVANTAGES:simple

DISADVANTAGES:unlimited liability, most benefits not deductible, single owner

Once the business outgrows a single person's span of control, that's when creating a separate entity becomes necessary - and "span of control" includes operations, investment capital, and ownership. So when it is time to bring in a partner to share control or the operations, finances, and ownership, that is when a Partnership is the logical progression of business type. Now there is just an extension of the Sole Proprietorship such that the business operations and all of its expenses just are put on the owners' tax return (in Schedule C), but that provides very little benefits. To make the Partnership effective, a partnership agreement needs to be drawn up which defines all the partners' duties, ownership positions, voting rights, how to bring in new partners, how to cut a partner out, who manages the partnership (the General Partner or "GP"), how the "GP" is elected, what the "GP" does, etc. Basically, the General Partner is the head officer of this business entity and provides direction for the operations; the General Partner has the most liability of all the partners because the "GP" is directing operations. Forms of the partnership business entity include:

• Partnership
• General Partnership ("GP")
• Limited Partnership ("LP")
• Limited Liability Partnership ("LLP")
• Professional Corporations ("P.C.")
• Master Limited Partnership ("MLP")
• Joint Venture

Partnerships are very effective for two specific purposes - owning assets (like office buildings) or because of the ability to pass through tax effects to the individual partners while still having a shield of sorts for liabilities (except for the General Partner which bears most of the liability risk) and for owning service based business entities wherein the lure is to stay with the service entity until you "make partner". Legal, engineering, and management consulting firms most likely will be "P.C.". For tax purposes, the partnership entity files a tax return (U.S. IRS Form 1065) which does not pay any tax, and then each partner receives a form which flows all the revenue and expenses down to their tax return (U.S. IRS Form 1065 K-1). Many times, when the partners die or change, the Partnership all ends.

ADVANTAGES:easy to establish, no double taxation, in some forms unequal distribution allowed

DISADVANTAGES:partnership agreements can be very complex, disagreements happen often

And then there was the corporation...

Once a business comes to the point when you as the owner, founder, and "chief cook and bottle washer" believe that the business will continue for a long period of time, that you may want to share ownership in varying pieces with individuals that you may know or not, and that the risk of you personally owning all of the assets and being liable is too great, that is when you should incorporate and form a Corporation. When a business is incorporated, it acts as if it is a separate individual under the law as it can sue or be sued, is taxed as a separate entity, and can own other assets. Most importantly, it provides the best level of limitation of risks for its owners, now called shareholders. Other attributes of corporations include:

• Shareholders own shares (common or otherwise) of the Corporation
• Shareholders elect the Board of Directors to oversee the operations of the business
• The Board of Directors hire Officers / management to conduct operations, set policies for Officers, and manage the risks of the Shareholders
• Officers manage the day to day operations of the company and can be held liable for deviation from policies set by the Board of Directors
• Corporations authorize a number of Common shares, each representing a proportional share of ownership and voting privilege; some Corporations define other classes of shares, some of which are called "Preferred shares" that have varying levels of ownership, voting rights, rights to assets, and liquidation rights.
• Corporations file their own tax form, U.S. IRS Form 1120.
• Corporations pay taxes on their own income (unless filing Subchapter S designation) and then can distribute excess earnings as Dividends, which are in turn taxed at the shareholder level.

Incorporating adds a lot of administrative functions that must be completed in a timely fashion each year to retain the liability shielding benefits of the Corporation; these activities include filing tax returns annually, filing franchise tax returns annually (state corporate income taxes), filing employment tax reports sometimes weekly, renew any local business licenses annually, file sales (local, county, and state) tax reports monthly, and other governmental reporting requirements. Doing all this to keep this shielding in place still requirements that management separates the Corporate entity's business from the shareholders' and management's business activities.

ADVANTAGES:limits shareholder liability, easier to raise funds, and deducts all costs

DISADVANTAGES:more reporting and reporting costs, higher overall taxes

An interesting hybrid, The LLC

Recently most states have introduced the Limited Liability Company ("LLC") form, which is a hybrid business entity having certain characteristics of both a Corporation and a Partnership or Sole proprietorship (depending on how many owners there are). The LLC is an unincorporated association with limited liability like a corporation, pass through taxation like a partnership, as well as some interesting characteristics, such as:

• LLC principals are most properly described as "members", but other terms can be used depending upon the bylaws or operating agreement.
• Single member LLC's can be disregarded for tax purposes and the owner can include the LLC's income on their personal return.
• An LLC may elect to be taxed as a sole proprietor, partnership, S corporation or C corporation, based upon the U.S. IRS form selected.
• Other variations include the Professional Limited Liability Company (PLLC or PL) as well as the Series LLC.

Today, the LLC is pervasively used for new business endeavors as it is so versatile and simple to administer. Having said that, for a more traditional company with many shareholders and extensive operations, the Corporation still provides the best entity; the LLC "veil" protection from liability is more easily pierced than a Corporation's.

ADVANTAGES:Simple to administer, flexible tax treatment

DISADVANTAGES:Liability protection is easier to pierce, selling ownership is more difficult

Wrapping it up...

Once a new business endeavor has been charted out and its business statement is complete, choosing a business entity type is a fine art. We recommend staying with a Sole Proprietorship until such time as the business brings on more employees or extensive operations. Continuing growth, we recommend the Limited Liability Company ("LLC") as the next step in your business' path due to its flexibility. When it is time bring in a large number of new investors, then it's time to re-incorporate as a Corporation.