How Should I Organize My Business?

One of the first questions any individual wanting to start up a business considers is what kind of entity is most beneficial for those involved. This question should not only be asked when starting a business, but throughout the life of the business so that no opportunities are missed. Three of the basic options are limited partnerships, C corporations, and S corporations. Each business - whether just starting out, or going into their 30th year of business - should periodically evaluate the advantages and disadvantages to maximize their potential.

Limited Partnership (LP)

In a Limited Partnership, one or more “general" partners manage the business while "limited" partners contribute capital and share in the profits but take no part in running the business. General partners remain personally liable for partnership debts while limited partners incur no liability with respect to partnership obligations beyond their capital contributions. The purpose of this form of business is to encourage investors to invest without risking more than the capital they have contributed. Death, disability, or withdrawal of a general partner dissolves the partnership unless the partnership agreement provides otherwise or all partners agree, in writing, to substitute a general partner. Note, death or incompetence of a Limited Partner has no effect on the partnership

Advantages of an LP include:

•  Limited liability for most investors. One, or possibly more, general partner(s) is required and there is no limit on limited investors (unlike S Corps). As a result, there can be a limitless number of limited partners whose liability is limited to their investment and unpaid capital contributions.

•  Centralized management . The general partner(s) makes day to day management decisions, rather than all partners.

•  Flow-through tax advantages. The entity itself does not pay taxes on the entity's income. Instead each partner shares the tax liability as it is passed through to each partner's individual tax return. This may be important in an organization's early years, when losses are common and may be passed through to use against the partners' other income.

•  Continuation of entity . An LP will dissolve upon death of a general partner but not of a limited partner.

•  Assignment of rights. Limited partners have a right to assign their interest in distributions in their partnership.

Disadvantages of an LP include:

•  Liability of the general partner(s). Due to the nature of the entity, the “general partner(s)” is liable for all debts of the entity. An LP may have one or more general partners. If there is only one, this partner bears the sole liability for the LP.

•  Difficult to transfer ownership. LP's require unanimous consent of all partners (both general and limited) in order to transfer ownership.

C Corporation

Corporations are a legally separate entity with a management style as follows. Shareholders are the owners of a corporation, who elect a Board of Directors, which then elects the officers. Other than the election of directors, shareholders do not typically participate in the operations of the corporation. The Board of Directors is responsible for the management of and exercising the rights and responsibilities of a corporation. The Board sets corporate policy and the strategy for the corporation. The Board elects officers, usually a CEO, vice president, treasurer and secretary, to follow the policies set by the Board and manage the corporation on a day-to-day basis. In a small corporation, the lines between the shareholders, Board of Directors, and officers tend to blur because the same people may be serving in all capacities.  

Advantages of a C Corp include:

•  Limited Liability. One of the key reasons for forming a corporation is the limited liability protection provided to its owners. Because a corporation is considered a separate legal entity, the entity itself is held liable while the shareholders have limited liability for the corporation's debts. The personal assets of shareholders are not at risk for satisfying corporate debts or liabilities.

•  Continuity of life. Since the corporation is a separate legal entity, its existence is not affected by death or incapacity of its shareholders, officers, or directors. The corporation will continue to exist until the shareholders decide to dissolve it or merge with another business.

•  Transferability . Shares of corporations are generally freely transferable because as a separate entity, the existence of a corporation is not dependent upon who the owners or investors are at any one time. Shares of corporations are freely transferable unless shareholders have "buy-sell" agreements limiting when and to whom shares may be sold or transferred. Securities laws may also restrict the transferability of shares.

•  Lower tax rate. Since the corporation is a separate legal entity, it pays taxes separate and apart from its owners. The Corporate tax rate is generally lower than the personal tax rate, which is advantageous to persons who want to delay the realization of income.

•  Capital Incentive . The stock structure also allows corporations to attract key and talented employees by offering an ownership interest in the form of stock options or stock.

•  Fringe Benefits . Corporations may often offer their employees unique fringe benefits. For example, owner-employees may often deduct health insurance premiums paid by the corporation from corporate income. In addition, Corporate-defined benefit plans often afford better retirement options and benefits than those offered by non-corporate plans.

•  Easier to raise capital. It can be much easier for a corporation to raise capital than it is for a partnership or sole proprietorship, because the corporation has stocks to sell. Investors can be lured with the prospect of dividends if the corporation makes a profit, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital  

Disadvantages of a C Corporation:

•  Double Taxation. While the tax rate is lower at the corporate level than the personal tax rate, the income is taxed twice under a corporate structure. The corporation must first pay income taxes on any profits that it makes. When the corporation makes distributions to stockholders, the distributions are treated as taxable income to the stockholders even though the corporation has already paid taxes on its profits.

•  Fees. It costs money to incorporate. There are typically four types of fees, including: a fee to file the articles of incorporation with the secretary of state; a first year franchise tax prepayment; fees for various governmental filings; and attorney fees.

•  Paperwork and formalities. The proper corporate formalities of organizing and running a corporation must be followed in order to receive the benefits of being a corporation. A huge aspect of the corporate formalities that must be followed consists of paperwork. Reports and tax returns must be compiled and filed in a timely fashion; business bank accounts and records must be maintained and kept separate from personal accounts and assets; records must be kept of corporate actions, including meetings of shareholders and Board of Directors; and licenses must be maintained. Where corporate formalities are not observed, shareholders may be held personally liable for corporate debts.

S Corporations .

An S Corporation begins its existence as a general, for-profit corporation upon filing the Articles of Incorporation at the state level. However, after the corporation has been formed, it may elect "S Corporation Status" by submitting IRS form 2553 to the Internal Revenue Service (in some cases a state filing is required as well). Once this filing is complete, the corporation, while retaining the same structure and limited liability protection as a regular corporation, is taxed like a partnership or sole proprietorship rather than as a separate entity. As a result, an S Corporation has many similar advantages and disadvantages as a regular C Corp.

Advantages 

•  C corporation characteristics mentioned above including limited liability, continuity of live, transferability, capital incentives, fringe benefits, and the ease of raising capital.

•  No Double Taxation. Since S Corporations are not treated as a separate entity, profits and loses flow through the entity to the owners rather than the S corporation being taxed itself. This can be extremely beneficial if losses are expected as the S Corporations losses can offset the owners' current incomes. Shareholders of S Corporations are able to deduct losses in proportion with and to the extent of their investment in the business.

Disadvantages:

•  Regulations/requirements. Numerous regulations and requirements must be upheld by an S Corporation. Stock can be held by no more than 75 persons, shareholders must be individuals, there can only be one class of stock, foreign shareholders are generally prohibited, and no more than 25% of the corporation's gross income can be derived from passive investment activities. For purposes of the 75 shareholder limit, a husband and wife count as one shareholder.

•  Formalities and Fees. S Corporations are subject to many of the same requirements as C Corporations. Such items include but are not limited to filing articles of incorporation, holding directors and shareholders meetings, keeping corporate minutes, and allowing shareholders to vote on major corporate decisions. These requirements result in higher legal and service costs as well as costs to set up the S corp.

•  IRS Scrutiny. The IRS keeps a sharp eye on shareholder-employees, who must receive reasonable compensation (subject to employment taxes) before any non-wage distributions may be made to that shareholder-employee .

•  Limited deductions. Unlike C corporations, shareholders owning more than two percent of an S corporation only receive a partial deduction on health insurance purchased for them by the corporation.

•  Higher tax rates . As the top tax rates are higher for individuals than corporations, S corporation shareholders may pay more income tax than C corporation shareholders who leave “nonexcessive” amounts in their corporation.

There is no quick answer for which entity is right for your business. The advantages and disadvantages must be weighed on a periodic basis evaluating which advantages are most important and which disadvantages must be avoided. By doing this, you are one step closer to being the entity that is right for you and your business.