What Legal Entity to Form for Your Business?

May 17, 2016|Business formation
Rodriques Law

One of the key decisions you will have to make at the early stages of starting your new company is whether to operate your business as a sole proprietor or structure it as a limited partnership, limited liability company or corporation.

Sole Proprietorship

A sole proprietor is someone who owns an unincorporated business by himself or herself. Sole proprietors do not enjoy the benefit of the legal distinction between the individual and the business and are personally liable for all of the debts and other obligations of the business.

Limited Partnership

A limited partnership is an association of two or more persons who carry on as co-owners of a business for profit. A limited partnership must have at least one limited partner and one general partner. The general partners are personally liable for all of the debts and obligations of the business but the limited partners typically are not. Limited partners may not participate in the management of the business or they will lose their limited liability status.

A limited partnership is formed by executing a partnership agreement and filing a Certificate of Limited Partnership with the Department of State. New York requires the partners of a limited partnership to adopt a partnership agreement.

Corporation

A corporation is a legal entity which grants limited liability to its owners (shareholders). Therefore, the shareholders of a corporation generally are not personally liable for the debts and obligations of the business.  In a corporation, the shareholders vote on certain significant matters, and they directly or indirectly elect management (directors and officers), which is then responsible for the operation of the business. A corporation can either be a C corporation or an S corporation.

A corporation is formed by filing a certificate of incorporation with the Department of State and preparing bylaws.

S corporations can issue only one class of the company stock, and are limited to a maximum of 100 individual shareholders, who must be U.S. residents.

Limited Liability Company

A limited liability company is an unincorporated organization of one or more members, each having limited liability for the contractual and other liabilities of the company. The owners of an LLC are referred to as “members.” LLCs can be managed by the members, like a general partnership, or by one or more managers, like a limited partnership. The managers of an LLC may or may not be members. The members are required to adopt an operating agreement, which sets forth, among other things, the rights and obligations of the members and how the company will be operated.

An LLC is formed by filing articles of organization with the Department of State and preparing an operating agreement.

LLCs offer a number of advantages over S corporations. LLCs can offer several different classes of membership with different rights; and an unlimited number of individuals, corporations, and partnerships may participate in an LLC.

LLCs (and limited partnerships) generally operate with far fewer formalities and enjoy greater flexibility in their business operations and management, than corporations. For example, an LLC does not have to have a board of directors, adhere very carefully to certain reporting requirements or generally subject to the same arduous rules, disclosures and expensive accounting as a corporation. Furthermore, unlike corporations, LLCs (and partnerships) have flexibility in how business profits are allocated.

Costs of Formation and Maintenance

LLCs and partnerships are much easier to operate and maintain than corporations. However, formation of LLCs and partnerships in New York involve greater up-front, out-of-pocket organizational costs than many other legal entities. This is substantially due to New York’s publishing requirement. Formation costs may also include attorney fees for an operating agreement for your LLC or a partnership agreement for your limited partnership.

Other costs include IRS form fees as well as fees for obtaining applicable licenses or permits to operate your business.

Tax Consequences

C corporations are subject to double taxation, that is, the corporation pays federal income tax on its profits, the shareholders pay income tax on any dividends they receive, and there is double taxation of capital gains upon dissolution. On the other hand, S corporations and LLCs combine many of the advantages of a C corporation, such as limited liability, with the flexibility of a partnership, such as “pass-through” taxation. A partnership is not subject to income tax. The partners are individually liable for their shares of the business’ income.

S corporations, for federal income tax purposes, are treated as a corporation for New York tax purposes. Thus, S corporations formed in New York are subject to a New York State corporation franchise tax. However, if it is anticipated that your startup will experience net operating losses initially, making an S election can be desirable.

In New York, an S corporation is allowed to own a qualified subchapter S subsidiary (“QSSS”). A QSSS is any domestic corporation that qualified as an S corporation and is 100 percent owned by an S corporation parent that elects to treat it as a QSSS. The parent corporation of a QSSS can also be a C corporation. The QSSS is not taxed as a separate corporation, and all its tax items are treated as belonging to the parent. In addition, QSSS is not subject to the New York corporate net income tax.

Buying and selling LLC and partnership interests raise complicated tax issues. In contrast, buying and selling corporate stock is fairly simple. One reason the sale of LLC interests is so complicated is that a member’s basis in an LLC interest changes frequently, for example, because of allocations of LLC profits and losses to the members, distribution of LLC cash and other assets to members, and admission of new members.  

Therefore, before you start your new company, you should ask an attorney who understand the tax rules to help you with some tax planning and restructuring, in order to see what alternatives might work better for you.

State of Formation

Once you decide what entity you plan to form you should give some thought as to which State the proposed entity will be formed. If your business is to be conducted primarily within, say, New York, there is rarely any significant reason to incorporate in another state, particularly since a foreign company must qualify to do business in New York, and thus pay fees (and taxes to two jurisdictions in the case of a foreign corporation).

Since the most frequent reason for choosing one entity-type over another for forming a startup or emerging company and the ultimate decision as to its State of formation is frequently motivated by the perceived tax benefits, you or your business attorney should consult a tax specialist or accountant for advice prior to the formation of the entity.

Conclusion

While these types of business entities are similar in some respects, there are significant differences regarding formation requirements, start-up costs, operational formalities and tax consequences. Therefore, if your plan is to grow and eventually sell all or part of your business, you would be wise to seek counsel before you begin your startup.