By David Beliveau
People usually establish business entities to protect their personal assets from the risks of operating a business. There are several types of business entities available, and each has its own set of pros and cons.
The types of business entities include sole proprietorship, partnership, Limited Liability Company (LLC), Limited Liability Partnership (LLP), Internal Revenue Code (IRC) subchapter C corporation, and IRC subchapter S corporation. The choice of business entity has both nontax and tax implications.
If someone hangs a shingle and conducts business in the absence of a formal business entity, he or she is deemed a sole proprietorship. If more than one person does so, they are deemed a partnership. Both sole proprietorships and partnerships do not offer any asset protection, so if the owner or owners get sued, business and personal assets are at risk. Both sole proprietorships and partnerships are conduits, for federal income tax purposes and are not subject to a separate income tax.
When a person or group establishes a Limited Liability Company (LLC) to conduct business, the owner or owners are known as members and are not required to be US citizens. An LLC may be member managed or manager managed. In the latter form of management, the manager does not have to be a member. Single member and multimember LLCs are meant to provide members with asset protection. However, as a result of case law (In re: Ashley Albright, 291 B.R. 538 (Bkr. D Colo. 2003); Olmstead v. FTC, SC01-109 (Fla. June 24, 2010)), it appears single member LLCs may no longer provide such protection.
Members of an LLC can choose how to divide business income and expenses among them, but all of the profit of an LLC is subject to self employment taxes, which include Social Security and Medicare taxes. Both single member and multimember LLCs are conduits for Federal income tax purposes and are not subject to a separate income tax.
A Limited Liability Partnership (LLP) is a business entity frequently established by professional service providers, such as attorneys, for asset protection. The liability of an LLP is meant to be limited to the business entity and the partner who commits a tort, not the other partners.
Forming a corporation also protects the assets of the owners, who are known as shareholders and who vote for directors of the corporation. The directors, who are not required to be shareholders, should meet at least annually to discuss the business operations and to elect officers of the corporation, such as a president, treasurer, and secretary/clerk, who are responsible for the daily business operations. The officers do not have to be shareholders or directors.
A corporation may be either an IRC subchapter C corporation or an IRC subchapter S corporation for Federal income tax purposes. The default is a C corporation, which is taxed twice – once at the business entity level and again at the shareholder level. An S corporation is a conduit for Federal income tax purposes. Consequently, there is no tax at the business entity level. Instead, the only tax is at the shareholder level. S corporations are subject to certain requirements, including the number and type of shareholders. For example, unlike an LLC, a non-US citizen cannot be an owner of the business entity.
Corporations also cannot make special allocations between owners/shareholders, as LLC members can. Instead, the income and expenses of a corporation have to be divided among the shareholders based on their respective ownership interests of the business entity. Not all of the profit of a corporation is subject to self employment taxes.
The choice of business entity may be determined by nontax or tax considerations, or both. A sole proprietor may become concerned about asset protection in connection with his or her business operation and decide to establish a formal business entity. The business owner may want to keep the respective tax compliance as simple as possible and decide to establish an LLC. Alternatively, the business owner may be concerned about having to pay more self employment taxes by operating as an LLC instead of as an S corporation and decide to establish an S corporation instead.