Types Of Business Entities
I must start this review with a disclaimer: I am not an attorney, an Enrolled Agent, or a Certified Public Accountant. The review below of the types of business entities is not intended to give you legal or tax advice. It is based on my personal experience and knowledge gained from owning and operating several businesses over a period of 40 years.
Limited Liability Company (LLC):
The Limited Liability Company is a newer business entity. It is a separate, distinct, legal entity, as is a corporation. Wyoming enacted the first LLC legislation in 1977. Even though other states followed Wyoming’s lead and enacted their own LLC legislation, LLCs were not widely recognized and acknowledged until the IRS finally ruled on the LLC’s tax status in 1988. They are now one of the most popular of all the business entities. In many states, the number of newly formed LLCs exceeds the number of newly formed corporations each year.
LLCs do not enjoy the same prominence as corporations. The LLC is probably not a good choice for you if you intend to grow your business to the point of attracting co-owners.
Many uniformed people form LLCs in their home state. They may think this will save them money. However, if their home state has high annual LLC fees or state income taxes and their LLC does not “do business” in their home state, then they should consider forming their LLC in tax-free Nevada.
LLCs are not separate taxpaying entities like corporations. Profits and losses are passed through to the owners of the LLC and the owners are taxed on their personal income tax return. If the LLC has only one member, it can be taxed as a sole proprietor or as a partnership.
Nevada allows an LLC to be formed with only one member. Completing the Articles of Organization and paying the Filing Fee is all that is necessary to set up an LLC in the State of Nevada.
Usually an Operating Agreement is drawn up like in a partnership. It should state the duties and obligations of the members, how the LLC will be managed and how the profits are to be divided, and how members’ interests may be sold.
One of the biggest things that set LLCs apart from corporations is that they do not have perpetual existence. You have to put a dissolution date in your Articles of Organization, the most common being 30 years.
LLCs do not require the same record keeping as corporations. There is flexibility in dividing the assets of the business, as well as how the profits are divided, if the LLC is dissolved.
There are two specialized LLCs that are available in Nevada: series and restricted.
Series Limited Liability Company:
In overall structure, a series limited liability company is comparable to a corporation with several subsidiaries. A series LLC has been described as a master LLC that has separate divisions.
Many people form LLCs in order to protect their personal assets from a lawsuit relating to their real estate holdings or business operations. Forming and maintaining a separate LLC to hold each real property or business operation may help to gain additional liability protection. By forming a separate LLC to own and hold each separate property or business organization, only the assets owned by that specific LLC would be subject to a judgment against that LLC. However, there are costs associated with forming and maintaining each separate LLC.
Another option may be to form a series LLC. Although each division of a series LLC can own separate assets, incur separate liabilities, and have different managers and members, a series LLC pays only one filing fee and files one income tax return each year, as long as each series member is also a founding member of the LLC. When non-founding members are added to a newly created division within the series LLC, that new division should file a separate partnership tax return for that division.
Furthermore, liability incurred by one division does not endanger assets titled in other subsidiary divisions of the same series LLC.
The procedure for adding and deleting divisions (know as series) is not straightforward. Additional series can be added by simply amending the series’ “Limited Liability Company Agreement” (equivalent to an Operating Agreement for other LLCs).
Restricted Limited Liability Company:
The restricted liability company is a special entity that is allowed Nevada law. Nevada is the first and only state to allow this type of entity. This entity takes advantage of Treas. Reg. §25.2704-2(b) which states that a restriction which is less restrictive than those that would apply under state law will be disregarded in valuing the interest for transfer tax purposes under IRC §2704(b). A restricted LLC is not the type of entity you want to set up yourself, so I am not going to discuss it in detail here. If this is something you are interested in, please discuss it with your CPA and your attorney.
A “c” corporation is a separate legal business entity, and its legal obligations and its tax status is separate from its owners. The corporation has perpetual existence.
The corporate creditors cannot attach the shareholder’s non-business assets.
Articles of Incorporation are filed with the Nevada Secretary of State. The corporation is governed by a set of by-laws, and a minimum of two annual meetings must be held each year: a shareholders meeting and a board of directors meeting. These are usually done on the same day a few minutes apart. The record keeping requirements are minimal but must be maintained to insure the corporation continues to hold its limitation of liability status.
Shareholders elect a board of directors to manage the business for them. In Nevada, a corporation needs only one shareholder and one director; this can be the same person.
A corporation is taxed as a separate person. The shareholders receive the profits of the corporation after the corporation has paid the federal taxes. For a small corporation, it is possible to minimize or eliminate these taxes by paying the owners a salary, which is a legitimate business expense and is tax deductible. The corporation pays taxes on its profits and the shareholders pay taxes on the dividends (if any) they receive. The corporate tax rate is lower than the highest personal income tax rate. If the corporation has a net loss, its shareholders are not able to claim this loss on their personal tax returns.
Another advantage of a corporation includes the option to transfer or sell shares. A corporation continues to exist even when one of the shareholders dies. There are many other benefits available to corporations that may not be available to other business entities. For a company that plans to have more than 30 stockholders or to trade publicly, a corporation is an excellent business entity to consider.
The “s” corporation is a regular c corporation that meets certain requirements under Subchapter S of the Internal Revenue Code. The corporation has a special tax designation that allows the income and expenses of the corporation to be ignored at the corporate level so that the shareholders pay taxes on the net income earned and claim all losses of the corporation on their personal income tax returns. As with a “c” corporation, for the small corporation it is possible to minimize or eliminate these taxes by paying the owners a salary.
The rules that govern “s” corporations make them unavailable or unappealing in a lot of situations. There can be no more than 75 shareholders and they all must be U.S. citizens. All the shareholders must agree with the decision to adopt the Subchapter “S” election. Banks, thrifts or insurance companies cannot elect Subchapter “S” status. All “s” corporations must have a fiscal year that ends on December 31 of each year. As with a “c” corporation, the record keeping requirements are minimal but must be maintained to insure the corporation keeps its limitation of liability status.
The primary difference in taxation rules between “s” corporations and partnerships (LLCs) is this: That in “s” corporations, income and deductions are allocated based on ownership interest alone.
Partnerships and LLCs have flexibility in how such items are allocated, as long as it is not done for tax avoidance purposes.
For example, you and I could have a partnership or an LLC where we each contribute 50% of the capital. However, we agree to allocate income 80% / 20% because you work full time for the business and I only part time.
Another big difference is that if an “s” corporation owner takes payment for his services as wages, he must follow payroll rules. If a partner takes payment for his services, he does so as a draw or as guaranteed payments, thus avoiding the payroll reporting requirements.
Charging Order Protection:
If a personal lawsuit is filed against a member of an LLC, the judgment can only be satisfied by a charging order — placing a lien on their percentage of distribution from the LLC. The courts cannot force an LLC to liquidate their assets in order to satisfy a judgment. They can only put a lien against any distributions you will be taking from that company.
When they put a Charging order against your LLC, they are responsible for the taxes on those earnings even if you do not have any distributions. Most attorneys will not obtain a charging order because of this liability.
In 2007, Nevada extended charging order protection to small corporations. If the corporation has more than one, but less than seventy-five, shareholders, is not a subsidiary of a publicly traded corporation, and is not a professional corporation, then a charging order is the only remedy available to a shareholder’s creditor.
This is a corporation that has tax-exempt status.
This is a corporation for doctors, dentists, attorneys, engineers, and other professionals that require a special license.
The sole proprietorship is the most simple business form since it is limited to one person’s business activities. When the sole proprietor dies, the business will no longer exist, and the assets will go to their heirs. The advantages of setting up a sole proprietorship are the cost, ease, and simplicity of record keeping.
The disadvantages, however, are tremendous. All of the sole proprietor’s business assets and all of their personal assets are at risk. Creditors can go after the owner’s business assets, personal assets, home, savings, etc. If it belongs to the owner, a creditor can go after it!
According to civil law, a partnership is a contract between two or more persons who agree to engage in a business. They contribute to the partnership by combining their knowledge, property, and effort and can agree to share in the partnership’s profits. Even though only a verbal agreement or handshake is needed to create a general partnership, a formal partnership agreement should always be created. In most instances, these agreements should be filed and accessible for public inspection. All partners share income and losses in a general partnership.
The main disadvantage is that the general partnership has a severe liability to persons injured by the partnership. All partners are jointly liable for the debts and the judgments of the partnership. If one of the partners commits to a business endeavor in the name of the company, each and every partner could be held personally liable for that business endeavor’s obligations and liabilities, resulting in a huge, personal financial exposure.
To form a limited partnership, a Certificate of Limited Partnership is filed with the Nevada Secretary of State. However, one or more partners contribute to the business enterprise. They do not participate in management of the business. The limited partners are silent partners and are liable only to the extent of the investment they made. Their position is similar to that of the shareholder in a large publicly traded corporation. They have no day-to-day responsibilities running the limited partnership. They only receive income, capital gains, and tax benefits.
The general partner collects fees and a percentage of the capital gains and income. The general partner is the only one exposed for the partnership debts and judgments. If the business assets were not sufficient to satisfy the creditors, the general partner could lose his or her personal assets as well. The safest way to form a limited partnership is to make a corporation the general partner, and that corporation will do nothing other than manage the limited partnership. This way corporation will not create any situation in which they could be held liable and be sued.
Restricted Limited Partnership:
This is another special entity that is allowed Nevada law. Nevada is the first and only state to allow this type of entity. This entity also takes advantage of Treas. Reg. §25.2704-2(b), which states that a restriction that is less restrictive than those that would apply under state law will be disregarded in valuing the interest for transfer tax purposes under IRC §2704(b). A restricted limited partnership is not the type of entity you want to set up yourself so I am not going to discuss it in detail here. If it is something you are interested in, please discuss this with your CPA and attorney.