Business Entities – A Quick Guide

Business entities comes in so many types that business owners can easily get confused. Here’s a quick guide that will hopefully shed a little light on business entities for you.

Business Entities

“C” Corporation: A corporation whose shares are held by shareholders. The entity stands apart from the shareholders for legal and tax purposes. The shares of the corporation may be “taken public” and traded on stock markets. Google is an example of a publicly traded “C” corporation.

Foreign Corporation: A corporation doing business in a jurisdiction beyond where it was formed. Microsoft is a Washington corporation. When it does business in New York, it is considered a “foreign corporation.”

General Partnership: A business effort involving two or more people, known as partners. Each partner is liable for all partnership debts and obligations regardless participation and contribution amounts. Put another way, a general partnership provides no protection against lawsuits.

Holding Company: Part of a double incorporation strategy. The sole purpose of a holding company is to own or control other companies. Said other companies typically are exposed to significant liability threats. For instance, many insurance companies use holding companies to suck off profits and limit lawsuit risks.

Joint Venture: A cooperative business effort between two or more parties. It is usually limited to a single business purpose and involves a sharing of responsibilities and revenues. For instance, a database programmer and web site designer might enter a joint venture to provide e-commerce solutions to businesses.

“LLC” – Limited Liability Company: A creation of state law in which one or more individuals form an entity providing the liability protection of a corporation, but the tax benefits of a partnership.

Limited Partnership: A partnership in which the business is managed by a general partner with limited partners supplying capital investment. The limited partners are prohibited from actively participating in the management of the partnership. In exchange, the limited partners liability is limited to the amount of their investment. In pursuing this business entity, the general partner is almost always a corporation.

Partnership by Estoppel: A partnership created by operation of law when two or more people pursue a business goal and hold themselves out to the public as such. This business entity is prevalent as it is the automatic designation for two people doing business who fail to take any steps to designate a business entity. In this entity, each partner is completely exposed to liability risks.

“S” Corporation: Similar to a “C” corporation, this entity provides solid asset protection for shareholders from business liabilities and debts. The primary difference is the entity can be taxed as a pass through entity and is limited to 75 shareholders.

Sole Proprietorship: A business owned and controlled by one person. The designation provides no protection from business liabilities. It is taxed on the person’s personal tax returns on schedule “C”.

Each of the above entities provides certain advantages to a business owner. If you consider the particulars of your efforts, you should be able to get an idea of which one is best for you.

Business Entity Mistakes – Criminal Conduct and Independence

In this age of information, most small business owners understand they need the protection provided by a corporation or limited liability company. Such protection, however, can be lost though certain actions.

Criminal Action

Creating a business entity only protects a business and shareholders from civil liability. Civil liability arises from a body of state and federal law that allows for compensation for alleged wrongs. These wrongs can arise in the form of negligence, contractual breach and so on. If an entity is found civilly liable, it must pay compensation, but no jail time is involved.

Neither a corporation, limited liability company nor any other entity will protect anyone from criminal liability. Claims to the contrary published on various web sites are simply wrong. A person forming a corporation to front for a ponzi scheme or scam to defraud consumers is going to receive no protection from criminal prosecution. If you have any doubts on this issue, simply consider the recent criminal convictions of the Tyco and Enron executives.

Standing Apart

Both corporations and limited liability companies are considered to “stand apart” from their investors for legal purposes. In essence, both entities are considered to be “persons” under the law. This legal fiction is, of course, what gives rise to the asset protection element of both entities. Unfortunately, many small businesses don’t understand this distinction and lose the asset protection when the most need it.

To maintain the asset protection benefits of a business entity, you must treat it as an independent party. For instance, you do not “own” a corporation. Such statements can come back to haunt you when a plaintiff’s attorney presents them in court while arguing the entity is a sham. To avoid this problem, you can simply say you are the President of the business entity or whatever position you hold.

In Closing

Forming a business entity is a necessary step for most small businesses. Once the entity is formed, make sure you follow the necessary formal procedures to maintain asset protection.

Tax Benefits to Choosing the Right Business Entity For Your New Or Old Home Based Business Part 2

Once you have a business you can identify with chosen you will need to consider what type of business entity do you want to be?

Choosing the business entity type that will work best for you can be mind boggling but let me try to simplify your decision.

You may choose from a Sole proprietorship, Limited Liability Co. known as an LLC, a corporation or a partnership. Some have advantages and disadvantages for liability protection as well as tax related advantageous and disadvantages.

Sole proprietorship – A sole proprietorship is designed only for one person. Married couples can elect to be taxed like a sole proprietorship; each spouse must file their own IRS schedule C as well as their own schedule SE for reporting Social Security and Medicare. By filing this way you both get credit for Social Security and Medicare taxes. The two of you must be the only owners and you both must actively participate in the business.

A sole proprietorship gives the least amount of protection from a liability stand point. There is no separation between the business and you. You and the business are viewed as one in the same, so the businesses liabilities are yours. If you should pass away, the business would cease to exist.

As for taxes your income is added in on your 1040 with the use of a schedule C. Your losses are also carried to the 1040 from the schedule C thus allowing your losses to carry over against any W2 income you may have. This is considered a pass through entity, because your income and losses are being passed through to your 1040. Most business deductions are allowed for sole proprietorship’s. Most home based businesses choose to be sole proprietorships.

There is no cost to become a sole proprietorship, no documents to file. You should check with your city or village to obtain a business license for working from your home. The cost is typically nominal around $15.00 TO $25.00 or so, but it is the correct way to start a business and again it shows you are in business to be in business, vs. being viewed as a hobby.

When opening a bank account, if you re not using your own name for the name of your business most will request you file an assumed name certificate with the county. The cost is around five to ten dollars. They then require that you run an ad in a local paper for two to three weeks announcing your new business and name. Then the bank will open your business checking account for you with your assumed business name. This is a very simple procedure that makes your business legitimate.

Limited Liability Company – A limited liability company, LLC is very similar to a sole proprietorship because its owners all jointly own the business and participate in the profits and losses together. The LLC does offer the owners some protection for the liabilities of the company vs. their own. You must file form with the state in order to create an LLC. Limited Liability companies are treated like a sole proprietorship for tax purposes. With a single owner, profits and losses are shown on a schedule C just like the sole proprietorship. If more than one owner, the LLC, is then viewed as a partnership. The LLC must use the IRS 1065 Partnership Form for taxes. The LLC must also utilize the IRS Schedule K1, Partners Share of Income, Credits, Deductions, etc. showing its member’s allocations of profits, losses credits and deductions. A copy is given to each member for calculating income or loss to be reported on their schedule E, Supplemental Income and Loss, along with their 1040 personal tax return. The schedule E flows through to the 1040, thus making a limited liability company a pass through entity as well.

Because you have filed a document with the state you can use them when opening a bank account in the businesses name.

A Limited Liability Company may elect to be taxed as a corporation by filing IRS Form 8832, or if you have two or more members and do not file the above form 8832 the LLC will be treated as a partnership. If only one owner you will be treated as a sole proprietorship when filing taxes you will use a schedule C.

You will also need to file for a city or village business license.

Corporations – A corporation can be classified as a C-Corp or as an S-Corp. Most small to mid sized businesses choose to be an S-Corp. due to tax reasons. Many S-Corps have only one owner. An S-Corp is also a pass through tax entity, because the income is passed through to your 1040’s. An S-Corp pays no taxes as an entity itself, all is passed through to its owners. An S-Corp can have up to 99 owners before it must become a C-Corp. The S-Corp taxes are reported on an IRS Form 1120S.

A C-Corporation is a state-chartered business that is owned by stock holders. No stock holder is personally liable for the debts of the corporation. Legal control of the C-Corp resides with the stock holders. The stock holders may or may not be responsible for day-to-day operations of the business; they delegate a board of directors and officers of the company. Corporations must file corporate tax returns to report the corporation’s income or losses. Income to officers is typically W2 income that must be shown on the IRS 1040 tax return of each officer. Because the C-corporation must pay income taxes on its corporate profits, and income paid to its owners is also taxed, it is considered to have a double tax. The C-Corp’s taxes must be reported on an IRS Form 1120.

Therefore most small-mid sized businesses choose not to be classified as a C-Corp. However, when first incorporating all business incorporate as a C-Corp and an election must be made in a timely manner to be taxed and viewed by the IRS as an S-Corp.

To become a corporation you must file incorporation papers with the state. Most will file in the state they live in. Some believe it is wise to incorporate in such states as Delaware. The issue with incorporating out of state is that you will need to file two tax returns, one with each state. I believe the benefit of other state incorporation’s is to hide or mask the true owners of the corporation. Again most businesses choose to incorporate in the state they choose to do business in.

A corporation gives protection to its owners in the fact they are separate. The corporation is a legal entity all on its own. The corporations can own real estate, property, a corporation can open bank accounts with the corporate identity, and corporations can also borrower money. The owners are typically protected from law suits and liabilities by the corporate veil.

The cost for incorporating is priced by each state. Most often a business will hire an attorney or another professional to prepare and file the corporate documents. Some tax professionals offer this service. You will also need to choose a registered agent for the company. A registered agent is the person who gets all documents pertaining to the corporation. A registered agent maybe a business owner, attorney or tax professional. You will also need to keep a record of annual meetings. A corporate seal is typically not necessary but an added cost if one chooses to use one.

A Partnership – there are two kinds of partnerships. The two most common are a general and limited liability partnership. A General Partnerships can be formed by an oral agreement between two people or more, but a legal partnership agreement is highly recommended for either partnership.

In a General Partnership each partner is liable for the debt of the entire business and responsible for the actions of the other partner. A general partnership is dissolved immediately upon the death of any of the partner’s involved – although the personal liability to partnership creditors exists even after the dissolution of the partnership.

A Limited Liability Partnership, also know as an LLP, each partner is liable only for the amount he or she invested in the partnership. In the case of a limited partner’s death, the partnership would remain intact. Each partner pays individual taxes on their proportionate share of net partnership income.

A partnership must file an IRS 1065 Form for the partnership. An IRS Schedule K1, Partners Share of Income, Credits, Deductions, etc. must be filed for each partner and attached to the 1065 IRS Form. A copy is given to each partner for calculating income or loss to be reported on their schedule E, Supplemental Income and Loss, along with their 1040 personal tax return. The schedule E flows through to the 1040, thus making a partnership a pass through entity as well.