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Prior to forming an entity in the United States, you should consult with a professional on the various forms of entities available to you.
FORMS OF ENTITIES
There are various forms of organizations to consider if you want to start a company or effectively hold title to your assets. Each organizational form has a set of unique characteristics and features. Therefore, choosing the right type of entity to conduct your business involves many considerations. In selecting an entity, you should compare the advantages and disadvantages of each type of organization while considering the pros and cons important to you. This discussion will compare the sole proprietorship, partnership, corporation, limited liability company, and the international business company. The advantages and disadvantages identified below are not inclusive, yet more notable than others.
The sole proprietorship is the simplest form of conducting business. An individual can form a proprietorship with minimal cost and documentation. A sole proprietorship, however, may be required to obtain a business license in the states in which it conducts business. Important considerations of a sole proprietorship include the following:
The owner of a sole proprietorship is personally liable for all business liabilities and debts. If the owner gets sued, all his personal assets as well as his business assets are at risk.
Some of the tax considerations of a sole proprietorship are summarized below:
- The sole proprietorship pays no taxes.
The income/losses flow through to the individual’s personal tax return.
- Net income is subject to self-employment tax.
- All income and expenses are reported on schedule C of the IRS form 1040.
The IRS scrutinizes the items reported on schedule C.
Proprietorships are not able to take advantage of several tax benefits available to corporations. These benefits include various retirement plans, medical reimbursement plans, and other business reimbursable expenses.
Transferability of Ownership/Continuity of Existence
The owner of a sole proprietorship cannot transfer the ownership of the business entity. The business entity terminates upon the death or retirement of the owner.
The personal assets as well as the assets of the sole proprietorship are not protected from creditors.
A general partnership is formed by two or more parties. Partners may be corporations, individuals, or other entities. A general partnership can be formed by an oral agreement, a handshake, or by a formal partnership agreement. Partners, however, should always have a written partnership agreement which outlines the rights, responsibilities, and ownership interest of each of the partners. Important considerations of a general partnership include the following:
All partners of a general partnership are personally liable for the debts incurred by each partner on behalf of the business. The individual partners are liable for such debts even if they did not approve of the debt or liability. In a general partnership, all of the partners could lose their houses, cars, and any other real or personal property as a result of a partner making a poor business decision.
Some of the tax characteristics of a general partnership are as follows:
The partnership pays no income taxes as the income/losses flow through to each partner on their individual tax return. In contrast, the shareholders of a corporation are subjected to double taxation. A corporation pays taxes at the corporate level and when the distributions are made to the shareholders, income taxes are paid by the shareholders.
A general partnership is not able to take advantage of many of the tax benefits available to corporations. These benefits include various retirement plans, medical reimbursement plans, and other business reimbursable expenses. In addition, the active partners are subject to a self-employment tax.
Transferability of Ownership
In a general partnership, the partners cannot transfer their interest in the partnership without the consent of all the partners.
Continuity of Existence
If a partner obtains approval to transfer his interest in the partnership, the legal status of the partnership would be affected upon the transfer. The existing partnership would be dissolved and a new partnership would have to be established.
All of the partners in a general partnership may participate in the management of the partnership.
A partner’s personal assets are at risk if the business debts of the partnership are not settled. Business creditors may pursue the personal assets of all or some of the partners or any partner whether or not that partner incurred the debt on behalf of the partnership. In other words, all partners are at risk for business debts of the partnership.
A partner’s personal interest in a partnership and the partnership’s assets are not subject to attachment by a partner’s personal creditor. However, a personal creditor has the right to execute or levy a partner’s equity interest in the partnership. If granted, the creditor is then entitled to the profits or cash flows distributed to the partner.
A limited partnership is similar to a general partnership. Unlike a general partnership, a limited partnership has two classes of partners; limited partners and general partners. Each type of partner has different rights. Below are some of the differences:
The general partners and limited partners of a limited partnership assume different levels of liability. The limited partners have limited liability as the liability of a limited partner cannot exceed the amount invested in the limited partnership. A limited partner, however, may lose its limited liability protection if he/she becomes involved in management decisions. The general partners have personal liability to the limited partners and personal liability for lawsuits filed against the partnership. General partners are responsible for all business debts of the partnership. See the general partnership section.
A limited partnership is taxed similarly to that of a general partnership. Limited partners, however, are not subject to SE tax. See "Taxes" in the general partnership section
Transferability of Ownership
Unlike a general partner, a limited partner may transfer or withdraw his interest in the partnership without the consent of the other partners.
Continuity of Existence
A transfer or a withdrawal of a limited partner’s interest does not affect the legal status of the entity. In other words, the death, disability, or withdrawal of a limited partner does not dissolve the partnership.
The general partners have control over the management decisions. The limited partners are prohibited by law from participating in the day to day decision making. If a limited partner becomes involved in management decisions, he may lose his/her limited liability protection.
The ownership interest in a limited partnership is generally protected from personal creditors while shares of a corporation may be seized by creditors. However, if a creditor obtains a personal judgment against a partner, he may be entitled to the equity interest of the partnership. In other words, the creditor would be entitled to the profits and cash flow distributed to the partner but would not become a partner. If properly planned, the partnership agreement should contain a provision which states that upon the election of the general partners, the limited partners will pay their proportionate share of tax on any profits whether or not the profits are actually distributed. This would discourage the creditor from taking the partnership interest as he/she would be forced to personally pay income taxes on the partnership income even if the income is not distributed.
To provide for maximum protection in a limited partnership, the general partner should be a corporation or an LLC. The corporation/LLC would then be personally liable for all debts of the partnership. Consequently, the corporation/LLC should not have significant assets and should only own a nominal percentage of the limited partnership.
While this is only an example of some of the asset protection strategies available with a limited partnership, other possibilities are available. One should consult with an attorney to determine the best strategy.
Summary of a Limited Partnership
When operating a business, a limited partnership structure may be a preferred choice over a general partnership structure due to its limited liability protection.
A limited partnership does not offer the partners the privacy benefits that a Nevada Corporation and International Business Company provide. A Nevada corporation or an International Business Company generally protects the identities of the shareholders. The income/losses from a limited partnership are reported on each partner's individual tax return, which identifies the owners of the partnership.
If you are considering a limited partnership structure for conducting a business or investing, an LLC should also be considered. Structured similar to a limited partnership, an LLC offers an attractive alternative over the limited partnership. The LLC has similar tax advantages, asset protection features, and the members and managers of an LLC do not have personal liability like the general partner of a limited partnership.
LIMITED LIABILITY COMPANY
The limited liability company, or LLC, is a hybrid between a corporation and a partnership. A limited liability company, like the limited partnership, combines many advantages of a corporation with those of a general partnership. Prior to forming an LLC, you need to determine whether you want "pass-through" taxation. If you do not want the benefits of the pass-through entity, then the LLC can be structured to be taxed as a corporation. Ownership of an LLC is held by the members and the LLC is operated by the managers. An LLC can be formed by an oral agreement, a handshake, or by a formal operating agreement. However, to ensure your rights are protected, you should always have a written operating agreement which outlines the rights, responsibilities, and ownership interest of each of the members. Below are some of the characteristics of an LLC:
In a limited liability company, both the members and the managers are protected from the business creditors.This is an advantage over the limited or general partnerships whereby the general partners are personally liable.
Several of the important tax characteristics of an LLC are summarized below:
There is no double taxation. The LLC is taxed as a partnership as long as there are at least two members. The limited liability company generally pays no income taxes as the income and losses flow through to each member on there individual tax return. However, their is a small tax on gross income if the gross income exceeds a certain amount. Check with you tax consultant to see what the gross amounts are for your state as the rates and tax volume may vary from year to year and by state.
1. The IRS does not recognize a single member LLC. Therefore, a single member LLC would be treated as a sole proprietorship. All income and expenses would be reported on schedule C of the IRS form 1040.
2. The pass-through income is subject to SE taxes if a member meets any one of the following (a) participates more than 500 hours a year (b) is personally liable for any business debts (c) has any authority to bind contracts on behalf of the LLC (d) meets the personal service test. There are three types of income under section 1402 that would not be subject to SE taxes. The income that is exempt from SE taxes is as follows:
1402 (a) 1 Rental income
1402 (a) 2 Interest and dividends
1402 (a) 3 Capital gains
Transferability of Ownership
If a member wants to transfer the ownership interest of the LLC, the member must obtain a written consent from all members
Continuity of Existence
A limited liability company cannot have an unlimited life. The termination date varies among states and is required to be stated in the articles of incorporation. This date is determined by the members upon incorporation. The dissolution date varies among states.
A limited liability company is owned by the members. The members can either manage the company themselves (member managed) or appoint a manager (manager managed). The management of an LLC should be defined in the operating agreement.
The ownership interest in a limited liability company is generally protected from personal creditors. However, if a creditor obtains a personal judgment against a member, he may be entitled to the member’s equity interest of the LLC. The creditor would be entitled to the profits and cash flow distributed to the member but would not be able to exercise management powers with respect to the LLC. If properly planned, the operating agreement should contain a provision that at the election of the managers, the members will pay their proportionate share of tax on any profits whether or not the profits, are actually distributed. This would discourage a creditor from taking a member’s interest as he/she would be required to personally pay income taxes on the members income even if the income is not distributed. In order for a member to obtain this protection, the LLC must be at least a two member LLC and must also be taxed as a partnership.
Summary of an LLC
An LLC is an excellent entity for investing and holding assets. It offers asset protection when structured as a partnership and favorable tax treatment for certain types of income. Capital gains, rental income, interest, and dividends are not subject to SE or personal holding taxes. Further, an LLC is not restricted on the type of shareholders (members). An LLC may have both natural (individual) and artificial (corporate, partnership, trust, and estate) members. In addition, the members do not have to be US citizens or hold US residency.
When determining whether an LLC should be utilized, you should investigate and consider the applicable state laws. The Laws governing LLC’s vary from state to state.
When determining whether a limited partnership should be utilized, you should review the laws of the state in which you will be conducting business to determine whether the state protects the interest of the limited partner. Some states protect the interests of limited partners more than other states. Similar to corporations, a limited partnership does not have to be established in your home state. You should establish your limited partnership in a state that offers the best protection.
A corporation is a legal entity separate from its owners. Therefore, if the corporation is structured properly, you may conduct business while remaining anonymous. A Nevada corporation or international business company is often used for privacy. Important considerations of a corporation are summarized below:
If a corporation is sued, the corporation may lose its assets but the personal assets of its owners or shareholders will not be touched. This is true as long as a creditor cannot pierce the "corporate veil". The corporate veil is a shield that protects the shareholders against business dealings, contracts, and other potential liabilities. For example, if a shareholder improperly commingles corporate and personal funds or uses corporate funds for personal assets (i.e., corporate money should not be used for personal use), then a creditor may attempt to pierce the corporate veil by proving that the corporation was merely the "alter ego" of its operators. In order to mitigate the potential for a creditor piercing the corporate veil, compliance with the following can help prove that the corporation is engaged in business and is separate from the owners.
1. Maintain adequate books and records
2. Keep business accounts separate from personal activity
3. Hold regular shareholder and director meetings
4. Conduct business only in the company’s name
5. Keep the corporation in good standing
Some of the tax characteristics of a corporation are as follows:
A corporation has more tax advantages than a sole proprietorship or partnership. Below are some of the tax advantages offered to corporations:
A corporation has various retirement, stock option and profit sharing plans available.
- A corporation may defer or pay no taxes on certain types of domestic and foreign income.
- A corporation can issue deferred compensation in the form of stock dividends and stock bonuses. There would be no income tax to the shareholder until the stocks are sold or converted to cash.
- A corporation can accumulate earnings and distribute the income when the shareholders are in a lower tax bracket.
Dividends received from corporate stockholdings are 85% tax free.
The tax disadvantages listed below may be significantly reduced if advanced tax
planning is performed:
- Many individuals set up a corporation to conduct investment business. While the objective of an individual is to operate a business, the IRS looks at this type of activity as merely a holding vehicle. If a corporation is formed for investing purposes, it may be considered a personal holding company. This arises when 60 percent or more of a corporation’s income is passive income (interest, royalties, dividends, rents, gains on stocks, etc.). If the income is not distributed, it is taxed at a much higher rate.
- The personal holding company status may be eliminated or the tax reduced if one has two operating entities. The corporation with the passive income would either perform services such as management, advisory, etc. or sell goods to the other entity. The corporation with the passive income would then receive active income thereby reducing the passive income percentage. This strategy works only if the transactions between the two entities have substance.
- The stockholders of a corporation are subject to double taxation. A corporation is taxed at the corporate level and distributions to the shareholders are taxed to the shareholder when they are received.
- The corporate income tax rate is higher in the lower income levels than the comparable individual rates for the owners of a partnership and sole proprietorship.
Transferability of ownership
The shares of a corporation can be easily transferred without disturbing the continuity of existence.
Continuity of Existence
The life of a corporation does not terminate with the death, retirement, or disability of a shareholder.
Some of the asset protection features of a corporation are as follows:
The assets of a corporation are protected against the shareholder’s personal liabilities. However, if a shareholder owns at least 51% of the outstanding shares, then a creditor of the shareholder may gain control of the corporation and liquidate the assets of a corporation. If successful, the creditor of the shareholder may then obtain both the personal and business assets. In order to reduce the possibility of such an event, the corporation should be structured whereby the shares of the corporation are owned by an LLC or a limited partnership. Also, international business companies are utilized for safeguarding assets.
Corporations may be used to protect personal assets by becoming a mortgage holder of these assets. In other words, if your personal home, business or other personal assets have equity, the corporation places a mortgage on these assets. Caution should be used when utilizing this strategy. Further, an attorney should be consulted before implementing this strategy. A Nevada corporation would be an excellent entity for this structure due to the anonymity.
Summary of a Corporation
Despite the government supervision, record-keeping requirements, and double taxation, many business planners consider the corporation/IBC an optimum structure to operate a business. To reduce the possibility of a creditor seizing control of the corporation’s assets, the outstanding shares should be owned by a limited partnership or a LLC.
If you are considering operating a business through a corporation, you should consider the LLC. The LLC would create "pass-through" income, thus, avoiding double taxation. Further, the ownership interest of an LLC can be protected from creditors if it is a two member LLC.