Sole
Proprietorship
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:
Unlimited Liability
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.
Taxes
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.
Asset Protection
The personal assets as well as the assets of the sole proprietorship
are not protected from creditors.
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General
Partnership
 |
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: |
Unlimited Liability
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.
Taxes
Some of the tax characteristics of a general partnership
are as follows:
Tax Advantages
- 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.
Tax Disadvantages
- 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.
Management
All of the partners in a general partnership may participate
in the management of the partnership.
Asset Protection
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.
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Limited
Partnership
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:
Limited Liability
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.
Taxes
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.
Management
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.
Asset 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.
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.
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Corporation
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:
Limited Liability
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.
- Maintain adequate books and
records
- Keep business accounts separate
from personal activity
- Hold regular shareholder and
director meetings
- Conduct business only in the
company’s name
- Keep the corporation in good
standing
Taxes
Some of the tax characteristics of a corporation are as follows:
Tax Advantages
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.
Disadvantages
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.
Asset Protection
Some of the asset protection features of a corporation are as
follows:
- Business Assets
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.
- Personal 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.
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Limited
Liability Company
The limited liability company,
or LLC, is a relatively new business entity. It 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:
Limited Liability
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.
Taxes
Several of the important tax characteristics of an LLC are summarized
below:
Tax Advantages
- The limited liability company
pays no income taxes as the income/losses flow through
to each member on their individual tax return. The LLC
is taxed as a partnership as long as there are at least
two members.
Tax Disadvantages
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.
Management
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.
Asset Protection
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 determing 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.
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