Areas of Practice - Business Taxation
Business Practice Group
Tax and Non-Tax Considerations in the Selection of a Business Entity
by Jeffrey M. Fetter
A sole proprietorship is a business owned and operated by a single person. A business certificate may be filed in the county clerk's office if the business is operating under an assumed name. Income of the owner is reported on the taxpayer's 1040, Schedule C.
Advantages:
- Very informal operation
- No formal requirements to organize
- Owner makes all decisions without having to be accountable to others
- No double taxation of an entity - all income reported on owner's returns
- Owner bound by acts of others in entity
- Ownership interest freely transferable
Disadvantages:
- No limitation of liability for owner from contractual or tort liability
- Reporting of all income on Schedule F my be disadvantage - i.e., no opportunity to shelter income
- Limitation on ability to deduct certain benefits provided to owner and owner's family
- Tax liability is at owner's rate. If separate entity utilized, could be opportunity to have lower tax rate or to share tax liability with others who have lower tax rate.
- Unless preliminary steps are taken, entity disappears upon death of owner
A general partnership is an organization which is composed of two or more persons. A partnership can be created without a written agreement. However, it is advisable to have a partnership agreement. A certificate of doing business as partners must be filed in the county clerk's office. Partnerships are not taxed as a separate legal entity. They are "pass through" entities.
Advantages:
- Very easy to organize - few formalities, nominal operating costs
- Decision-making process may be very informal if desired
- Detailed statute provides guidance on decision- making and on other matters concerning operation and dissolution if no agreement in place
- Pass through tax treatment for owners avoiding double taxation
- Entity files Form 1065, not Schedule C
- Partnership interests are not freely transferable
- May generally be liquidated tax free
Disadvantages:
- Unlimited personal liability for owners for acts of entity and acts of partners and employees acting in name of entity
- Partnership interests are not freely transferable
- Entity dissolves upon occurrence of certain triggering events (death, bankruptcy or withdrawal of a partner)
- Any partner may dissolve partnership by withdrawal
- Each partner may obligate the partnership
A corporation is a legal "person" that is created by filing of a certificate of incorporation in the Secretary of State's office. A corporation generally has perpetual existence. The owners or shareholders of a corporation have limited liability for the corporation's activities. A corporation is taxed as an entity separate and apart from its owners (unless S status is elected by the entity and its shareholders).
Advantages:
- Limited liability of owners for tort and contractual liability of entity: liability limited to capital contribution that is utilized for purchase of shares. Exception: wages (New York) and certain taxes (sales/payroll).
- Owners are not liable for acts of co-owners
- Entity not terminated upon death, bankruptcy or withdrawal of owners (unless otherwise agreed in writing). Entity's existence may be perpetual.
- Interests (stock ownership) are freely transferable (unless restricted by agreement)
- Ability to have centralized management, i.e., several owners but board of directors / officers selected to manage day to day operations
- Ownership interests may be different among owners, i.e., voting/nonvoting interests, preferred/common interests
- If low profits, C corporation may allow use of lower tax bracket than pass through entity
- C corporation offers the ability to deduct benefits payable to owners. S corporation's ability is limited, similar to a sole proprietorship.
- Ability to retain profits and avoid taxation at personal level
- Corporation laws throughout country are very similar and have long history of interpretation
Disadvantages:
- Certain operating procedures must be followed to avoid piercing of corporate veil and resulting in personal liability for owners (i.e., annual meetings of shareholders, directors; maintenance of corporate minutes, etc.)
- Depending on tax structure (C vs. S) double taxation in operations and upon disposition of assets
D. Limited Liability Companies:
Effective as of October, 1994, New York State allows the creation of a limited liability company which is a legal entity that offers its owners protection from personal liability but allows the entity's owners to be taxed as a partnership. An LLC is created by filing "Articles of Organization" with the Secretary of State and entering into an operating agreement. LLCL Section 1203 or by converting a general partnership to an LLC on a tax free basis.
Advantages:
- Owners enjoy limited liability for obligations and liabilities of entity and other owners
- Pass through entity - avoids double taxation
- Flexibility in management and governance. Management may be by members or by managing members (similar to a board of directors).
- Ownership interests may be structured in a manner similar to corporation (i.e., voting/nonvoting interests, preferred/common interests)
- Common form of business operation internationally
Disadvantages:
- Similar to a corporation technical operating requirements must be followed in order to enjoy limited liability and to avoid piercing of the veil
- Certain steps must be taken in operating agreement and procedurally in order to avoid dissolution upon death, bankruptcy or withdrawal of an owner/member
- May affect eligibility for ASCS/FSA payment programs
- Must be careful to avoid unnecessary self-employment tax for those not active in business
E. Limited Liability Partnerships:
A limited liability partnership is a general partnership, the owners of which are protected against tort and contract liability for acts of the other partners or acts of the partnership itself. In New York, LLPs may be composed only of certain professional firms (i.e. architects, accountants, physicians, lawyers, etc.).
A limited partnership is a partnership which has "general" and "limited" partners. General partners have unlimited liability for the acts of the partners and of the entity. Limited partners are not liable for the acts of the partners or of the entity itself. Taxed as a general partnership (i.e., a "pass through" entity). Limited Partnerships are created upon filing a certificate of limited partnership in the Secretary of State's office.
Advantages:
- Offers all advantages of partnership
- Allows creation of interests that have limited liability (more attractive to investors)
- Having general and limited partners allows for centralization of management in the hands of the general partners
- Flexibility as to allocation of losses and profits among general and limited partners
- Limited partner interests are not subject to attachment by creditors - limited to charging order
- Ability to transfer equity interests to others while retaining control by general partners
- Form of entity may allow for greater valuation discounts to enhance ability to reduce estate values for owners' estate plans
- Only general partners may dissolve the partnership
Disadvantages:
- General partners are personally liable for business activities as in a general partnership
- Limited partners may not participate in management or they risk loss of protection from liability for acts and obligations of entity and partners
- Interests are not freely transferable
- More costly to organize than general partnership (filing requirements, publication requirements)
Issues to Consider in the Selection of an Entity
- Taxability of the entity and its owners.
- Ability of owners to obligate the entity and other owners. Personal liability of the owners for actions and liability of themselves, each others and the entity.
- Centralization of management within the entity.
- Transferability of interests in the entity. Ability to restrict transferability by agreement.
- Perpetual or limited existence of entity.
- Expense of formation and technical requirements which must be followed in the operation of the entity.
- Form of ownership interests. E.g., S corporations may not have entities and certain trusts as owners and number of owners is limited (75).
- Flexibility with respect to allocations of profits and losses of entity.
- Form of capital contributions being made, equity and non-equity, voting and nonvoting interests being created.
- Does the entity fit within the owners' estate plans. E.g., only certain trusts may be shareholders of S corporations, may be desire to limit liability of estate for actions of entity etc.
- What requirements are set forth in the statutes for resolution of shareholder, director disputes? E.g., ability of a minority shareholder to petition a court for dissolution. May a shareholders or partnership agreement govern instead of statute?
- Events which may cause or result in dissolution and tax effects of dissolution.
- Annual or other regular filing requirements are there for the entity? E.g., tax returns, biennial statements with New York State, etc.
- Need for keeping owner's participation on an anonymous basis.
