One of the first decisions that you will have to make as a business owner is how your company will be structured. There is no “right” answer to the question, “Which legal structure should I choose?”  The “right answer” for you will depend on many factors, such as:

• Your personal tax situation
• The type of business you are starting
• The number of owners
• Whether or not you have employees

The key issues you need to consider in selecting the legal structure for your business are taxes and liability.  Legal and financial advice should be sought to determine which legal structure is most appropriate for you and your business.

Common legal structures available to small business owners include:

• Sole Proprietorship
• General Partnership
• Limited Partnership
• Limited Liability Partnership
• C-Corporation
• S-Corporation
• Limited Liability Company
• There are other entities; however, they are beyond the scope of this dissertation.

Sole Proprietorship

The business is owned and operated by one person.  There is no legal distinction between the individual owner and the business itself.

Taxes

Income Tax –

• Sole proprietorships are “pass-through” entities.  That is, the profits and losses from the business are passed through from the business to the owner for tax purposes.  Revenues and expenses are reported on a Schedule C, and the net profit or loss is transferred to the owner’s 1040.  As a result, profits are taxed only once at the owner’s personal tax bracket.  Likewise, losses offset other income.

Self-employment Tax-

• All net profits are subject to federal self-employment tax.
• The self-employment tax is equivalent to the Medicare and Social Security tax that an employee pays from their earnings.

Liability

• Unlimited liability for the owner, who is personally liable for the actions of the company and its employees.
• It is possible to self-insure against personal liability.
• Of course, business liability insurance is available.

Other Issues

• Administrative set-up and maintenance costs are low.
• Relatively few regulatory requirements.
• Sole ownership of profits and decision-making power.
• Can be difficult to raise capital for the business.
• Lack of continuity.  The owner and the business are one in the same, so if something happens to the owner, then the life of the business is threatened.

General Partnership

Like the sole proprietorship, the partnership is not a separate legal entity.  The partnership has two or more partners.  If two or more individuals start a business together, without formalizing it into a corporation or other formal entity, they are by definition a “general partnership”.

Taxes

Income Tax –

• Partnerships are “pass-through” entities.  As with the sole proprietorship, the profits or losses from the business are passed through from the business to the owners for tax purposes, based on percentage of ownership.  The partnership files an informational return (Form 1065) that reports revenues and expenses and issues a form K-1 to each partner.  Each partner reports profits or losses on his or her personal tax return, based on percentage of ownership.  As a result, profits are taxed only once at the owners’ personal tax bracket.  Likewise, losses offset other income.

Self-employment Tax-

• All net profits are subject to federal self-employment tax.
  • The Self-employment tax is equivalent to the Medicare and Social Security tax an employee pays from their earnings.

Liability

• Unlimited liability for the general partners, who are personally liable for the actions of the company and its employees.
• Each partner is responsible for the business dealings of other partners, thus increasing the liability exposure.
• It is possible to self-insure against personal liability.
• Of course, business liability insurance is available.

Other Issues

• Administrative set up and maintenance costs are low.
• Relatively few regulatory requirements.
• More skills, experience and capital available from multiple partners.
• A written partnership agreement, ideally drafted by an attorney, is critical to help the partnership deal with such issues as:  initial investment of partners; distribution of profits and losses; each partner’s responsibilities; new partner entrance into partnership; old partner exit from partnership.

Limited Partnership (“Ltd.”)

A limited partnership differs from a general partnership in that it protects limited partners’ personal assets outside of their investment in the partnership.  The formation and operation of a limited partnership requires more formality than a general partnership.  A limited partnership must have a least one general partner, who operates the business and assumes liability.  Limited partners are merely investors and, therefore, are restricted from exercising any control or operational power.

Limited Liability Partnership (“LLP”)

The LLP is relatively new and is a hybrid of the general partnership and the limited partnership, and has eclipsed both in popularity in recent years. The LLP has the added advantage of liability protection from the actions of the company and its employees, as well as liability protection for each partner from the actions of each of the other partners.

Other Issues

• Better liability protection than a limited partnership for all partners
• Filing fees, both initially and annually, are very inexpensive compared to a limited partnership
• Retains the accounting and tax advantages of a general partnership
• Set up and administrative costs are more expensive because, typically, each partner is a separate legal entity.

C- Corporation

A legal form of doing business that creates a separate legal entity from the individual owners.  The legal entity has rights and responsibilities, just as a person would (i.e. borrow money, enter into contracts, file lawsuits, etc.).  A C-Corporation has one or more shareholders (owners).

Taxes

• A C-Corporation is NOT a pass-through entity, and therefore is subject to double taxation.
• Profits of the corporation are taxed at the corporate rate and then again at the shareholder’s personal tax rate when these profits are paid out as dividends.Profits are subject toFloridacorporate income tax.

Any corporate earnings over $5,000.00 are subject to a 5.5% tax rate

• Distributions are not subject to self-employment tax.  Officers in a corporation are employees of that corporation, so salaries paid are subject to federal payroll taxes.

Liability

• Shareholders are not personally liable.
• Potential liability for failure to properly maintain or operate the company.

Other Issues

• Ownership is easily exchanged between individuals.
• Company exists in perpetuity – it does not cease to exist with the death of owners.
• Easier structure to raise capital.
• Moderate administrative costs to setup and run.
• More regulatory requirements than other structures.
• A non-U.S. citizen can be a shareholder (see “S” corporation).
• A C Corp. can accumulate cash for future projects without it being immediately taxed as a distribution to shareholders.

S- Corporation

A variation of the corporate form, allowing for pass-through of profits and losses to shareholders’ personal tax returns much like a sole proprietorship or partnership.  A C- corporation (with one or more shareholders) files IRS Form 2553 to elect treatment as an S-Corporation for tax purposes, and this form must be filed within 75 days from the filing of the Articles of Incorporation.

Taxes

• Owners are only taxed once.  All profits (or losses) of the corporation pass through to the shareholders’ personal tax returns according to percentage of ownership.
• Since all profits “pass-through”, no profits are subject toFloridacorporate income tax.
• Distributions are not subject to self-employment tax.
• The IRS expects that shareholders who work in the business take a “reasonable” salary in addition to distributions.  This salary is subject to federal payroll taxes.
• There is no flexibility in the allocation of profits and losses that pass-through.  Distribution is strictly based on percentage of ownership.

Liability

• Shareholders are not personally liable.
• Potential liability for failure to properly maintain or operate the company.

Other Issues

• There are limits on the number of shareholders.  At this time, an S-corporation can have no more than 100 shareholders, and each shareholder must consent to the S-election.  A married couple who file a joint tax return can be treated as one shareholder.
• There are also limits on WHO can be a shareholder.  Shareholders must be individuals, estates, exempt organizations, or certain trusts.  Shareholders an S-corporation must be US citizens and a natural person (i.e., not another corporation, limited liability company or other business organization).
• Additionally, S-corporations are limited to having only one class of stock.  However, voting differences within a class of shares is permissible.  Preferred stock is not allowed.
• The S-corporation must use the calendar year as its fiscal year unless it can demonstrate to the IRS that another fiscal year satisfies a business purpose.

Limited Liability Company (LLC)

An LLC offers some of the tax advantages of a partnership with the same liability protection of the corporate structure.  An LLC has “members” rather than “shareholders” or “partners”, and “managers” rather than officers.

Taxes

• Owners are only taxed once.  As with other pass-through entities, profits or losses pass to the members’ personal tax returns.
• The LLC allows for special allocation of profit and losses.  Unlike the S-corporation, distributions do not have to align with percentage of ownership.
• A “single-person” LLC can be taxed like a sole proprietorship.  Owners report profits and losses using a Schedule C, which simplifies the tax reporting process. A “single person” LLC does not have to file a separate LLC tax return.
• Like S-corporations, the company must pay employment taxes on salaries paid to employee-members.  Additionally, members may also have to pay tax on distributions.
• Since all profits “pass-through” to members, the entity is not subject toFloridacorporate income tax.

Liability

• Offers the same limited liability protections as a corporate structure provided rules regarding governance and maintenance are followed.

Other Issues

• Higher administrative costs to set up and run, and more regulations than partnerships and sole proprietorships; however, the costs are similar to a corporation.
• InFlorida, an LLC has one or more members.  There is no maximum number.
• Members may include individuals, corporations, other LLCs, foreign entities.
• LLC members must have other members’ approval to sell their interest.

The LLC is ideally suited for 1) real property transactions – an LLC owns real estate separate from the operating business; 2) when there is a “money” partner and a “sweat equity” partner – allows for special allocation of profits and losses.