"ANIMAL CRACKERS"

The business world is host to a menagerie of organizations. To get this started, let’s have a little quiz:

Which of the following is NOT a form of legal entity?
(a) Massachusetts business trust
(b) S corporation
(c) Limited liability limited partnership
(d) Joint venture
(e) All of these are legal entity forms

Besides the sole proprietorship, which is not a true business entity, the simplest – and oldest – form of business entity is the partnership. Two or more persons carrying on a business can be a partnership. Any partner may legally bind the partnership, and each partner is personally liable for the debts and liabilities of the partnership. A written agreement isn’t required but is a really good idea. There is a lot of flexibility in how the agreement can be written.

Partnerships come in several flavors: the regular, or general, partnership we described above. Then there is the limited partnership, the limited liability partnership and, yes Virginia, we have the limited liability limited partnership. Like we said, it’s quite a menagerie!

Next up is the corporation, the next oldest to the partnership. A corporation is created by filing a document called ‘articles of incorporation.’ Properly formed and run, the corporation will be treated as a separate legal entity, and the owners’ assets will not be exposed to the corporation’s debts and liabilities. Corporations have a lot of moving parts: shareholders, directors, officers, bylaws and so forth. There are more formalities attached to a corporation, compared with a partnership.

The zinger with corporations has to do with taxes. Income is taxable to the corporation; then, when distributions are made to the shareholders, the distributions also generally get taxed, albeit at lower top rate. This is the notorious “double tax” of corporations. So, what’s a mother to do? Well, to the rescue comes the S corporation election: when filed with the IRS, this election magically converts the corporation to an ‘S corporation.’ When that happens, the corporation no longer pays tax separately; instead, everything is passed through to the shareholders, and they pay the tax. (The S election is only available to certain small, simple corporations.)

So, you have the partnership with its great flexibility of structure but potential liability of the partners. And you have the corporation with its fairly rigid structure but limited liability of the shareholders. Wouldn’t it be nice if there were a happy medium of those two? Well, beginning a few decades ago, there came to be the limited liability company, which combines those two favored attributes. Like the corporation, the LLC is created by filing a document. What’s more, beginning around 1988 the limited liability company was able to achieve pass-through tax status, like the partnership and the S corporation.

Alright, this has gone on too long as it is, so we’re going to stop there. But there will be future articles on pass-through entities and their tax features. Oh, so what is the answer to the quiz? It’s (b) the S corporation – not a separate legal entity, but rather a tax status obtained by a filing with the IRS.

Hungry for more crackers? See our Business Entities 101.