“Business Entities 101”
Your accountant, attorney or other business adviser can and should help you identify and evaluate the numerous factors which go into that decision. This summary will provide general background information and identify and summarize some of these factors.
Following are some of the more basic factors which help determine the appropriate entity for the new business:
- The type of business
- Owner’s concern over potential business liabilities
- Tax considerations
- Expected size of the business and number of employees
- Expected management style of the business
- Whether the business will operate in more than one state
Click on each entity type to read a detailed description:
• Sole Proprietorship
A sole proprietorship does not pay federal income tax or file a tax return. Instead, the income and deductible expenses of the business are simply reported on the owner’s Form 1040 personal tax return. The sole proprietor lists the profit or loss information for the business on Schedule C which is then attached and filed with the owner’s Form 1040.
Partners may limit their liability by forming a limited partnership, which is accomplished by filing a certificate of limited partnership with the Secretary of State. A limited partnership must have at least one general partner, who manages the partnership and has unlimited liability for partnership debts and judgments. The limited partners, on the other hand, generally do not take part in the management and have no liability beyond their respective investments in the partnership. Certain partnerships may limit the liability of general partners by registering the partnership as limited liability partnership with the secretary of state or other state official.
Partnerships are treated as "pass-through" entities under federal tax law. This means that the various items of income, gain, loss, deduction and credit are not taxed to the partnership itself, but rather "flow through" to the individual partners’ tax returns. Certain partnerships, especially limited partnerships, may be subject to very complex tax rules governing tax basis, and allocations of profits and losses among the partners.
In most cases, there is no tax liability when a partnership is formed and initial property is contributed to it. But receiving a partnership interest in return for services performed for the partnership can have unexpected tax consequences. Persons planning this kind of arrangement should consult a tax adviser to assist in properly documenting this plan.
In December of 2017, Congress passed, and the President signed, a major tax reform bill that changed the taxation of pass-through entities. Section 199 of the Code now enables owners of pass-through entities (as well as Sole Proprietorships) to deduct up to 20% of “qualified business income” that they earn from the entity. The details and calculations under this Section are complex, and tax experts are working out the ways to benefit from this Section.
• Corporation, S Corp
Properly formed and run, the corporation will be treated as a separate legal entity. Thus, only the assets of the corporation — not the personal assets of the shareholders — are available to satisfy claims against the corporation. Of course, some creditors such as lending institutions may require shareholders to guarantee payment of loans made to the corporation.
When a corporation is established, the founders contribute money or property to the corporation in exchange for stock. The shares of stock represent the ownership interests of the shareholders in the corporation. The type of stock normally issued by a new corporation is “common stock.” The shareholders have one vote at meetings for each share of stock owned. If so authorized, a corporation may issue different types, or “classes,” of stock such as non-voting stock or preferred stock. But most small, new corporations engaged in active business operations have little need for different classes of stock. A corporation is permitted to have a single shareholder.
The articles of incorporation which are filed to form the corporation must state the number of “authorized shares” of stock. This is the total amount of stock which the corporation may legally issue. Out of this “authorized capital,” the corporation issues stock to the shareholders. The corporation may change the amount of authorized capital from time to time by amending its articles of incorporation. At the time of incorporation, it is prudent to issue only a fairly small percentage of the authorized shares to the initial shareholder(s), reserving the remaining authorized stock for future issuance. Stock certificates are usually issued to document the ownership of the shareholder(s). There is no maximum on the number of shares that can be authorized, but some states, including Delaware and Nevada, base their initial filing or annual corporation franchise tax, at least in part, on the number of shares authorized.
The board of directors is responsible for the overall management of the corporation. Day-to-day management of operations is delegated to the officers, for example, the president, vice president, secretary or treasurer. The shareholders, as the owners of the corporation, elect the Directors who, in turn, elect the officers. This management structure is carved out in the New Mexico statutes and is fairly rigid, but again this rigidity has little effect on the corporation’s everyday activities. In very small corporations, only one or two persons may perform all of the above roles in the corporation.
An “S corporation” is formed and documented in the same way as a regular, or C, corporation. The difference is that an S corporation has elected special tax status, as discussed in the following section.
A corporation is a taxable entity separate and distinct from the owners (shareholders). A regular corporation is taxed according to Subchapter C of the Internal Revenue Code and therefore is sometimes called a "C" corporation. Taxable income and gains and deductions and credits of a C corporation are reported on the corporation’s tax return. Then, if the corporation distributes money or property as dividends to the shareholders, they may have to pay tax on those amounts received. (This is sometimes referred to as the "double taxation" of corporate earnings.)
Many if not most small corporations elect to be taxed as "S Corporations" (named for Subchapter S of the Internal Revenue Code) by filing a form with the IRS. The resulting tax situation is similar to that of a partnership: the S corporation files a special type of tax return, and income, deductions and credits of the corporation are "passed through" the corporation and are reported directly by the shareholders on their individual tax returns. An S corporation, however, may be liable for certain employment taxes. An S corporation is subject to several limitations, including those limiting the number of shareholders (currently 100), restricting the types of shareholders — mainly to individuals and certain trusts — and limiting the corporation to one class of stock. In addition, most tax advisers are not comfortable using a corporation as a real estate investment entity.
As with a partnership, the formation of a corporation and contribution of initial property to it does not usually create any tax liability.
See PARTNERSHIP, Taxation for information about the changes under the 2017 Tax Act affecting pass-through entities.
• Limited Liability Company
An LLC is a separate legal entity in which the owners are called “members.” Their ownership interest in the company is called a “membership interest.” Just as a corporation issues stock to the initial shareholders, the membership interests of the LLC members are given in exchange for money, property or services contributed to the LLC. Unlike a corporation, there is no distinction between authorized and issued interests–the LLC may create new membership interests at any time if the members so desire. Also like a corporation, the liability of LLC members is generally limited to the assets of the company and does not extend to the personal assets of the members. In contrast to the S corporation, which is limited to one class of stock, an LLC may have more than one class of membership interests (unless the owners plan to elect S corporation status – see below, Taxation) although the average operating LLC typically has little need for this. An LLC is permitted to have a single member. Membership certificates may be issued to the LLC members, although this is not required.
The members may govern the entity themselves or may appoint one or more “managers” to do so. Usually, the managers are also members of the LLC, but this is not legally required. The decision of whether, and to what extent, to have the company managed by managers can be complicated and should involve advice from an expert.
The rights and duties of the members and, if any, managers, the profit-sharing arrangements, and certain other aspects of the LLC operations are generally contained in a written operating agreement. The operating agreement resembles a cross between corporation bylaws and a partnership agreement. The New Mexico LLC Act permits considerable flexibility in provisions that may be contained in the operating agreement. Although not legally required, a well thought-out, written operating agreement is extremely important to assure the proper functioning of the entity.
An LLC with two or more members will be taxed as a partnership if no other election is made. An LLC with only one individual as the member will be disregarded for federal tax purposes; the sole member would then be taxed like a sole proprietor and would not file a separate tax return for the LLC.
However, either a single-member or a multiple-member company may elect to be taxed as a corporation (including an S corporation). Your tax adviser can discuss the advantages and disadvantages of the different tax forms. An LLC desiring to elect S corporation status would be subject to the restrictions applicable to S corporations (See "Corporation – Taxation" above). An LLC set up primarily to invest in real estate usually should not elect corporation status.
In most cases, forming an LLC and contributing initial money or other property to it does not create any tax liability.
An LLC that is taxed as a partnership or S Corporation is considered a “pass-through entity” under the federal income tax. See PARTNERSHIP, Taxation for information about the changes under the 2017 Tax Act affecting pass-through entities.
Factors In Choosing the Entity
How does the accountant, attorney or other professional adviser employ the various factors in recommending a business entity to the client? The factors listed at the beginning of this discussion might be applied as follows:
Click on each factor to read a detailed description:
• Type of Business
• Potential Liability
• Tax Considerations
• Expected Size of Business
• Expected Management Style
• Operations In Multiple States
• Cost Factors
- The corporation, at least in New Mexico, is the most expensive entity to form and to operate. The initial filing fees are higher and a corporate franchise tax is due every two years. A separate tax return must be prepared and filed for the corporation, as well.
- The limited liability company has lower filing fees and no fees or franchise tax after formation. A separate tax return is required, as it is for a corporation, unless the LLC is a single member LLC and does not elect corporation or S corp status.
- A general partnership is formed simply by agreement among the partners, written or oral. A limited partnership or limited liability partnership, by contrast, does require a filing with the Secretary of State and requires a fee. A separate tax return will always be required for a partnership.
- The sole proprietorship, of course, is the least expensive on both counts, costing nothing additional to set up or operate, because no separate entity is involved. Also, no separate tax return is needed.
• Entity Comparison Chart
- *1 Not a separate entity type; merely a tax status if elected
- *2 General partner remains liable for partnership obligations; limited partners not liable
- *3 Unless it elects to be taxed as a regular corporation