Law Offices of Ronald D. Jackson

Business Law

Choose the Right Legal Structure for Your Business

Take the guesswork out of organizing your business

Disclaimer: This is not legal advice.

Should you organize your business as a C corporation, an S corporation, limited liability company(LLC), a partnership, or something else? The answer to that question can help you achieve business success. In business, form is as important as substance. When it comes to business form, one size does not fit all. The tradeoffs between incorporation, partnerships and other business entities are significant. The choice you make today can seriously affect what your company will be or even can be in the future.

The 5 Most Common Choices

The five most common business forms are sole proprietorship, partnership, C corporation, S corporation, and LLC. Different business entities have advantages and disadvantages.

Sole proprietorship. Generally, this is the simplest — not necessarily the best — form for a single individual to conduct a business. This entity can generally begin life with a checking account and a business plan. It is not a separate legal entity from its owner. It does not involve the shifting of any assets from one individual to another individual or entity. Net income or losses of the business flow to the owner for tax purposes. The owner remains personally liable for all debts of the business.

Partnership. The partnership form encompasses a variety of business associations, such as joint ventures and syndicates. Business partnerships come in two basic flavors — general and limited. Two or more persons create a general partnership when they carry-on a business for profit. A limited partnership must have one or more general partners and one or more limited partners. Unlike a limited partnership, however, no magic words are necessary to form a general partnership. In addition, the state requires no formal registration documents to form a general partnership as it does for a limited partnership. Although highly desirable, having a written agreement is not necessary to have a general partnership. General partners are liable on all debts of the partnership and for wrongdoing of other partners. Oregon recently adopted the rule that a partnership is an entity distinct from its partners. Consistent with this model, a judgement creditor must first look to the assets of the partnership. The individual partner’s assets are at risk if the partnership cannot pay. In a limited partnership, limited partners cannot participate in management activities, but have limited liability. They are liable only to the extent of any unpaid capital contributions. "Pass-through" tax treatment is an important attribute of the partnership form. Generally, the partnership entity is not subject to taxation. Partnerships pass profits and losses separately to partners for tax purposes.

C Corporation. A C Corporation is a separate legal entity, created pursuant to state law. As a separate legal entity, the C corporation can enter contracts, sue and be sued, own property. It can do these things in its own corporate name. Unlike an S Corporation there is no restriction as to the type of shareholder (e.g. nonresident alien) that can own stock in a C corporation. Shareholders enjoy limited liability on corporation debts. Like limited partners in a limited partnership, shareholders in a C corporation are only liable to the extent of their capital contribution. Compared to some other business forms, however, the C corporation is more expensive to create and maintain. Corporations must follow certain "corporate formalities." These formalities include such things as holding regular director and shareholder meetings, keeping separate books and records, and using the corporate name. They also must make annual reports and pay annual fees to the state. Diligent attention to these formalities is important. Without corporate formalities, owners risk losing the protections of limited liability afforded them by doing business in the corporate form. Operating as a C corporation form has its tax advantages and drawbacks. Net income or loss is taxed at the corporate level, and dividends are taxed to shareholders. Although double taxation can be an issue, there are methods to avoid it. The C corporation offers some significant advantages too. Generally, health insurance premiums and life insurance premiums are deductible by the corporation and not taxable to employees or stockholders of a C corporation. For emerging and growth companies, operating as a C corporation offers the possibilities of stock bonus plans and stock ownerships.

S Corporations. This is a "small business corporation," which you form when you make a valid election with the Internal Revenue Service. The "S" designation is a federal tax designation. The rules governing S corporations are like a double-edged sword. While the government gives S corporations favorable tax treatment, they are subject to restrictive rules about ownership, type of stock and business activity. S corporations cannot have more than 100 shareholders and a nonresident alien cannot be a shareholder. It can issue only one class of stock, however, the stock can have different voting rights. Additionally, some types of corporations are ineligible. An S corporation is a "pass through" entity for tax purposes; it passes profits and losses generally through to its shareholders. The corporate form, however, gives shareholders of an S corporation limited liability for debts and wrongdoing of the corporation. This protection is the same as the government provides shareholders of other types of corporations.

Limited Liability Company (LLC). An LLC is a hybrid organization with attributes of a partnership and a corporation. It is an unincorporated association, organized under state law. Usually, it has two or more members, but it can have only one. The member of a one person LLC must wear several hats. Therefore, it is very important for a one member LLC to comply with the formalities of the LLC. Unlike an S corporation, there are no US citizenship requirements for members, and no limits on the number of members. Unlike in a limited partnership, all members of an LLC may participate in management without risking loss of limited liability. LLC members are not liable to creditors beyond their agreed upon capital contribution. Like a partnership, an LLC is a "pass through" entity for tax purposes. However, under some situations the tax result can be better with the LLC form. This is because in some situations, all members of an LLC, despite lack of personal liability, may receive "tax basis" for LLC liabilities.

Choose the Form that Fits Best

What is the best legal entity for your business? It depends on the type of business, your goals, and the goals of your investors, employees and others. Choosing the most appropriate business entity is like tailoring a suit. To wear it right, it must fit right. The earlier discussion showed that each of the legal entities has pluses and minuses. An attorney selects the best business form by strategically evaluating all available options. Consideration of the present needs and future expectations of the business and its stakeholders is paramount.

There is a broad range of tax and non-tax related issues that can affect the choice. The list below includes some of these issues. This list is not comprehensive; it only introduces the kinds of issues involved in choosing the most appropriate form.

• How many owners will your business have? A business with only one owner can organize as a sole proprietorship, some form of corporation, or LLC. A business that has multiple owners can be a general or limited partnership, some form of corporation, or an LLC. An S corporation will not be available if the business has more than 100 shareholders.
• Who are the owners? Nonresidents, aliens, corporations or other business entities as owners will affect your choice of business entity. An S corporation has "ownership" restrictions, and is not an option if nonresident aliens or certain other business entities are shareholders. Other than a sole proprietorship, which is limited to an individual, the other business forms generally do not restrict the type of owner or shareholder.
• How long will the business activity go on? Generally, the corporate entity has perpetual life. In contrast, a partnership can exist for as long or as short a period as the partners need it to. Two independent software developers might use a partnership to jointly develop a computer program. They can go their separate ways when the short-term project is completed.
• How will the profits (and losses) of the business be handled? Generally, the sole proprietorship, partnership, S corporation and LLC are not taxable entities. These entities pass the amount and character of profits and losses from the entity's business activities through to owners. These "pass through" tax benefits could be very important to owners. However, these "pass through" vehicles can yield very different tax results and are not equal.
• How will you compensate employees? Will there be incentive plans to attract and retain talent? Will there be fringe benefits (e.g., health and life insurance plans) for employees and owners? Stock bonus plans, options, warrants and other forms of incentive compensation are available in the corporate form. In addition, if the plans are nondiscriminatory, the C corporation can deduct health and life insurance premiums and provide tax-free fringe benefits to employees. The opportunities for incentive plans and tax free benefits may make the C corporation an attractive option. This might especially be true for the high tech or growth company. These companies must recruit and retain highly skilled employees.
• How will you finance the business? The choice of business entity will affect how your business can get money to operate and grow. A sole proprietorship must rely on the individual proprietor’s funds and loans from others. Partnerships and LLCs are financed with contributions and loans from partners or members and others. Corporations can issue stock to shareholders and raise money though bonds and other debt instruments. In particular, your choice of entity will be critical in the event your business becomes a candidate to "go public." "Going public" occurs when a company sells registered shares of stock to the public. In such a case, the C corporation may be attractive, because of its flexible capital structure and ability to accumulate earnings, at lower tax rates, for the reasonable needs of the business.
• Do you need limited liability? The ability to limit the extent that one is liable for debts and actions of the business may be important. Limited liability may be the best known characteristic of a corporation. The feature is also available in a limited partnership and LLC. Unlike a limited partnership, however, LLCs offer limited liability to all members. This feature may make the LLC attractive to a business where all members want to fully participate in business decisions. As a practical matter, many small businesses cannot get loans without the personal guarantees of the owners. In addition, an owner can sometimes use insurance as protection against tort — but not creditor — liability risks.

Choosing the best business form is a strategic decision that must relate to your particular situation. Standard "out of the box" solutions are not enough. The choice of business entity will influence many of your other options. It can affect your personal liability, fundraising tactics, property arrangements, employees' compensation, and other important areas. The choice will affect your bottom-line. Know what your options are before making this important decision. Take the guesswork out of what your business should be.