New business owners have many important decisions to make to get their business off the ground. One of the most important choices is the form of legal entity the business will take. Three of the most popular entity types are limited liability companies, limited partnerships, and Subchapter S corporations. C corporations are still available; however, they have lost popularity in recent years due to a less favorable tax structure compared to ‘pass-through’ entities. Limited liability companies, limited partnerships and S corporations all provide liability protection and are taxed as ‘pass-through’ entities, but there are many important differences between them.
Limited Liability Company
A limited liability company (LLC) is a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes and a partnership for federal tax purposes.
The owners of an LLC (called “members”) are generally not liable for the debts of the business except to the extent of their investment. Thus, the owners can operate the business with the security of knowing that their personal assets are protected from the entity’s creditors. This protection is far greater than that afforded by general partnerships.
LLCs can be treated as partnerships for federal tax purposes. LLC earnings ‘pass-through’ to the members and are reported on the members’ individual tax returns. LLC losses ‘pass-through’ to the members as well and are deductible on their individual tax returns subject to certain limitations.
An LLC that is taxable as a partnership can allocate, among other items, income and losses to its members by special allocation. Also, LLCs are not subject to the restrictions the Internal Revenue Code imposes on S corporations regarding the number of shareholders and the types of ownership interests that may be issued.
A limited partnership (LP) can be the most suitable entity for a new business venture that raises capital from private investors but also provides those investors with limited liability protection.
LPs allow you to raise capital to fund the business without giving up control or being saddled with considerable start-up debt. A general partner assumes the role of managing and operating the business. Investors who contribute capital receive limited partnership interests in exchange for their contributions. Limited partners are able to share in the entity’s financial results without managing the business or risking personal liability.
The general partner is usually personally liable for the entity’s debts. The risk of this liability can be minimized by: (i) creating a corporation to manage the partnership and serve as general partner, and (ii) procuring adequate insurance to cover potential liabilities arising from operation of the business.
The partnership is a ‘pass-through’ entity for tax purposes, with each general and limited partner including their share of income, deductions, credits, and losses, on their individual tax return.
Subchapter S Corporation
In an Subchapter S corporation (S Corp), the shareholders are not personally liable for corporate debts. In order to receive this protection, the corporation should be a viable entity separate from its shareholders and incorporated in accordance with applicable state regulations.
S Corp shareholders report their percentage shares of profits and losses on their personal tax returns. S Corp profits are taxed directly to the shareholder whether or not the profits are distributed from the entity. S Corp losses are deductible by shareholders to the extent of their basis which includes what they paid for their stock and any loans made to the entity. Losses that cannot be deducted because they exceed shareholder basis are carried forward and can be deducted when there is sufficient basis. No special allocations to shareholders are permitted.
An S Corp can lose its status if the original shareholders transfer stock to an ineligible shareholder such as another corporation, partnership, or nonresident alien or if shareholder distributions are not distributed according to ownership percentages. If the S election is terminated, the corporation becomes a taxable entity (a C corporation). Shareholders of a C corporation are not able to deduct losses and corporate earnings could be subject to double taxation.
To conclude, the entity choice will depend upon the nature and size of the business entity, the level of activity of the participants, consideration of tax consequences, concerns for succession and management, as well as potential liability protection. The proper choice of business entity is a critical decision, one which shouldn’t be made without solid professional advice. A little planning ahead of time can alleviate unexpected problems in the future.