Choosing the right legal structure for your business is a crucial decision that will influence the nature of your taxes, personal liability, registration requirements, and operations. Below we will cover some of the common pass-through entities chosen by business owners, and some of the implications of each.
Partnerships are informally and simply created as an association between two or more individuals to operate a business for profit. Typically, there are three common classifications:
- General partnership – All liabilities and responsibility are shared equally, meaning both partners take part in the operation of the business, and are equally liable for the debts created by the business. Partners have unlimited liability for partnership debts. Without a partnership agreement, profits and losses will be shared equally based on the number of partners.
- Limited partnership – Must have at least one “general partner” and one “limited partner.” General partners assume ownership of business operations and have unlimited liability, while limited partners have usually only invested capital and have no voting rights and limited liability. Without a partnership agreement, profits and losses are distributed in proportion to capital investments.
- Limited liability partnership – All partners have limited personal liability, meaning they are not liable for acts of malpractice or negligence committed by other partners, though all partners have unlimited liability for partnership contracts and debts. Popular with professionals who rely heavily on reputation, such as lawyers and accountants.
Partnerships are pass-through (or flow-through) entities when it comes to taxation, meaning the entity itself does not pay income taxes but instead passes through the income to the partners. The entity will file a Form 1065 return and each member will receive a K-1 that flows through to their individual Schedule E, detailing items of income, loss, and other reportable and informational items.
General partnerships are informally created since the owners have unlimited liability, but limited partnerships and limited liability partnerships require a formal filing with their respective state agencies, though all are easier to form than a corporation. General partners cannot freely transfer their ownership interest without approval of other partners, though their profits interest can be assigned.
Many states (though not all) allow for the formation of Limited Liability Companies (LLCs). This business structure has characteristics of both partnerships and corporations. From a tax standpoint they are typically pass-through entities like a partnership (though they can be C or S-Corporations), though they provide their owners with the limited liability protection of a corporation. This limited liability protects owners from being held personally liable for debts and other obligations that may be incurred by the business, meaning that the owners’ assets cannot be used for legal claims against the business.
For tax purposes, a single-member LLC is typically referred to as a “disregarded entity” and is treated like a sole proprietorship, meaning that income, losses, and other tax information is reported to the IRS on Schedule C, accompanying the owner’s tax return. An LLC with multiple members will usually be treated as a partnership for tax purposes – the entity will file a Form 1065 return and each member of the LLC will receive a K-1 that flows through to their individual Schedule Es.
An LLC is a legal entity that is formally created via filing a certificate in the state that allows for their formation. As a legal entity, it can sue or be sued in its own name. Similarly to other partnerships, a member in an LLC cannot freely transfer their ownership interest, and new members must be admitted upon the approval of the other members. Allocations of profits and losses are typically made in accordance with the LLC agreement, though in the absence of any such provisions will either be allocated equally, or in proportion to members’ capital contributions. Businesses that are required to obtain a license in order to operate (such as CPA firms or doctors’ offices) are not permitted to form LLCs in many states, though instead may form Professional Limited Liability Companies.
Like LLC’s, S corporations also protect their business owners’ personal assets from all corporate liability as a separate and distinct legal entity. They are considered pass-through entities, meaning they do not pay taxes at the corporate (“entity”) level like C corporations, and instead file Form 1120S, with all shareholders receiving a K-1 which will pass-through profits and losses to their individual returns. This differs from a C corporation, where taxes will be paid at the entity level on the corporation’s earnings, and then again at the shareholder level when dividends are received. Though their taxability is similar to other non-corporations, S corporations are still considered corporations and require formal creation. Following the creation of the C corporation, an S election must be filed to allow for the new filing status. There are strict standards for corporations looking to qualify for S corporation status, including:
- No more than 100 shareholders
- All shareholders must be individuals
- All shareholders must be residents or citizens of the US
- Must be a domestic corporation
- There can be only 1 class of stock
Beyond the tax implications, the benefits of forming an S corporation are similar to a C corporation. Both entities have limited liability protection as previously mentioned and are considered separate legal entities. Additionally, all corporate entities allow for shareholders to own the company via stock issuance, making ownership easily transferable, and will have boards of directors.
The selection of a pass-through business entity and the entity’s subsequent taxation is complex and will vary depending on the individual business. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied upon for tax, legal, or accounting advice. If you have any questions about forming a new business or your current business structure and taxation, please do not hesitate to contact us at Lear & Pannepacker.