A sole proprietorship is the simplest form of business entity. It requires no formal organization papers or formalities for conducting the business. Essentially, an individual functions as a business and they are liable for all of the debts and liabilities incurred in conducting it. A sole proprietorship is generally considered an “informal” business organization. That is, it does not require any formal documentation or 4state filings to legally create it. It is a single individual conducting business in his or her individual capacity. Usually a d.b.a. (“doing business as”) or an assumed name will be used for conducting the business.
To create a sole proprietorship the individual simply obtains the necessary business licenses, tax numbers if necessary, and perhaps registers a name. Then the individual conducts the business, making all decisions for the company and receiving all of the profit. Employees may be hired and business assets purchased and disposed of. There are no required annual reports or meetings. If the business is sold, it is treated as a sale of the assets of the business, not as the transfer of the business itself. Therefore, gain or loss on sale is determined on an asset by asset basis.
As a sole proprietor, the business owner is personally liable for all of the debts, obligations, and liabilities of the company. All assets of the company are the individual’s assets since a separate entity does not exist. No separate tax return is filed. The individual completes a schedule C to account for the income and expenses of the company and claims all income or loss on his or her individual tax return. The sole proprietor also files a Schedule SE for self-employment taxes. Quarterly estimated tax returns must be filed to avoid tax penalties.
The sole proprietorship is often the entity of choice for small startup businesses due to its simplicity and lack of formalities. This is clearly its strength. Its lack of separate structure is also its weakness, however. Since no separate entity exists, there is no shielding of the proprietor from the liabilities of the company. Depending on the type of business conducted, this may be more or less of a concern. Any individual who deals in the buying, selling or leasing of real estate in his or her own name should consider some other form of doing business. Over recent years, liability for a contaminated property has raised grave concerns for those in the chain of title on real estate. The liability for cleanup is not limited to those who caused the contamination but extends generally to all owners in the chain of title. Leasing property to others can also be a risky business where limited liability should be sought. Case law is replete with plaintiffs suing landlords for liability based on the conditions of the property and personal injuries that arose out of that condition. Whenever a business has substantial liability risks, a proprietorship is not the best choice.
From a tax planning perspective, the sole proprietorship provides little opportunity for tax relief. Business expenses can be offset against business income, however, all income over expense is considered self-employment income and subject to the self-employment tax. As any small business owner will tell you, it is self-employment tax that is the major tax problem. Some deductions, such as health insurance, are also limited to a sole proprietor though this is changing. Other types of business organizations have greater flexibility in tax planning in most cases.
In summary, sole proprietorships are ideal for small startup companies having a single owner with activities that raise few liability risks and few tax avoidance needs. Individuals “testing the water” can do so without the startup costs associated with other business organizations and yet move to a more sophisticated organization as the business shows promise. However, in most cases, a formalized business structure can save significantly on both tax liability and avoid liability as well.
A partnership is simply a joint venture of two or more individuals conducting a business together for profit. Like the sole proprietorship, the partners are liable for the debts and liabilities of the business individually. Again, no formal organization is required although a written partnership agreement is always recommended. This type of business entity is essentially a creature of the contract between the partners. A general partnership is an association of two or more people or entities conducting business together as co-owners for profit. Like the sole proprietorship, a general partnership can be informally formed. All that is required is an agreement by the parties to conduct business together as co-owners. At times, even the parties themselves do not realize that they have created a partnership.
Though a general partnership can be informally established, such partnerships usually end in a dispute. To avoid this result, a written partnership agreement establishing how the partnership will be managed and the profits divided is in everyone’s best interest. A partnership, unlike a sole proprietorship, is an entity separate from the partners themselves for state law purposes. Therefore, the partnership may own property in its own name. However, the partnership is not a tax-paying entity. A general partnership is managed by its partners, although the partnership agreement can change this. Third parties may deal with any of the partners and any partner may bind the partnership. All partners are individually liable for the debts and obligations of the partnership. The unlimited liability of the partner in a partnership despite the ability for all partners to bind the partnership is the major drawback of the partnership form of doing business. It has caused most people to select limited liability companies, limited partnerships, and limited liability partnerships rather than the general partnership form.
For tax purposes, the partnership is treated as a flow-through entity. That is, the partnership does not pay tax but files an informational return showing the allocation of income and loss among the partners. The partners then must claim the income and loss on their own tax returns. This creates a single level of tax at the individual level that is appealing to many businesses. However, this single level of tax can be accomplished with other business forms without risking the liability inherent in the general partnership form.
Since all of the benefits of the partnership form, for tax purposes, can be obtained using other business forms while providing limited liability for the participants, a general partnership is rarely the entity of choice. If a partnership is proposed, the parties involved should consider creating a limited liability company instead, especially given the “check the box” regulations that simplify the taxation issues.
A corporation is an entity separate from any of the parties forming it. It consists of shareholders who own the company, directors who make overarching business decisions, and officers which handle the day to day management of the company. The shareholders are essentially investors and are not liable for the debts and liabilities of the company. Their interests are freely transferable and the corporation’s existence is perpetual unless otherwise provided. A corporation is created by the filing of Articles of Incorporation with the State, and the formalities set forth in the statute must be followed.
An S corporation is an entity established under state law for conducting business. Such an entity has its own existence separate and apart from its owners. It is made up of three primary groups; the shareholders, the directors, and officers. The shareholders are the owners of the company. They have ultimate control but generally, make only major decisions that affect the company. Their most important impact on the company is through the election of directors. This is usually done at an annual meeting held for such purposes. The directors are elected by the shareholders and make the major business decisions that affect the company on a more specific level, such as what direction the company is going to take. The board of directors elects the officers of the company (president, secretary, treasurer, etc.) at an annual meeting.
The officers of the company are employees of the company and manage the day to day affairs of the company under the general direction of the board. They sign the checks, pay the bills, and manage the business operations. A corporate structure separates ownership and management in the company. In small, closely-held corporations, the same individuals will likely serve as shareholders, directors, and officers. In large, publicly traded corporations, shareholders rarely serve as directors or officers unless they own large blocks of stock.
A corporation is formed by the adoption of Articles of Incorporation. These Articles set out the name of the company, its duration, its registered office and registered agent, and other matters. The individuals creating the corporation are called incorporators and are often the original shareholders of the corporation. Corporate bylaws establish the management of the corporation. They also set forth the duties of the shareholders, directors, and officers, as well as required meetings and notices. A corporation, if properly managed and funded, provides protection to the shareholders from the liabilities and obligations of the company. That is, the shareholders risk their investment in the company, but do not place at risk their personal assets. Thus, a shareholder’s personal assets are not subject to the claims of the corporate creditors.
A corporation, however, is taxed as an entity separate and apart from its shareholders. This creates a “double taxation.” That is, the corporation is taxed on its profits at the corporate level, and then dividend distributions to shareholders are again taxed at the shareholder level. This double taxation can be devastating for small businesses. Recognizing the inequity of double taxation for small businesses, Congress created an exception to the double taxation rule. Small business corporations (“S Corporations”), as defined in the code, can make an election (an “S Election”) to have the corporation ignored for federal tax purposes, and have all the income and loss of the corporation flow through to the individual shareholders.
To ensure that this structure is available only to small businesses, limitations are placed on the number and types of shareholders that can hold stock in an S Corporation. To qualify as an S Corporation there can be no more than 70 shareholders and they can only be individuals or certain types of trusts. Numerous other requirements also apply. As most small business owners will tell you, the most devastating tax on such owners with modest incomes is the self-employment tax. It taxes you at 15.3 percent of your income without any deductions. An S Corporation provides a special planning opportunity for such small business owners. Corporate dividends are not subject to self-employment tax. In a regular C Corporation, a dividend is subject to double taxation. However, dividends from an S Corporation avoid the self-employment tax while also avoiding the double taxation. As long as the employee-owner is drawing a reasonable salary, an appropriate amount of dividends can be paid without self-employment tax liability. Such amounts are still subject to income tax, however. Though more formalities are required to maintain the liability protection in a corporation than in limited liability companies, the tax benefits will often outweigh this factor.
A corporation is an entity established under state law for conducting business. It has its own existence separate and apart from its owners. A corporation is made up of three primary groups, the shareholders, the directors, and the officers. The shareholders are the owners of the company. Their most important impact on the company is through the election of the board of directors. This is done at an annual meeting held for such purposes. The directors are elected by the shareholders and make major business decisions that affect company policy and direction. They also elect the officers.
The officers of the company include the President (often called the chief operating officer or CEO), any number of Vice Presidents, the Secretary, and Treasurer. The officers are employees of the company and manage its day to day affairs. They sign the checks, pay the bills, hire and fire employees, and manage all of the other day-to-day business operations.
Filing Articles of Incorporation forms a corporation with the State. These Articles set out the name of the company, its duration, its registered office, registered agent, and other matters. The persons creating the corporation are often the original shareholders of the corporation and are called incorporators. Corporate laws establish the management of the corporation in broad terms. It also sets out the duties of the shareholders, directors, and officers, as well as required meetings and notices. A great deal of the statutory rules for corporations can be modified within the bylaws of the corporation if desired.
One advantage of the corporate form is its limitation of shareholder liability. Although the shareholder’s investment is at risk, the shareholder’s other assets are shielded from liabilities of the company. If the corporation is properly managed and maintained, the most a shareholder can lose is the amount of the investment in the corporation. In small closely-held corporations, the same individuals will likely serve as shareholders, directors, and officers. In large, publicly traded corporations, shareholders rarely serve as directors or officers unless they own large blocks of stock.
When we think of C corporations, we generally think of large companies like IBM or General Motors. These companies are classic examples of the “C” corporation. The C corporation is subject to a double taxation. That is, the profits of the corporation are taxed at the corporate level and the corporation pays taxes to the IRS. Then, when the company distributes the profits by paying dividends, the dividends are taxed as income to the individuals who must pay tax to the IRS. This is the chief disadvantage of a C corporation.
A C corporation has many advantages, however. It may have an unlimited number of shareholders and the types of entities that may hold stocks are not limited. This means, for example, one corporation may hold stock of another corporation. Like corporations generally, a C corporation shields the owners from liability. C corporations are excellent vehicles for raising venture capital, though stringent federal guidelines must be followed, including potential filing requirements. Also, fringe benefits to employees are generally tax deductible to the corporation, including 401(k) plans, and health insurance.
Although we have spoken of C corporations as large companies, C corporations do not have to be large. They can have few stockholders who also act as the directors and officers. These are referred to as closely held corporations. They are C corporations but the stock of these companies are not publicly traded and control is kept in relatively few hands. Often, such closely held C corporations will avoid corporate-level taxation by distributing all income as salary with no dividends. The use of the C corporation for small businesses is currently not en vogue. However, for certain growing businesses with specific needs, it can be an attractive business alternative.
Limited Liability Companies (LLC)
A limited liability company is another hybrid of partnerships and corporations. Though quite new in the United States, they have a long history in Europe. This entity provides limited liability for ALL of the “members” while management of the company may remain the same as a general or limited partnership. Its structure is very flexible allowing for a wide variety of situations and is essentially governed by a contract between the members. A filing of Articles of Organization with the State is required, but other formalities are minimal. The LLC is now used as the primary vehicle for asset protection and estate planning, replacing the limited partnership.
A Single Owner Limited Liability Company:
Limited Liability Companies (LLC) have been growing in popularity as the business entity of choice. An LLC allows the owners to protect their personal assets from business liabilities and yet avoid the double taxation of a corporation. State Law originally limited the use of an LLC to the traditional partnership context where there is more than one owner. However, the Utah State Legislature eliminated the two-person minimum requirement. As of May 5, 1997, an LLC may be formed in Utah with only one member.
This change in the law opens the opportunity for many people to use an LLC who previously would not have considered it. In certain situations, using a one member LLC will be advantageous instead of an S Corporation, Sole Proprietorship, or other business forms. An LLC has the advantages of limiting the liability of the member of the business but has “flow-through” tax treatment. This means profits of the company at the business level are subject to tax only at the individual level.
Because of the “Check-the-Box” regulations, the availability of a one person LLC has even greater potential. Under the regulations, one person entities can be ignored for tax purposes. Therefore, unlike a partnership that must file an informational return, a one-person LLC can be ignored and file no tax return at all. All of the income and deductions show on the individual owner’s schedule C as if the entity did not exist.
The one person LLC is ideal for the sole proprietor who wants limited liability but does not want the complexity of running a corporation or filing corporate tax returns. The one person LLC is also ideal for those who wish to invest in Real Estate in Salt Lake City and segregate their liability on different properties or protect against potential environmental liabilities. With the simplicity and protection of the one person LLC, there is no longer a reason to conduct business as a sole proprietor.
A limited partnership (LTD) is a hybrid of a corporation and a partnership. The general partners manage the business on a day to day basis and are personally liable for the debts and liabilities of the partnership. However, the limited partners do not participate in the management of the business and only their assets used for the purchase of their partnership interest are at risk for the debts and liabilities of the partnership. To form a limited partnership, a filing must be made with the State, and the formalities set forth in the statutes must be followed. The limited partnership is a hybrid of a corporation and a partnership. It contains general and limited partners. The general partners are personally liable for all of the liabilities of the partnership and have control of the partnership. The limited partners have limited liability (that is, their only risk is their investment) and can have only limited input into the management and control of the partnership. Limited partners are similar to shareholders and general partners to partners, thus its hybrid nature.
Unlike a general partnership, a limited partnership cannot be formed informally. A certificate of Limited Partnership must be filed with the state and a written partnership agreement established.
The limited partnership is taxed for income tax purposes in the same manner as a general partnership. It is a flow-through entity. It files an informational return showing the allocation of income and loss among the partners, and then the partners must claim the income and losses on their own returns. Limited partnerships were used in the past as the entity of choice for tax shelters. Since the demise of tax shelters, they have fallen out of favor. However, limited partnerships are an extremely effective tool for estate tax planning. Most of the estate tax benefits of partnerships are also available in the limited liability company.
For individuals with assets more than $2,000,000 ($3 million if a married couple), the usual living trust planning is insufficient to completely insulate them from estate taxes. A common wish of such individuals is to make annual gifts of up to the annual gift tax exclusion (currently $11,000) to individual family members, reducing the size of their estate both by the amount given and the future increases in the value of the assets. However, outright gifts can be disconcerting to the giver due to the loss of control, especially in ongoing businesses. Furthermore, some types of assets (ie. real estate) can be difficult and messy to divide into the appropriate amounts. By creating a family limited partnership, we can place assets into the partnership and gift away limited partnership shares or units. This can simplify the gifting and maintain the control of the original owner.
Besides control and simplification benefits, the family limited partnership can have dramatic estate tax benefits over outright gifting. Since the interests owned by a family limited partnership are not particularly marketable and it has little control, these interests are â€œdiscountedâ€ for estate and gift tax purposes. For example, if you give a gift of a 1/10th interest in a piece of real estate worth $100,000, you have made a gift for gift taxes purposes of $10,000. If, on the other hand, you make a gift of a 1/10th interest in a family limited partnership that owns a $100,000 piece of real estate, your gift may be valued for gift tax purposes at $5,000 or $6,000. In other words, we can gift more without adverse tax consequences. Furthermore, when the general partner dies, his or her interest becomes a limited partnership interest and can receive the same type of valuation discounts. Discounts have fallen into disfavor with the IRS in recent rulings and therefore should be used only with great care.
The family limited partnership can be an extremely powerful estate planning tool. It is not for everyone, but can significantly decrease estate and gift taxes in the appropriate circumstances.
Please call us today at 801-290-5888 for a free initial consultation to discuss your Business options.