When you are starting a business, one of the first things you need to determine is how to best structure your business by choosing the proper business entity (C-corp, S-corp, LLC, etc.). There are numerous options out there and each has its pros and cons. You, your attorney, and your accountant should discuss which business entity is best for you.
Here is a very brief overview of some common business entities and their characteristics:
UNINCORPORATED BUSINESS ENTITIES
General Partnership: Two or more people going into a for-profit business together will generally be considered a general partnership unless they specifically choose otherwise. General partnerships are not separate entities for tax or state legal purposes, so the income from the partnership “passes through” to the partners as personal income. The general partners are fully liable for the full amount of their partnership debts even when those debts exceed their investment in the partnership, exposing their personal property to cover business debts.
Sole Proprietor: When only one person starts a for-profit business, they will be considered a sole proprietor unless they specifically choose otherwise. Sole proprietorships are not separate entities for tax or state legal purposes, so the income from the business “passes through” to sole proprietor as personal income. Like a general partnership, a sole proprietor is fully liable for the full amount of their business debts even when those debts exceed their investment in the business, exposing their personal property to cover business debts.
INCORPORATED BUSINESS ENTITIES
C-corporation: In order to become a C-corp, you must file Articles of Incorporation with the state. Additional administrative work will be necessary to maintain a corporation. Namely, bylaws should be drafted, minutes of the board of directors and shareholders’ meetings should be kept, and a shareholder agreement is strongly recommended to define the relative rights and responsibilities of each shareholder class. A C-corp is treated as a separate entity for federal and state tax purposes, so the corporation is taxed on the corporate income and when dividends are paid out to the shareholders, this amount is taxed as personal income to the shareholders. The shareholders are only liable for the corporation’s debts to the extent of their investment in the corporation.
S-corporation: In order to become an S-corp, you must file Articles of Incorporation with the state. Additional administrative work will be necessary to maintain a corporation. Namely, bylaws should be drafted, minutes of the board of directors and shareholders’ meetings should be kept, and a shareholder agreement is strongly recommended to define the relative rights and responsibilities of each shareholder class. Unlike a C-corp, an S-corp is not treated as a separate entity for federal and state tax purposes, so the corporation is not taxed on the corporate income. The income of the S-corp is taxed as personal income to the shareholders. Although an S-corp generally does not pay any tax, it still must file an annual information tax return with the IRS and report each shareholder’s pro rata share of profits and losses on a Schedule K-1. The shareholders are only liable for the corporation’s debts to the extent of their investment in the corporation.
Limited Liability Corporation (LLC): In order to become an LLC, you must file Articles of Organization with the state. If there is more than one member of the LLC, it is strongly recommended that you have a membership and operating agreement in place to define the relative rights and responsibilities of each member. With an LLC you have the option to be treated as a separate entity for federal and state tax purposes or not. In MN, the default choice is to be treated as a corporation, in which case you will be taxed like a C-corp. However, in the Articles of Organization you can elect to be treated as a partnership with your income allocations defined in your membership and operating agreement. The shareholders are only liable for the LLC’s debts to the extent of their investment in the corporation.
Limited Partnership: An Limited Partnership (LP) is formed when the partnership files a Certificate of Limited Partnership with the state. An LP has both general partners and limited partners. The general partners have the authority to conduct the regular operations of the business. Limited partnerships are not separate entities for tax or state legal purposes, so the income from the partnership “passes through” to the partners as personal income per their allocable share of the business. The general partners are fully liable for the full amount of LP’s debts even when those debts exceed their investment in the partnership, exposing their personal property to cover business debts. The limited partners are only liable for the amount equal to their share of the investment into the LP, unless there is some other contractual obligation to take on more liability.
There are many more business entities that blend aspects from all the entities above. Determining which entity is right for you should be done with the help of an attorney and/or an accountant. Please contact me if you need help setting up your new business or would just like to talk through your options.