Overview of Business Organizations

Overview of Business Organizations


Business Organizations

When choosing an appropriate business entity, it is important to consider numerous factors, such as ease of formation, Federal and State income tax laws, management rights and control, liability for losses, transferability of ownership interests, and continuity.[1]

Sole Proprietorship

A sole proprietorship is an unincorporated business owned by a single person. This business entity form usually does not require governmental filing, other than a fictitious-business-name statement, which provides the owner’s name and address and the name under which the owner will conduct business.[2] The main advantages of this business entity form is the owner’s absolute control in terms of management rights, and avoidance of double taxation, as a sole proprietorship is not a separate legal entity.[3] The sole proprietor reports the business’s expenses and income on his or her personal income tax return.[4] The main disadvantage of a sole proprietorship is the owner’s unlimited personal liability for the losses of the business.[5] The sole proprietor can freely transfer interest in the business, but the death of a sole proprietor will dissolve the sole proprietorship.[6] Notably, sole proprietorships can also be a “default” entity because if a single person conducts a business without filing with a state to form some other entity (an LLC for example), the business will be considered a sole proprietorship.

Partnerships

There are various kinds of business partnerships, including general partnerships, limited partnerships (LP), limited liability partnerships (LLP), and limited liability limited partnerships (LLLP). Partnership law originated in the common law; however, it is now codified in the Uniform Partnership Act and the Revised Uniform Partnership Act.[7]

General Partnership

A general partnership is an unincorporated business association that does not require any filings with a state. A general partnership is formed whenever two or more persons co-own a business for profit.[8] As such, general partnerships can be created by default.[9] The main characteristics of general partnerships are: Each partner has unlimited liability with respect to the partnership; each partner has equal rights to management and control; only the partners are taxed (the partnership by default is not a separate taxable entity, though tax filings can be made to elect otherwise); the financial interest of each partner is freely transferable, but all partners need to agree in order to transfer membership in the partnership; and, lastly, general partnerships have advantages in terms of continuity, since death, bankruptcy, or withdrawal of a partner usually does not dissolve a general partnership (under the Revised Uniform Partnership Act).[10]

Limited Partnership (LP)

A limited partnership is an unincorporated business association that requires filing of a certificate of limited partnership with the state.[11] Each limited partnership must have at least one general partner and at least one limited partner.[12] The main characteristics of limited partnerships are: General partners have unlimited liability for partnership debts; while limited partners have limited liability, general partners have equal management and control rights and limited partners have no management and control rights; a limited partnership may elect not to be a separate taxable entity in order to avoid double taxation, except for publicly traded limited partnerships which are subject to corporate income taxation; partners may assign their financial interests in the partnership, but the assignee can become a limited partner only if all partners consent; and, lastly, only death, bankruptcy, or withdrawal of a general partner will dissolve a limited partnership.[13]

Limited Liability Partnership (LLP)

A limited liability partnership is an unincorporated business association that requires filing of a certificate of limited liability partnership with the state.[14] Limited liability partnership is essentially a general partnership that enables partners to limit their liability for misconduct of other partners, but each partner has unlimited liability for their own misconduct.[15] The limited liability partnership is typically used by professional partnerships, such as law firms or accounting firms, because state law restricts professional partnerships from organizing as limited partnerships. Apart from specific filing requirements and the ability to limit liability, limited liability partnerships are no different than general partnerships.

Limited Liability Limited Partnership (LLLP)

A limited liability limited partnership is an unincorporated business association that requires filing of a certificate of limited liability limited partnership with the State.[16] A limited liability limited partnership is essentially a limited partnership that enables general partners to limit their liability, just like in an LLP.[17] Apart from the ability to limit liability of general partners, limited liability limited partnerships are no different than limited partnerships.

Limited Liability Company (LLC)

Limited Liability Company is an unincorporated business association that requires filing with the State.[18] An LLC combines the benefits of partnership laws with the benefits of corporation laws. In an LLC, all of its members have limited liability, but each member can participate in management decisions, which makes LLCs very attractive.[19] On top of that, in a properly structured LLC, only the members are taxed, as the LLC may elect not to be a separate taxable entity.[20] If an LLC has only one member, it is taxed as a sole proprietorship by default, unless the member elects to have the LLC taxed as a corporation (which is rare).[21] Typically, members may assign their financial interests in the LLC, but an assignee can become a member only if all members consent, or if the LLC’s operating agreement provides otherwise.[22] It varies from State to State whether death, bankruptcy, or withdrawal of a member necessarily dissolves an LLC, and the State default rules can often be modified by the LLC operating agreement.

Corporations

A corporation is a business entity form whose existence is distinct from those that own it and/or manage it.[23] The main characteristics of a corporation are:

(1) it can be formed only by filing with the state, and filings must substantially comply with a state incorporation statute;

(2) it is a separate legal entity from its owners and/or managers and, as such, it can independently sue, be sued, contract, and hold title to corporate property;

(3) its management is heavily centralized, and those in management do not even have to be shareholders;

(4) shareholders generally have limited liability for the corporation’s debts and legal obligations;

(5) unless otherwise specified in the articles of incorporation, a corporation has perpetual existence, so death or withdrawal of a shareholder or those in management will not terminate the existence of a corporation;

(6) ownership of corporate shares is easily transferable;

(7) a corporation itself can be considered a “person” or a “citizen.” Such classification is important for corporations because “personhood” entitles corporations to many important protections provided in the Constitution of the United States of America, while “citizenship” is important for jurisdictional issues in litigation; and

(8) since a corporation is a separate legal entity, it is subject to double taxation, unless it elects to be taxed as an S Corporation (so called because it is taxed under Subchapter S of the Internal Revenue Code).[24] Under the double taxation principle based on Subchapter C of the Internal Revenue Code, the income of the corporation itself is directly taxed, and corporate profits are taxed separately a second time in the hands of the corporation’s owners once they are distributed.[25]

S Corporations

In order to become an S corporation, a corporation must submit specific forms to the Internal Revenue Service signed by all the shareholders (Form 2553 Election by a Small Business Corporation).[26] Becoming an S Corporation allows corporations to avoid double taxation on the corporate income by passing corporate income to their shareholders for federal tax purposes (it also enables a corporation to pass losses, deductions, and credits to their shareholders).[27] In essence, becoming an S corporation enables corporations to be taxed as a partnership. The corporation must meet the following requirements in order to qualify for S Corporation status:

(1) it must be a domestic corporation;

(2) it must have only allowable shareholders, who may be individuals, certain trusts, and estates, but may not be partnerships, corporations or non-resident alien shareholders;

(3) it cannot have more than 100 shareholders;

(4) it must have only one class of stock; and

(5) it must not fall into an ineligible corporation category, such as certain financial institutions, insurance companies, and domestic international sales corporations.[28]

 


Footnotes

[1] Richard A. Mann & Barry S. Roberts, Smith’s & Roberson’s Business Law 668-670 (15th ed. 2012).

[2] Roger Meiners, Al H. Ringleb, & Frances L. Edwards, The Legal Environment of Business 368 (11th ed. 2011). 

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id. at 368.

[8] Revised Uniform Partnership Act (“RUPA”) § 101(6).

[9] RUPA § 202.

[10] Mann & Roberts, supra note 1, at 598.

[11] Revised Uniform Limited Partnership Act (“RULPA”) 201.

[12] RULPA § 101(7).

[13] Mann & Roberts, supra note 1, at 645-650.

[14] RUPA § 1001(c).

[15] Mann & Roberts, supra note 1, at 654.

[16] Id.

[17] RULPA § 102(9); RULPA § 404(c).

[18] Meiners, Ringleb, & Edwards, supra note 2, at 380-383.

[19] Id.

[20] Id.

[21] Id.

[22] Id.

[23] Mann & Roberts, supra note 1, at 668-670.

[24] Id.

[25] Constance E. Bagley & Craig E. Dauchy, The Entrepreneur’s Guide to Business Law 56-58 (4th ed. 2011).

[27] Id.

[28] Internal Revenue Code § 1361(b).