Choosing the type of business entity that’s right for your business is a difficult decision yet one of the most important decisions involved in the start-up phase of a business. The type of entity you choose has a direct impact on the way your business will pay taxes, the method you’ll use to draw profits from the business and the extent of personal liability for debts and obligations of the business. The information below should help you decide which type of business entity is right for your business however it is recommended that you consult with an attorney and an accountant to discuss these matters before opening your business.
Sole Proprietorship
This is the easiest and least costly method of starting and operating a business. You can form a sole proprietorship by finding a location and opening the door for business. The new sole proprietor would be wise to check the availability of the name he plans to use for the business with the Corporation Bureau and to file a fictitious name registration. A sole proprietor may not operate a business under any name other than his surname without registration. It would also be prudent to check local business registration and licensing requirements as well as local zoning requirements governing the location of the business operations.
The temptation to operate as a sole proprietorship is great and many succumb. The shortcomings of this form of business are great as well. There is absolutely no liability protection between a sole proprietor and his business and there are no tax benefits. Although there are no particular record keeping requirements, it often leads to sloppy business practices. Sloppy business practices can lead to poor decision making and sets up failure. At the very least, the sole proprietor becomes vulnerable to an IRS audit and lawsuits. Planning, at the beginning, can save you money on an ongoing basis and protect the assets that you have worked so hard to accumulate.
Partnership
There are several types of partnerships. The most common types are general partnerships, limited partnerships and limited liability partnerships. A general partnership can be formed simply by an oral agreement between two or more persons, but a written partnership agreement is highly recommended and invaluable in resolving disputes. As with a sole proprietorship, the partners of a general partnership should check the availability of the name they plan to use for the partnership with the Corporation Bureau and the partnership is not permitted to operate a business under any name other than the surnames of the partners without filing a fictitious name registration.
Also, as with a sole proprietorship, a general partnership affords no liability protection to a partner’s personal assets. As a result, it is possible to hold a general partner personally responsible for the debts of the partnership. In addition, partners are responsible for the other partner’s business actions, as well as their own. A Partnership Agreement should include the following:
- Type of business
- Amount of equity invested by each partner
- Division of profit or loss
- A Partner’s compensation
- Duration of partnership
- Restrictions of authority and expenditures
- Dispute settlement clause
- Partnership valuation provisions
- Buyout in case of death or incapacity
- Provisions for changes to the partnership
- Provisions for dissolution and distribution of assets
Corporation
A corporation is a separate legal entity and carries with it limited liability protection for its owners or shareholders. Liability is generally limited to an owner’s investment in the corporation. As a result, an owner cannot usually be held responsible for the debts of the corporation. A corporation is formed by filing Articles of Incorporation with the Department of State. Shares of stock are issued to the shareholders, Bylaws are adopted, and a board of directors is elected. Control of the corporation depends on stock ownership. Persons with the largest percentage of share ownership, not the total number of shareholders, control the corporation. With control of stock shares or 51 percent of stock, a person or group is able to make policy decisions.
Control is exercised through regular board of directors’ meetings and annual shareholders’ meetings. The board of directors manage the corporation and appoint officers (president, secretary, treasurer) to supervise the ongoing daily affairs of the corporation. The laws require that regular director and shareholder meetings be held at least once a year, minutes of those meetings be kept, and any decisions made at those meetings be formalized in the form of written resolutions. Small, closely-held corporations can operate more informally, but record-keeping cannot be eliminated entirely. Failure to maintain these records will jeopardize the corporate status and leave the shareholders vulnerable to personal attack and responsibility for tax liability and corporate debt. Officers of a corporation can be liable to shareholders for improper actions. Liability is generally limited to stock ownership, except where fraud is involved.
What should you do?
You may want to incorporate as a “C” or “S” corporation. The “C” corporation is a tax-paying entity. Double taxation is a potential negative feature as there are taxed on earnings at the entity level and then again when distributed to the shareholders as dividends. The “S” corporation is formed by making a special IRS election. Pennsylvania also requires the filing of a special election for Pennsylvania “S” status. When properly made and maintained, these elections allow “flow-through” taxation treatment (profits and/or losses are passed directly through to the shareholders and not taxed at the entity level) similar to that which partnerships and limited liability companys enjoy. An “S” corporation is limited to 75 shareholders and they cannot be corporations, nonresident aliens, general or limited partnerships, pension plans, charitable organizations or certain trusts.
It is highly recommended that the shareholders enter into a written “Buy – Sell” Agreement or “Shareholders'” Agreement to provide for certain restrictions on the transfer of the stock of the Company by a shareholder, and to provide for certain options and obligations upon the termination of employment of a shareholder, the voluntary withdraw of a shareholder or the death or disability of a shareholder.
Statutory “Close” Corporation
A Statutory “Close” Corporation (“SCC”) is a closely- held corporation that elects “Close” corporation status. A closely held corporation is a business corporation with no more than 30 shareholders and is generally characterized as a corporation that lacks of any ready market for the corporation’s stock and substantial participation by the majority shareholder in the management, direction and operations of the corporation exists.
The primary advantage of a SCC is that it allows the shareholders to agree to manage the internal operations of the corporation as if it were a partnership. The result is that shareholders are permitted to manage the affairs of the corporation directly, thereby disposing of the need to conduct elections for directors at shareholder meetings. The statute recognizes the realities of many closely-held corporations in which there is a relaxation, or even total disregard, of corporate formalities. Such disregard, in the absence of statutory protection, is a substantial factor. Courts rely on this factor in deciding whether to hold shareholders personally liable for corporate acts.
In addition, the statute provides standard shareholder protections such as prohibitions on free transferability of shares, higher shareholder voting requirements necessary to make fundamental changes (i.e. amending articles or merging or dissolving the corporation) and mandatory buyout provisions for the estate of a deceased shareholder, protections that, in the absence of a SCC election, would not exist without a “Buy – Sell” or “Shareholders'” Agreement.
A SCC is permitted to make elections under the Internal Revenue Code and the Pennsylvania Revenue Code. Therefore, it is to be taxed as an “S” corporation.
Professional Corporation
A professional corporation is a business corporation with built-in limitations. The limitations require that only licensed persons are authorized (but not required) to render professional services by means of a professional corporation in all cases. Examples of professionals required to be licensed in Pennsylvania include but are not limited to personal services rendered as an architect, professional engineer, physician, certified public accountant and attorney. It is important to note that the specific occupation of the professional considering professional incorporation as well as the licensing law. They may constrain the choice of entity.
The professional corporation acts just like a business corporation with respect to insulating shareholders from nonprofessional liability. In addition, a professional corporation protects shareholders from personal liability for claims related to a co-shareholder’s negligence, error, omission, incompetence or malfeasance while rendering professional services on behalf of the corporation. A professional corporation, however, will not protect a shareholder for his own professional negligence or the professional negligence of a co-shareholder under his or her direct supervision and control.
A professional corporation is permitted to make elections under the Internal Revenue Code and the Pennsylvania Revenue Code to be taxed as an “S” corporation. Caution is in order for a professional corporation that does not elect Internal Revenue Code “S” status since certain personal service corporations are denied the benefit of progressive tax rates generally available to other corporations.
Limited Liability Company
The limited liability company (“LLC”) is a relatively new form of doing business. It is NOT a corporation, it is NOT a partnership and it is NOT a sole proprietorship. An LLC is a blend of some of the best characteristics of corporations, partnerships and sole proprietorships. It is a separate legal entity and like a corporation, no member is personally liable for the company debts. For tax purposes, it is entitled to be treated as a partnership. It therefore carries with it the “flow through” tax benefits that C corporations do not have. It is very flexible and simple to run and, like a sole proprietorship, there is no statutory necessity to keep minutes, hold meetings or make resolutions that can trip up many corporation owners.
The owners of an LLC are not referred to as shareholders or partners, rather they are referred to as MEMBERS. The members can be virtually any entity including individuals (residents or foreigners), corporations, other LLCs, trusts, pension plans etc. Pennsylvania permits single member LLCs which can elect to be taxed as either a sole proprietorship or as a corporation. A husband and wife are considered two members for formation purposes.
An LLC is formed by filing a Certificate of Organization with the Department of State. In addition, the members must agree as to how the affairs of the LLC will be managed. This may be accomplished simply by an oral agreement between the members; however, a written agreement is highly recommended and invaluable in resolving disputes. The written agreement is known as an “Operating Agreement”. It should include provisions restricting transfers of a member’s interest, electing partnership tax treatment as well as other similar provisions.
Limited Partnership
In a Limited Partnership, one or more “general” partners manage the business while “limited” partners contribute capital and share in the profits but take no part in running the business. General partners remain personally liable for partnership debts. Limited partners incur no liability with respect to partnership obligations beyond their capital contributions. The purpose of this form of business is to encourage investors to invest without risking more than they have contributed.
Setting up and operating a limited partnership are very similar to that of starting a small, for-profit corporation. Pennsylvania requires the filing of a Certificate of Limited Partnership with the Department of State. There are statutory requirements as well that apply restrictions on the use and availability of partnership names, rules regarding the manner of calling and holding meetings, voting and many other corporation-like requirements.
Death, disability, or withdrawal of the sole remaining general partner dissolves the partnership. This is unless the partnership agreement provides otherwise or a majority of partners agree, in writing, to substitute a general partner. We recommend a written limited partnership agreement governing rights, powers and liabilities. This would be invaluable in resolving any disputes. Death or incompetence of a Limited Partner however has no effect on the partnership.
Limited Liability Partnership
A limited liability partnership (“LLP”) is a form of general partnership. It provides an individual partner protection against personal liability for certain partnership obligations.
The LLP is essentially a general partnership in form, with one important difference. This is unlike a general partnership, in which individual partners are liable for the partnership’s debts and obligations. An LLP provides each of its individual partners protection against personal liability for certain partnership liabilities. Specifically, it protects partners from personal liability for claims related to a co-partner’s negligence, error, omission, incompetence, or malfeasance.
Registration as an LLP is required in Pennsylvania and is effected by filing a written statement of registration. Department of State sets forth the name and principal office address, a statement that the partnership is registering as a limited liability partnership and a statement that the registration has been authorized by at least a majority of the partners.
On an annual basis, Pennsylvania requires the filing of a certificate of annual registration. This is accompanied with an annual registration fee equal to a base amount times the number of general partners.
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