Forming a Corporation-Corporations vs. LLCs vs. Partnerships
Forming a Company; What Kind of Business Do I Use?
Corporations vs. LLCs vs. Partnerships
The most frequently asked questions we receive from our clients is “what type of corporate entity do I need for my business? Is it ‘better’ to form a Corporation, LLC or Partnership?” Many factors determine the answer to that question and the answer is specific to every business and its particular circumstance, priorities and goals. While one client cares mostly about an owner’s tax treatment, another client might care mostly about start-up filing costs or which state or country’s laws gives more favorable rights to management or ownership. That’s why it’s wise to evaluate your needs and the alternatives with your lawyer and accountants (we’re glad to suggest a qualified law firm or accountant if you don’t yet have one).
So while intuitively it may seem like one kind of business entity always would be better than any other, this really isn’t the case. While business types have evolved over the years, and some are even more popular at particular times in history, all have their functions—their strengths and weaknesses—and are in use today. As you think about forming a company, think about which of these broad types it might best fit into.
Forming a Corporation—What is it?
Corporations have been the most conventional entity historically. In the eyes of the law, a corporation is considered a person separate and distinct from its owner(s), created by the actions of its creators. Because of this, any liability of the corporation is generally limited to the money or other assets that the corporation has and not to those of its owners—because the corporation is liable for its actions as if it were a person separate and distinct from its owners. In other words, forming a corporation creates an entity that is separate from its owners and can be liable for its actions without necessarily making the owners liable too. Thus, simply stated, the corporation can in most cases shield its owners from the actions taken by the corporation. Further, because a corporation is considered a separate person, its income is taxed like anyone else’s would be (of course at a separate rate set for corporations as opposed to individuals). The bad news about forming a corporation here is that the corporation’s income, when it’s distributed to the owners, is taxed again as personal income to those owners. This is often referred to as “double taxation” because as separate legal persons, both the corporation and its owners must each pay taxes on their incomes. But when you think about it, this is logical and consistent with the idea that the corporation is being treated as a separate person acting on its own behalf, since all people have to pay taxes.
When forming a corporation it’s helpful to understand the basic mechanics of the entity. The owners of a corporation are called “shareholders.” Shareholders own units of the corporation called shares of “stock” signifying an ownership interest in the proportional share of the corporation’s profits and assets. Corporations can have different categories of stock each with different rights or different owners with different amounts of stock or that own the different types of stock. The corporation’s shareholders generally have the power to elect the people who run the corporation itself—its directors and officers. The corporation is formed by filing “Articles of Association” with the state or country in which it is formed. The corporation also has “By-Laws” which describes the rules and regulation of a corporation’s management. Some jurisdictions require that the owners and/or officers be publicly available while others do not.
Corporate and related law applies to businesses which have formed corporations and continues to develop on the fundamental themes mentioned here. One such development has given one the choice of forming an S Corporation versus a C Corporation. The S corporation is a relatively recent version of the corporation developed in tax law. When the corporation is incorporated, a filing can be made with the IRS indicating that the owners want it to be an “S Corporation.” Forming an S Corporation enables the corporation to avoid double taxation (meaning that both the corporation and its owners pay taxes on their incomes) by being treated differently just for the purposes of paying taxes. In order to receive the benefits of forming an S Corporation, the filers need to agree to restrictions on the corporation—such as the types of stock, types of owners and the like—and as a result the IRS allows the C Corporation’s income to “flow through” to its owners instead of being taxed both at the corporate level and the shareholder level.
Whether forming a C Corporation or forming an S Corporation, the corporation acts a legal person separate from the owners, liability to the owners is limited to the amount of money (or other assets) the owners have contributed in return for their stock ownership, meetings are held and officers are elected so that the corporation can do its business and act on its own behalf. Forming a C Corporation versus an S Corporation is a choice one should make considering the business owners’ specific tax objectives and corporate goals.
Forming a Partnership—What is it?
Forming Partnerships is an idea probably as old as corporations, and in many states they can be created by the owner’s actions when intended, and sometimes when unintended, without filing papers with anyone. In a regular General Partnership, unlike in corporations, the partners are liable for their own actions, those of the partnership, and also responsible for the actions of their partners (unless limited by the partnership agreement) up to what they have contributed for their ownership and more.
In the simplest case, forming a partnership is where you and a partner contribute money or other assets to start a business—let’s say s/he contributes 60% and you contribute 40%. So you agree that s/he can receive 60% of the profit, if any, and you’re entitled to your 40%. You both manage the business and make decisions together as you go. If one of you needs to contribute more money, you just negotiate and change the understanding.
Unlike when forming a corporation, any profits distributed by the partnership are not taxed at the partnership level since the partnership is not a separate person in the eyes of the law—instead, any money earned “flows through” directly to the partners themselves as income upon which they must pay their taxes. This makes sense since the partners whom formed a partnership are acting together more as individuals and not really intending to create a separate legal entity to keep all of their profits. And because of that all the profits are going directly to the partners themselves—as additional income for the purposes of their own taxes—and is not subject to the double taxation that we saw with forming corporations. Absent any additional arrangement, if you and your partners are ever sued for any of your actions, then you can both be liable up to what you have contributed to your partnership, and often very likely more, since you were acting together as individuals. And this makes sense since you were both representing this business together in a simple partnership where your actions are its actions, and its money is your money and vice versa.
As with corporations, new types of partnerships have evolved to limit some liability for certain partners in a partnership. For example, a groups may now form a Limited Partnership, which requires a formal filing, where a partner is permitted to limit his or her liability to the amount invested—but then requires that that person not be involved in the day-to-day management of the partnership—while most day to day responsibilities and powers and the bulk of the liability remains with the general partner. Further, while a partnership can be created merely by the actions of the owners, it is best to create a partnership formally to address different scenarios up-front to avoid any problems later—and Limited Partnerships and other varieties so require formal filings for their creation. At its heart, forming a partnership and operating it meant to be straightforward—two or more people are acting together for their own benefit, and they are not seeking to incorporate a more complex entity with all of the requirements that that usually entails. A partnership can be formed formally or deemed to have been formed by the actions of the partners. Some specific types of partnerships, like Limited Partnerships, require that specific paperwork be filed in order to be formed. In this instance, these partnerships would have a “Partnership Agreement” describing the rules and rights and responsibilities of the relevant categories, if more than one, of the partners.
Forming a Limited Liability Company—What is it?
The most recent and perhaps flexible entity to develop out of corporate and partnership law is the Limited Liability Company (“LLC”). This corporate form is perceived to be versatile by many because it combines beneficial features of the corporation and partnership along with favorable rules regarding the owners and their agreement amongst themselves. For instance, the LLC has the corporation’s qualities of being a separate legal person providing its owners with limited liability and the partnership’s quality of pass-through taxation. The LLC also even permits there to be only one owner who operates this entity while they’re protected from liability since the LLC is considered an entity separate from its owner(s).
Similar to shareholders in a corporation, an LLC has owners which are called “members” who own “units.” The LLC has a managing member(s) to manage the entity’s operations and an “Operating Agreement” which is the document regulating the rights and responsibilities of the members. The LLC is a entity formed formally by filing documentation with the state according to the laws required in that state. These laws can vary meaningfully which is why it’s worthwhile to consult a knowledgeable lawyer and accountant. The rules regarding ownership of an LLC can be versatile, with few restrictions on the types of owners and how it can be owned. And its income generally passes through to its members without being taxed at the company level.
Final Words on Corporations vs. Partnerships vs. Limited Liability Companies
No matter which entity you choose, the success of your business begins with selecting the appropriate corporate entity. There are many factors that business owners should consider when selecting a corporate form for their business. It’s helpful if an owner first has a vision of how his company will operate and its specific goals. We have outlined several corporate forms here with some of the basic information distinguishing each. It’s also prudent to consult a lawyer and accountant to select the best type of entity and location in which to form it. There are many details and entities to understand and choose from when incorporating a company, but we’re glad to help you through the formation process to ensure that your business pushes off with the strongest start!