All business entities address the same basic concerns. Each has its own advantages and disadvantages and while it is impossible to discuss all of the nuances of each type of entity, this addresses several reasons people set up business entities, especially from the perspective of a small business.
Types of Business Entities
The most common forms of business entities are Sole Proprietorships, General Partnerships, Limited Partnerships (“LP”), Limited Liability Companies (“LLC”), and Corporations. Corporations also come in two forms, the S-Corporation and the C-Corporation.
Other forms of business that this we will not be discussing are the Professional Corporations and Limited Liability Partnerships.
The default business entity for an individual person is a sole proprietorship and the default business entity for more than one person is a partnership. This means that if a person opens an ice cream store without any additional legal work, the business is a sole proprietorship. If two people own the ice cream store together, they have a partnership.
This is important because if a person starts a business entity like an LLC or a Corporation, but the set up is somehow defective or incomplete; the fall back is to a sole proprietorship or a partnership, which can have serious tax consequences or asset protection consequences.
LP’s, LLC’s, and Corporations are formed by filing Articles with the Secretary of State. The owners of the new business entity execute documents governing the internal workings of the business such as a Limited Partnership Agreement, an LLC Operating Agreement, or Corporation Bylaws.
Ownership and Management
Owners of any business can run the business themselves, or they can appoint someone to run it for them. In an LLC, the LLC is run by the Manager and the owners are called Members. In an LP, the LP is run by the General Partner, and the owners are collectively called Partners. In a Corporation, the Corporation is managed by the Board of Directors (who elects a President to run the day to day operations) and the owners are called Shareholders.
A major benefit of establishing a business entity is liability protection. For a sole proprietor or a General Partnership, the owner’s personal assets can be reached to satisfy the debts of the business. Liability that arises from the operation of the business is called “inside liability.” Conversely, the assets of a sole proprietor can be reached by creditors of the owner for personal debts. Liability that arises from the owners actions apart from the operating a business (like car accidents or personal guarantees) is called “outside liability.” Business entity structures help manage these two liability risks.
Both Corporations and LLC’s provide limit inside liability. In other words, a Corporation or an LLC protects the owner’s personal assets from business liability.
However, a Corporation does not provide outside liability protection—the LLC does.
Limited Partnerships fall somewhat in between. In a Limited Partnership, there are at least two owners, the General Partner, who has no inside liability protection, and the Limited Partner, who is afforded inside liability protection. In other words, if a business liability arises, the General Partner is subject to all the liability while the Limited Partner is not. The Limited Partnership provides outside liability protection just like an LLC, so the business itself is protected from the liabilities of the owners of the Limited Partnership.
All business entities are taxed as one of the following:
- Sole Proprietor (1040) *default
- Partnership (1065) *default
- S-Corp (1120S)
- C-Corp (1120)
An important issue to remember when trying to understand business taxation is that the laws for tax purposes do not always reflect the state law purposes. They’re simply not identical. For example, an LLC with only one owner (“ Single Member LLC ”) is a separate entity from its Member/Owner. In a lawsuit, the Single Member LLC can be sued, while the Member is not, and vice versa. The Single Member LLC can even have its own Taxpayer ID number, however, for income tax purposes, the Single Member LLC can be completely disregarded and all of it’s income would be reported directly on the Member’s 1040 Tax Return. In other words, for state law, the LLC exists, for tax purposes, it doesn’t.
A sole proprietor 1040 reports its income on Schedule C for active businesses and Schedule E for rental properties. With a few exceptions, any business that is not a rental business would be considered an active business. When a person does business under a “DBA” or “Doing Business As,” if they haven’t set up a business entity, then that DBA falls under the sole proprietor 1040 category. By default, a Single Member LLC is taxed a sole proprietor 1040. When this occurs, the Single Member LLC is said to be “disregarded” and it does not file it’s own tax return.
A partnership (1065) is a “flow through entity” meaning that any income generated by the partnership is reported by the partnership, but then “flows” to the partners’ tax returns. The partnership itself does not pay any tax, it merely reports how much it made and who the partners are who will be paying the tax on that income. By default, any time two persons engage in business, the business will be taxed as a partnership unless it takes action to be taxed an S-Corporation 1120S or a C-Corporation 1120.