By Thomas S. Cullen, published on September 4, 2004, in Savannah Morning News.
One of the initial decisions facing someone starting a business is choosing the appropriate entity for the business.
Too many times, this decision is either not made at all, delayed until “the business is big enough” or made without any thought about the types of entities available or the advantages and disadvantages of each option.
There are four types of entities under Georgia law: sole proprietorship, partnership, corporation or limited liability company.
A sole proprietorship is owned and managed by one individual. It is not separately taxed by the IRS, so all income or losses of the business are treated as income or losses of the owner.
The owner is personally liable for the business’ liabilities (i.e. a creditor of the business can sue the owner individually).
The owner’s interest in a sole proprietorship is an interest in the business’ assets; therefore, a sole proprietor cannot transfer his interest in the business but can only sell the underlying assets.
There are several types of partnerships: general partnerships, limited partnerships, limited liability partnerships and limited liability limited partnerships.
A general partnership is a similar to a sole proprietorship but with more than one owner. The partners own and manage the business.
Like a sole proprietorship, all income or losses of the business are treated as income or losses of the partners in proportion to their partnership interests. Each partner is personally liable for the liabilities of the business.
A partner cannot transfer his interest in the partnership and the partnership ceases to exist upon the death or withdrawal of any partner. A limited partnership is a general partnership with general partners and limited partners. The general partners manage the business and are personally liable for the partnership’s liabilities.
The limited partners should be silent investors who have no role in the management of the partnership and are not personally liable for partnership liabilities. The partnership may continue to exist after the death or withdrawal of any limited partner, but not of a general partner.
A limited liability partnership is a general partnership in which the partners are not liable for the liabilities of the partnership. A limited liability limited partnership is a limited partnership where the general partners are not personally liable for the liabilities of the partnership.
A corporation is a separate legal entity owned by one or more shareholders.
The shareholders elect a board of directors, that elects officers to manage the corporation.
Shareholders may transfer their shares in a corporation, subject to applicable federal and state securities laws and any agreements among the shareholders. The death of a shareholder does not affect the existence of a corporation.
None of the shareholders is liable for the corporation’s liabilities; provided the corporation complies with certain requirements and formalities. For federal income tax purposes, there are two types of corporations: subchapter “C” corporations and subchapter “S” corporations.
A “C” corporation is taxed as a separate legal entity by the IRS. Any dividends paid by the corporation to its shareholders are taxed twice (once inside the corporation on its income and again outside the corporation on the amount of dividends paid to the shareholders).
A subchapter “S” corporation is a corporation that has elected to be taxed as a partnership, therefore, the income of a subchapter “S” corporation will only be taxed once. To qualify as a subchapter “S,” the corporation must have 75 or fewer shareholders, the owners generally must be United States citizens and residents, and the corporation must only have one class of stock.
Limited liability company
A limited liability company combines elements of a subchapter “S” corporation and a partnership.
The owners of the interests in a limited liability company are not personally liable for the liabilities of the business. A limited liability company can be managed either by its owners or by managers elected by the owners.
A limited liability company can be taxed, in the discretion of its owners, as a corporation, an “S” corporation or a partnership. The owners of a limited liability company can freely transfer their ownership interests, subject to applicable federal and state securities laws and any agreements among the owners.
Determining the type
In deciding which entity is most appropriate for a business, the owner must determine:
- The number of owners of the business
- Who will manage it and what management rights the owners will have
- If some owners will have different rights than other owners (such as guarantied returns on investments, preferred distributions or liquidation preferences)
- What risks are involved with the business and whether the owners are willing to risk their personal assets in connection with the business.
In addition, the business owner should consider the tax implications to the business and its owners with respect to each potential entity. Selecting an entity is one of the first steps toward establishing a successful business. A business owner should consult with an accountant or attorney in determining the most appropriate entity for the business.