Introduction

If you are starting a business (by yourself or with others) and trying to figure out whether a limited liability company (LLC) or corporation will best meet your needs, this book will help you make the right choice. If you have already organized your business but want to explore the possibility of converting to a business entity with more favorable legal and tax characteristics this book will help you make an informed decision.

Although the focus of this book is on choosing whether to form an LLC or a corporation, you cannot make an informed decision without learning about all the types of business entities -- including sole proprietorships, partnerships, LLCs, and corporations. this book explains the legal and tax characteristics of each of these business entities and the basic rules for converting one type of business to another. This book also provides information about some of the less well known entity ways of structuring a business. For example, two legal spin-offs of the basic partnership form -- the limited partnership and the registered limited liability partnership -- are discussed in this chapter. This book also covers S corporations, which have some characteristics of the more well known C corporation (including limited liability) but are taxed like a partnership.

The book is divided into two parts. Part One, Understanding Business Entities, discusses basic information about each type of business entity. It includes the following chapters:

• Chapter 1 discusses each type of business entity, including the relative advantages and disadvantages of each.
• Chapter 2 explains how your choice of entities affects your personal liability for debts against your business.
• Chapter 3 examines the relative ease with which each of the entities can be formed and managed.
• Chapter 4 covers how each entity deals with profits, losses, investments, and taxes.
• Chapter 5 explains how doing business out of state may affect your choice of entity.

Part Two, Converting or Modifying Your Business Entity, includes the following chapters:

• Chapter 6 discusses converting a sole proprietorship to another entity.
• Chapter 7 discusses converting a partnership to another entity.
• Chapter 8 discusses converting a limited liability company to another entity.
• Chapter 9 discusses converting a corporation to another entity, and reorganizing or dissolving a corporation.
• Chapter 10 provides examples of various conversion scenarios discussed in previous chapters.

This book also includes each state's corporate and LLC website information (in the appendix).

Although business law and tax rules can get a bit complicated, don't worry: they're presented here in real-life contexts, without off-putting legal or tax jargon, and without the technicalities best left to legal and tax professionals. You'll also find an array of resources, including books and websites that will help you figure out the ideal entity type for your business. By the time you finish this book, you'll understand what each type of entity has to offer, and you'll be ready to choose the right structure for your company.

Why Your Choice of Entity Matters

Do you really have time to read this book? Shouldn't you be devoting more time to your accounting, your competition, your overhead, or your business plan? After all, as Calvin Coolidge once said, "The chief business of the American people is business" -- so why not hire a lawyer to advise you about your legal form, put down this book, and get back to work?

Here are three reasons why you need to learn more about the various legal forms your business might take:

• You're making a business decision. Your ability to raise capital, defend your rights, survive business taxation, or manage your company efficiently is all tied to your choice of business entity. In other words, your decision about what type of business entity to form can be as crucial to your business success as your marketing, hiring, or sales decisions. The only way you can be sure you're on the right course, even if you hire a lawyer, is to understand the legal and financial basics of each business structure.
• You'll save money. Hiring a lawyer can be helpful, particularly if there are disputes among multiple owners of a business. But hiring a lawyer can also be expensive or unnecessary. If you take the time to read this book, you can save money and make a reasoned decision about your choice of entity. You can also save money by using products or services that specialize in business formation.
• You'll keep your options open. Every growing business changes its form of entity. Most start as sole proprietorships or partnerships and then evolve into corporations or LLCs. The business entity you choose today may affect your choice of entity in the future. In other words, you're not just picking a business form; you're plotting a business strategy. The more information you have, the better equipped you will be to plot the right course.

Now that you know why this is an important decision, it's time to learn some basic information about each type of business entity.

Sole Proprietorships

The simplest way to be in business for yourself is as a "sole proprietor." This is just a fancy way of saying that you are the owner of a one-person business. There's almost no cost or bureaucratic red tape involved in forming a sole proprietorship, other than the usual license, permit, and other regulatory requirements that your state and/or locality imposes on any business. And you don't have to do anything to create a sole proprietorship: If you start a one-person business and don't form a corporation or LLC, you have created a sole proprietorship, and that's how the state and the IRS will treat your business.

As a practical matter, most one-person businesses start out as sole proprietorships just to keep things simple.

EXAMPLE: Winston is a graphic artist who started a sideline computer graphics business in his garage. Winston works only part time in his own business and has no employees. He has just a couple of clients and no pressing personal liability issues, so he chooses to operate as a sole proprietor (his other choices would be to form an LLC or a corporation). Outside of a business license, fictitious name filing, and tax permit, Winston does not need to file any legal paperwork. Unless Winston takes steps to change the legal structure of his business -- by filing the necessary papers with his state to form a one-person LLC or corporation -- his business will automatically be classified and treated as a sole proprietorship.

Number of Owners

By definition, a sole proprietorship has only one owner. If your one-person business grows and you wish to include other owners, you will need to choose another business structure, such as a partnership, LLC, or corporation.

Liability for Business Debts

Unfortunately, although forming and running a sole proprietorship is simple, it can also be risky. That's because sole proprietors are 100% personally liable for all business debts and legal claims. For example, if someone slips and falls in a sole proprietor's business and sues, the owner is responsible for paying any resulting court award (unless commercial liability insurance covers it). Similarly, if the business fails to pay suppliers, banks, or bills from other businesses, the owner is personally liable for the unpaid debts. This means that the owner's personal assets, such as his or her bank accounts, equity in a house or car, and other personal assets can be taken by court order and sold to repay business debts and judgments.

Of course, some businesses are much more vulnerable to debts and lawsuits than others. If you run a part-time business that does not operate on credit and is unlikely to engender lawsuits, you probably don't need to worry about these issues. (Chapter 2 provides more information about personal liability.)

Income Taxation

Sole proprietors report their business profits or losses on IRS Schedule C, Profit and Loss From Business (Sole Proprietorship), which they file with their 1040 individual federal tax returns. The owner's profits are taxed at his or her individual income tax rate. This is called "pass-through" taxation because the income passes through the business to the owner's individual tax return. In other words, like a partnership, a sole proprietorship is not taxed separately under the federal tax scheme.

Most startup business owners prefer pass-through taxation of their business income, at least in the beginning. Why? reporting and paying individual income taxes by preparing a Schedule C (and a Schedule SE for self-employment tax) is a lot easier than preparing a corporate tax return or dealing with partnership income taxes.

Because sole proprietors are self-employed, they have no employer to chip in part of their Social Security and Medicare taxes (called "self-employment taxes" for those working for themselves and "Fica taxes" for regular employees). Regular employees generally pay half of these taxes through payroll deductions, and the employer pays the other half. Sole proprietors must pay the entire amount themselves (by preparing Schedule SE, Self-Employment Tax Return, which must be filed along with a Schedule C and 1040 income tax return each year).

Although this might seem like a disadvantage of forming a sole proprietorship, it actually isn't. If that same sole proprietor had instead formed a one-person corporation, he or she would personally pay half of the tax and the corporation would pay the other half. The money would come from two different sources, and the tax reporting requirements are different, but the whole amount still ultimately comes out of the owner's pocket.

Unincorporated business owners can deduct the cost of health insurance. Current federal tax law allows sole proprietors, partners, and LLC owners who work as employees in their business to deduct the full cost of health insurance premiums paid out by their business for themselves and the other employees in the business. This tax break -- formerly only available to corporations -- is now available to unincorporated business owners who work in their business.

General Partnerships

A partnership is a business in which two or more owners agree to share profits (and losses). If you go into business with at least one other person, you have automatically formed a general partnership -- even if you never signed a formal partnership agreement. A general partnership really can be started with a handshake (although it makes far more sense to prepare and sign a written partnership agreement -- see "create a Written Partnership agreement," below).

EXAMPLE: Two Web designers set up a side business to design websites for nonprofit organizations. They are too busy working to bother thinking about the best business structure for their new sideline business. Without taking any formal action or creating a partnership agreement, they have formed a partnership. If the partners were to have a dispute -- over the division of profits, perhaps -- in the absence of an agreement, state partnership law would control the outcome. Once they realize that their informality might subject them to rules that are not of their choosing, they decide to prepare a written partnership agreement.

Number of Partners

General partnerships may be formed by two or more people; by definition, there is no such thing as a one-person partnership. Legally, there is no upper limit on the number of partners who may be admitted into a partnership, but general partnerships with many owners tend to have problems reaching a consensus on business decisions and may be subject to divisive disputes among contending management factions. In larger partnerships, one or more partners may be designated as managing partners to eliminate day-to-day bickering, but delegating authority to a select group of managing partners is rare in small business partnerships. Why? because doing so can be risky for the nonmanaging partners -- who, by definition, won't be keeping a close eye on the business, but will still be personally liable for partnership debts. So, to minimize risks and keep all the partners honest, all general partners usually take an active hand in management.

Personal Liability for Business Debts

Each partner is personally liable for all business debts and any claims (including court judgments) against the partnership that the business can't pay. For example, if the business fails to pay its suppliers, the partners are personally responsible for paying these business debts and may have to mortgage their houses, sell their cars, and empty personal bank accounts to come up with the necessary cash.

And creditors don't have to respect the partners' internal arrangements about who owns what percentage of the company's assets or who is responsible for what share of the partnership's debts. If the business owes money it can't pay, the creditor may go after any general partner for the entire debt, regardless of his or her partnership ownership percentage. (If this happens, the partner who is sued can in turn sue the other partners to force them to repay their shares of the debt, but this can be costly and time-consuming.)

Personal liability for business debts is even more worrisome, because each general partner may bind the entire partnership (and all of the partners) to a contract or business deal. In legal jargon, each partner is an agent of the partnership, with the right to undertake obligations on its behalf. (Fortunately, there are a few significant limitations to this agency rule -- to be valid, a contract or deal must generally be within the scope of the partnership's business, and the outside person who makes the deal with a partner must reasonably think that the partner is authorized to act on behalf of the partnership.)

If a partnership can't fulfill a valid contract or other business deal, each partner may be held personally liable for the amount owed. This personal liability for the debts of the entire partnership, coupled with the agency authority of each partner to bind the others, makes the general partnership riskier than a sole proprietorship (where only the proprietor can legally bind the business) and far riskier than entities such as LLCs, corporations, and limited partnerships, which offer at least some of the owners limited personal liability for business debts.

General Partnership Income Taxation

Like a sole proprietorship, a general partnership is treated as a pass-through tax entity. The profits (and losses) pass through the business entity to the partners, who pay taxes on any profits on their individual returns at their individual tax rates.

Partnership taxation is more complicated than sole proprietorship taxation, however, and most partnerships of any size will likely need a tax adviser who understands partnership tax and procedures. Although a partnership does not pay its own taxes, it must file an informational return each year, IRS Form 1065, U.S. Partnership Return of Income. In addition, the partnership must give each partner a filled-in IRS Schedule K-1 (Form 1065), Partner's Share of Income, Credits, and Deductions, which shows the proportionate share of partnership profits or losses each person carries over to his or her individual 1040 tax return at the end of the year.

Each partner must pay taxes on his or her entire share of profits, even if the partnership chooses to reinvest the profits in the business rather than distributing all of them to the partners. The technical way of saying this is that the partners are taxed on their "allocated" profits, not on their "distributed" profits.

What about self-employment (Social Security and Medicare) taxes? Although general partners are not considered employees of the partnership, they must pay self-employment taxes on their share of partnership income.

Self-employment tax rules may change. Partners, LLC members, and S corporation shareholders can be treated differently when it comes to self-employment taxes, even though they are all owners of pass-through businesses. To deal with this inconsistency, the U.S. Treasury Department has been trying to revamp the entire self-employment tax scheme to make it apply uniformly to all of these entities. So far, final regulations have not been adopted, but everyone in the tax field expects an eventual change in how the self-employment tax rules apply to all multiowner pass-through taxentities: partnerships, LLCs, and S corporations alike. Ask your tax adviser for the latest information.

Limited Liability Companies (LLCs)

The limited liability company (LLC) is the newest kid on the block of business organizations. It has become popular with many small business owners, in part because it was custom-designed by state legislatures to overcome limitations of each of the other business forms -- including the corporation. Essentially, the LLC is a business ownership structure that allows owners to pay business taxes on their individual income tax returns like partners (or, for a one-person LLC, like a sole proprietorship), but that also gives the owners the legal protection of personal limited liability for business debts and judgments as if they had formed a corporation. So, an LLC provides both pass-through taxation of business profits (like a partnership) and limited personal liability for business debts (like a corporation).

EXAMPLE: Barry and Sam jointly own and run a flower shop, Aunt Jessica's Florals, which specializes in unique flower arrangements. Lately, business has been particularly rosy, and the two men plan to sign a long-term contract with a flower importer to supply them with larger quantities of seasonal flowers. Once they receive the additional flowers, they will be able to create more floral pieces and wholesale them to a wider market. Both men are sensitive to the fact that they will encounter more risks as their business grows. They decide to protect their personal assets from business risks by converting to an LLC. They could accomplish the same result by incorporating, but they prefer the simplicity of paying taxes on their business income on their individual income tax returns, rather than splitting business income between themselves and their corporation. If they begin making more money than each needs to take home, they can convert their LLC to a corporation to obtain lower corporate income tax rates on earnings kept in the business or, as an alternative, they can make an IRS election to have their LLC taxed as a corporation without changing its legal structure at all.

Number of Owners

In every state, you can form an LLC with only one member. LLC members need not be residents of the state where they form their LLC (or even the United States, for that matter), and other business entities, such as a corporation or another LLC, can be LLC owners.

Limited Liability

Under each state's LLC laws, the owners of an LLC are not personally liable for its debts and other liabilities. This personal legal liability protection is the same as that offered to shareholders of a corporation.

Pass-Through Taxation

Federal and state tax laws treat an LLC as a partnership -- or, for a one-owner LLC, as a sole proprietorship. The LLC owners report LLC income, losses, credits, and deductions on their individual income tax returns. The LLC itself does not pay income tax. However, as with partnerships, there are "check-the-box" tax rules that allow an LLC to elect corporate tax treatment if its owners wish to leave income in the business and have it taxed at separate corporate income tax rates. Chapter 4 explains how corporate tax treatment works.

Finding your state's LLC tax rules. Some states impose an annual fee or tax on LLCs, in addition to the individual income tax that owners pay on LLC profits allocated to them each year. To find out whether your state imposes an LLC tax, go to your state's tax department website. The appendix contains state tax office website information.

Because a co-owned LLC is taxed as a partnership, it files standard partnership tax returns (IRS Form 1065 and Schedules K) with the IRS and the state, and the LLC owners pay taxes on their share of LLC profits on their individual income tax returns. (Each owner gets a Schedule K-1 from the LLC, which shows the owner's share of LLC profits and deductions. the owner attaches the K-1 to his or her individual income tax return.)

An LLC with only one owner is treated as a sole proprietorship for tax purposes. The owner includes profits or losses from the LLC's operations, as well as deductions and credits allowable to the business, on a Schedule C filed with the owner's individual income tax return.

If a sole-owner or multiowner LLC elects corporate tax treatment, the LLC is treated and taxed as a corporation, not as a sole proprietorship or partnership. The LLC files corporate income tax returns, reporting and paying corporate income tax on any profits retained in the LLC. The LLC members report and pay individual income tax only on salaries paid to them or distributions of LLC profits or losses that are paid as "dividends." However, as is true for partnerships, LLCs that may benefit from electing corporate tax treatment usually decide to go ahead and incorporate. By doing so, they get corporate tax treatment plus the other "built-in" advantages the corporation provides, such as access to capital, capital sharing with employees, tax-deductible employee fringe benefits, and built-in management formalities.

Management

Most LLCs are managed by all the owners (also called members). This is known as "member-management." But state law also allows for management by one or more specially appointed managers, who may be members or nonmembers. Not surprisingly (but somewhat awkwardly), this arrangement is known as "manager-management." In other words, an LLC can appoint one or more of its members, or one of its CEOs, or even a person contracted from outside the LLC, to manage its affairs. This manager setup is somewhat atypical for small, closely held LLCs; it makes sense only if one person wishes to assume full-time control of the LLC, while the other owners act as passive investors in the enterprise.

Formation Requirements

Like a corporation, it takes some paperwork to get an LLC going. You must file a legal document (usually called articles of organization) with the state business filing office. And if the LLC will maintain a business presence in another state, such as a branch office, you must also file registration or qualification papers with the other state's business filing office. (For more on out-of-state requirements, see chapter 5.) LLC formation fees vary, but most are comparable to the fee each state charges for incorporation.

Like a partnership, an LLC should prepare an operating agreement to spell out how the LLC will be owned, how profits and losses will be divided, how departing or deceased members will be bought out, and other essential ownership details. If you don't prepare an operating agreement, the default provisions of the state's LLC act will apply to the operation of your LLC. Because virtually all LLC owners will want to control exactly how profits and losses are apportioned among the members (as well as other essential LLC operating rules), you'll want to prepare an LLC operating agreement.

Want more information about LLCs? See Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), for instructions on how to form an LLC in each state, how to prepare an operating agreement, and how to handle other LLC formation requirements. You can also learn more about LLC formation procedures and fees for your state by visiting your state's business filing office website. You can find the Web address of your state's business filing office in the appendix. Nolo (www.nolo.com) offers LLC Maker, a software program (Windows only), that allows you to choose a valid LLC name in your state, generate and file LLC articles of organization, prepare an LLC operating agreement, and choose important tax options that qualify your LLC for partnership tax treatment.

Corporations

A corporation, like an LLC, is a statutory creature, created and regulated by state law. In short, if you want the "privilege" -- that's what the courts call it -- of turning your business enterprise into a corporation, you must follow the requirements of your state's business corporation law or business corporation act (BCA). What sets the corporation apart, in a theoretical sense, from all other types of businesses is that it is a legal and tax entity separate from any of the people who own, control, manage, or operate it.

Federal and state laws view the corporation as a legal "person," which means that the corporation can enter into its own contracts, incur its own debts, and pay its own taxes, separate and apart from its owners.

For tax purposes, there are two types of corporations: "C" corporations and "S" corporations. A C corporation is just another name for a regular for-profit corporation -- a corporation taxed under normal corporate income tax rules. The letter c comes from Subchapter C of the Internal Revenue Code and is used to distinguish these regular corporations from "S" corporations, a more specialized type of corporation that is regulated under Subchapter S of the Internal Revenue Code.

An S corporation gets the pass-through tax treatment of a partnership (with some important technical differences) and the limited liability of a corporation, much like an LLC. This section covers the more common and widely accepted C corporation. (S corporations are discussed in more detail below.)

To form a corporation, you pay corporate filing fees and prepare and file formal organizational papers, usually called "articles of incorporation," with a state agency (in most states, the secretary or department of state). Once formed, the corporation assumes an independent legal life separate from its owners. This separate legal life leads to a number of familiar traditional corporate characteristics, discussed below.

Number of Shareholders (Owners) and Directors

A corporation can have as many or as few shareholders as it wants. However, every corporation needs directors and officers to manage and run its day-to-day business. In most states, it is possible to set up a one-person corporation in which one person acts as the sole shareholder, director, president, secretary, and treasurer of the corporation.

Limited Liability for Shareholders

A corporation provides all of its owners -- that is, its shareholders -- with the benefits of limited personal liability protection. If a court judgment is entered against the corporation or the corporation can't pay its bills, only the corporation's assets are at stake. The shareholders stand to lose only the money that they've invested; creditors cannot go after their personal assets.

Traditionally, business owners formed corporations primarily to wrap themselves in the legal mantle of limited liability to avoid personal exposure to business debts and claims. Of course, now that LLCs have entered the picture, small business owners can choose between the two entity types if they are looking for limited liability protection.

C Corporation Income Taxation

In an unincorporated business, the owners pay individual income taxes on all net profits of the business, regardless of how much they actually receive each year. For example, assume that a partnership or an LLC has two owners and earns $100,000 in net profits. If the owners split profits equally, each must report and pay individual income taxes on $50,000 of business profits. This is true even if all of the profits are kept in the business checking account to meet upcoming business expenses -- not paid out to the owners.

In contrast, a corporation is a legal entity separate from its shareholders and files its own tax return, paying taxes on any profits left in the business. Unlike LLC members, shareholders who work for the corporation are treated as employees who receive salaries for their work in the business. The corporation deducts owners' salaries as a business expense when it computes its net taxable income. But because the owners of a small corporation also manage the business as its directors, they have the luxury (within reasonable limits) of deciding how much to pay themselves in salary. In short, the owners decide how much of the profits will be taxed at the corporate level and how much will be paid out to them and taxed on their individual returns.

Two results follow from this:

• the owners pay individual income taxes only on salary amounts they actually receive, not on all the net profits of the business
• the corporation -- which, remember, is a separate tax entity -- pays corporate taxes on the net profits actually retained in the business.

In effect, the corporate tax scheme is more accurate, because it taxes the business only for profits actually retained in the business, while taxing the owners only on profits they actually receive. This type of income-splitting between the company and the owners can lead to tax savings, at least for small corporations.

The corporation's owners file individual income tax returns and pay taxes, at their individual tax rates, on the salaries and any bonuses they receive. At the end of the year, the corporation files a corporate tax return, IRS Form 1120, Corporate Income Tax Return, and pays its own income taxes on the profits left in the company. corporate tax rates (see "tax rates on taxable corporate income," below) are lower than most shareholders' individual tax rates for the first $75,000 of income (profits are taxed at 15% for the first $50,000, and 25% for the next $25,000). So, if the owners decide to retain profits in the business for expansion or other business needs, profits of up to $75,000 will be taxed at rates that are almost surely lower than the owners' individual tax rates, resulting in an overall tax savings.

EXAMPLE: Justine and Janine are partners in Just Jams & Jellies, a specialty store selling gourmet canned preserves. Business has boomed, and the owners' net taxable income has reached a level where it is taxed at an individual tax rate of 35%. If the owners incorporate, they can leave $75,000 worth of profits in their business, which will be taxed at the lower corporate tax rates of 15% and 25%. This saves Justine and Janine significant dollars when tax time rolls around.

Some small businesses, however, don't need this corporate tax strategy (known as "income-splitting"); instead of leaving some money in the business, their owners wish to pay out all net profits to themselves at the end of each tax year.

EXAMPLE 1: Winston set up his own computer graphics company as a sideline to his day job. Like many other small service business owners, he does not reinvest the profits of his self-employment business, but happily deposits every last cent into his own personal checking account. Corporate tax treatment will not benefit Winston, because he doesn't accumulate money in his business.

EXAMPLE 2: Linux and Colleen own and work part time for their own LLC, a retail sales business that employs one full-time worker, Vince. Linux and Colleen share in the LLC's profits as owners, not employees (the normal set-up for LLC members). Gross sales revenue of the business this year is expected to be $200,000. Cost of inventory sold will be $50,000, so net sales revenue is $150,000. Linux and Colleen annually pay Vince $50,000 in salary and their landlord $25,000 to rent their storefront property. Other normal business expenses total about $20,000 per year, so the net profits will be about $55,000. The owners need to pay out all of this money to themselves for their hard work and to help meet their own living expenses (they also rely on their personal savings to help them get by as their business gets going). Again, as in the example above, income-splitting is not a viable tax strategy here, because the owners need to take all of the profits out of the business.

But for other small businesses, even those with modest net incomes, the corporate tax strategy may be worthwhile. Many small business owners have to retain profits in their businesses to handle upcoming costs of doing business, purchase inventory, pay employee salaries, and fund their other necessary and regular business expenses, such as rent and insurance. Owners might need to retain net profits in the business even if they are not paying themselves as much in profits as they would like. In these situations, being able to pay the lower corporate tax rates on net income left in the business may result in tax savings.

EXAMPLE: Let's imagine Linux and Colleen a few years from now. Their LLC is making more money. For the past two years, their gross sales have averaged $500,000, and their cost of inventory sold has remained level at 25% of gross sales, or $125,000. Vince, the only full-time employee, and the owners have had to work harder to meet increased customer demand, giving up many of their weekends to the business. Vince's salary has increased to $75,000, but other expenses have stayed almost level at $60,000. Net LLC profits now average $240,000 per year, with each owner taking home a $120,000 share.

Linux and Colleen agree to look for a slightly more upscale storefront, hoping to sell more-expensive items (with higher margins) to a more-affluent clientele. They know that they'll have to come up with a lot of money to move into a new space, and they also expect to need additional funds to start stocking the higher-priced inventory. In addition, they discuss the possibility of hiring another full-time worker -- if only to allow themselves to have more weekend time away from the business. They each realize they'll have to take a temporary cut in their share of paid-out profits to fund the move and expansion. Realizing they will need to begin retaining a substantial amount of LLC profits in the business in order to accomplish these plans, they decide to elect corporate tax treatment so that the profits kept in the business will be taxed at lower corporate income tax rates.

Now for one last income tax item: When a corporation is sold or dissolved, the shareholders and their corporation must each pay taxes on any increased value (appreciation) of assets owned by the corporation. This means that a double tax is paid on the same appreciation -- once by the corporation and again by its owners. For businesses that own real estate or buy other types of property that are likely to increase in value, this can be a big disadvantage. The rules here are complex and tricky -- just realize that one of the more technical issues of deciding whether to incorporate has to do with the tax consequences that will occur when you sell or dissolve your business. This is definitely one area where you'll want some expert tax advice before making your decision.

Corporate Management

Because a corporation has a legal existence separate from its owners, you must pay more attention to its legal care and feeding than you would for a sole proprietorship, a partnership, or an LLC.

Corporations are owned by shareholders and managed by a board of directors. This means that the owners of a small corporation must periodically wear different legal hats. As directors, they must hold annual meetings required by state law. They must also keep minutes of meetings, prepare formal documentation (in the form of resolutions or written consents to corporate actions) of important decisions made during the life of the corporation, and keep a paper trail of all legal and financial dealings between the corporation and its shareholders.

Making corporate life even more complicated, the board of directors must appoint officers to supervise daily corporate business. State law usually requires the board to appoint at least a president (CEO), a secretary, and a treasurer. In practice, however, because a small corporation's shareholders usually act as both its board of directors and its officers, this simply means that one person or a few people are going to hold several corporate titles.

EXAMPLE: Tornado Air Conditioning Service, Inc. is owned and operated by Ted and his spouse Valerie. They name themselves as the only two directors in the corporate articles they file with the state. At the first organizational meeting of the board, they appoint Valerie as both President and Treasurer, and Ted as both corporate VP and Secretary. They also approve the issuance of the corporation's initial shares to Ted and Valerie, its only two shareholders.

Corporate Capital and Stock Structure

A corporation issues stock to its shareholders in exchange for capital they invest in the business. The way in which corporate stock allows corporations to structure ownership remains unique in the world of business entities and leads to a few special benefits. For example, a corporation can parcel out ownership interests in the form of shares, which can be divided into classes, each with different rights to vote, receive dividends, and receive cash if the business is liquidated.

Corporate stock is also a very useful way to fund employee stock option or bonus plans. In addition, you can use it to fund a buyout of another business or exchange or convert it into the shares of another corporation to effect a merger or consolidation. And, of course, the corporate stock structure is almost essential if a business wants to raise money from the public in an initial public offering (IPO). The state corporation statutes flesh out the full potential of corporate stock ownership and provide legal rules procedures that are used throughout the banking, investment, and legal community to funnel private and public capital into corporate coffers.

Employee Fringe Benefits

Even small corporations have the opportunity to offer fringe benefits -- such as group term-life and medical reimbursement plans -- to their employees, as well as stock purchase, option, and incentive plans. The owner/employees who receive these benefits normally do not have to pay tax on the value of these benefits. And the corporation can generally deduct the cost of providing these benefits.

... And the Runner-Ups: Limited Partnerships, S Corporations, and RLLPs

The preceding sections discuss the four most common business entities: sole proprietorships, partnerships, limited liability companies, and corporations. This section covers a few less-common variations on some of these entities. Although these entities may not be well-known, they offer advantages for certain kinds of businesses -- so you should consider them before making your final decision about what type of business to form.

Limited Partnerships

A limited partnership is similar to a general partnership, except it has two types of partners. A limited partnership must have at least one general partner, who manages the business and is personally liable for its debts and claims. (General partners have the same broad rights and responsibilities as the partners discussed in the general partnership section, above.) And, by definition, a limited partnership must also have at least one limited partner, and usually has more. A limited partner is typically an investor who contributes capital to the business but is not involved in day-to-day management. The limited partners are not personally liable for business debts and claims. They function much like passive shareholders in a small corporation, investing with the expectation of receiving a share of both profits and the eventual increase in the value of the business.

Liability

A limited partnership must have at least one general partner, who is personally liable for the debts and other liabilities of the business (unless the general partner goes to the trouble of setting up his own corporation or LLC, which is discussed below). This differs from corporations and LLCs, in which all members are automatically covered by the cloak of limited liability protection.

As long as limited partners do not participate in management, they do not have personal liability for business debts and claims. However, if limited partners participate in decision making, this shield disappears, and they will be subject to personal liability for business debts. For that reason, if an owner of a limited partnership wants the benefit of limited liability protection, he or she must step back from active management of the business and invest in it as a passive investor only -- something that is all but impossible for the millions of small business owners who plan to be active in their own businesses.

Income Taxation

For income tax purposes, limited partnerships generally are treated like general partnerships, with all partners individually reporting and paying taxes on their share of the profits each year. The limited partnership files an informational partnership tax return (IRS Form 1065, U.S. Partnership Return of Income, the same tax form that applies to a general partnership), and each partner receives IRS Schedule K-1 (1065), Partner's Share of Income, Credits, Deductions, etc. from the partnership. Each partner then files this form with his or her individual IRS 1040 tax return. Limited partners, as a rule, do not have to pay self-employment taxes -- because they are not active in the business, their share of partnership income is not considered "earned income" for purposes of the self-employment tax.

Management

As noted, limited partners are generally prohibited from managing the business. Some states have carved out some new exceptions to this ban, however, usually to allow a limited partner to vote on issues that affect the basic structure of the partnership, including the removal of general partners, terminating the partnership, amending the partnership agreement, or selling all or most of the assets of the partnership. If all owners want to be active in their company, they are probably better off forming an LLC or a corporation, which would allow all owners/ investors to run the business while enjoying the protection of limited liability for business debts.

Although this business form is less versatile than an LLC, some companies still operate as limited partnerships. This usually happens in investment firms, where the investors insist that the managers of the company (the general partners) be on the hook for bad business decisions -- the investors believe that the managers will be less likely to make unsound investments if their personal assets are at stake. But in other, usually larger, limited partnerships, the general partner is actually a limited liability enterprise such as an LLC or a corporation. This allows the general partner to avoid personal liability altogether.

EXAMPLE: In 1985, Situs Holdings, a limited partnership, was established as a real estate development company. Its general partner is the Situs Corporation, and it has 20 limited partners. The limited partners are individuals who invest money to purchase and improve the company's real estate holdings, while the general partner, the Situs Corporation, manages Situs Holdings's properties in exchange for a management fee. The Situs Corporation is owned by Sid Block and his two daughters, Elizabeth and Jackie. All of the partners (the Situs Corporation and the limited partners) share in a percentage of the profits of Situs Holdings.

Note that the general partner is a corporation. This is a standard technique used to limit the personal liability of the general partner in larger limited partnerships, particularly if the liabilities of the company may be hefty. In this situation, the company's real estate debts are substantial, and the potential liabilities associated with the renovation and sale of properties are also considerable -- general contractor liability claims, purchaser rescissions, and other disputes that may end up in court can go into the million-dollar range. Of course, the whole Situs ownership scheme was established before the LLC came into existence. If Sid and his daughters and the limited partners had to do it all over again, their legal and tax advisers would probably recommend a much simpler setup -- namely, forming one manager-managed LLC to hold and develop the properties. All of the LLC managers and the nonmanaging members (the investors) would enjoy limited liability protection.

Forming a Limited Partnership

To create a limited partnership, you must pay an initial fee and file papers with the state -- usually a "certificate of limited partnership." This document is similar to the articles (or certificate) filed by a corporation or an LLC and includes information about the general and limited partners. Filing fees are about the same for limited partnerships as for a corporation or an LLC.

S Corporations

An S corporation is a corporation that qualifies for special tax treatment under the Internal Revenue Code (and state corporate tax statutes as well). To form one, you'll have to jump through the same state incorporation hoops as you would to form a regular C corporation. This means you have to file articles of incorporation with the state and pay a state filing fee. Then, to convert the new corporation into an S corporation, the shareholders must sign and file an S corporation tax election, IRS Form 2253 (and possibly a separate S tax election with the state tax agency). But as you'll see below, choosing S corporation status is a tax, not a legal, election -- the same legal corporation rules applicable to C corporations also apply to S corporations.

LLCs have largely replaced S corporations. Formerly, the only way that all owners of a business could obtain personal liability protection while retaining pass-through taxation of business income was to form an S corporation. Since the arrival of the LLC, however, S corporations have largely fallen out of favor. The LLC provides substantially the same benefits as an S corporation without several of the significant restrictions of S corporations (discussed below).

Number of Shareholders (Owners) and Directors

Generally, an S corporation may have no more than 100 shareholders, all of whom must be either individuals who are U.S. citizens or residents, or certain types of trusts or estates. While the 100-shareholder limit may not be much of an inconvenience -- after all, most small businesses have fewer than five owners -- the other shareholder restrictions can be significant.

Limited Liability for Shareholders

Because S corporations are the same legally as C corporations under state law, all S corporation shareholders have limited personal liability protection from the debts and other liabilities of the corporation.

S Corporation Income Taxation

Once a corporation makes an S corporation tax election, its profits and losses pass through the corporation and are reported on the individual tax returns of the S corporation's shareholders. This means that any profits an S corporation retains at the end of the year are not taxed at the business entity level at corporate tax rates (as is the case for a regular C corporation), but instead allocated through to the S corporation's owners. In other words, S corporation profits are allocated and taxed to each shareholder each year at the shareholder's individual income tax rates (this is the same basic pass-through tax treatment afforded partnership and LLC owners).

S Corporations Compared to LLCs

Before the LLC business form came along, forming an S corporation was the preferred way for business owners to obtain personal liability protection while retaining pass-through taxation of business income. However, now that the LLC is on the scene, S corporations no longer hold much allure for most business owners. Here's why:

• Formation requirements. To form an S corporation, you must first form a regular C corporation, then convert it to an S corporation by filing an S corporation tax election with the IRS. This involves more paperwork than simply forming an LLC.
• Corporate formalities. S corporation shareholders, like LLC members, are protected from personal liability for the debts of the business. But to keep this limited liability protection, you have to follow corporate rules when running your business. This means that you have to issue stock, elect officers, hold regular board of directors' and shareholders' meetings, keep corporate minutes of all meetings, and follow the mandatory rules found in your state's corporation code. By contrast, if you form an LLC, you won't have to jump through most of these legal hoops -- you just have to make sure your management team is in agreement on major decisions and go about your business. Although it makes sense to hold formal LLC meetings from time to time to record important management decisions, you get to decide when you really need to do this.
• Ownership restrictions. Because S corporation stock may be owned only by individuals who are U.S. citizens or residents, it doesn't have the same organizational flexibility of the LLC. (Special types of trusts and other special entities can own S corporation shares, too, but these exceptions don't help the average businessperson.) Even if an S corporation initially meets the U.S. citizen (or resident) requirement, its shareholders can't sell their shares to a foreign citizen or to a company (like a corporation or an LLC), on pain of losing S corporation tax status. (This also means that some of the C corporation's main benefits -- namely, the ability to set up employee stock option and bonus plans and to bring in venture and public capital -- are pretty much out of the question.) In contrast, any type of person or entity can become an LLC member: a U.S. citizen, a citizen of a foreign country, another LLC, a corporation, or a limited partnership.
• Required allocation of profits and losses. An S corporation is prohibited from setting up more than one class of stock (an exception is provided to allow it to issue voting and nonvoting shares), and the S corporation's profits and losses must be distributed to the shareholders in proportion to their stockholdings. LLCs have more flexibility in this regard; they can tailor the allocations of profits and losses to meet the needs of investors -- for example, an LLC can bring in an investor for a share of LLC profits or losses that is disproportionately larger than his or her capital interest.

EXAMPLE: Ely and Natalie want to go into business designing solar-powered hot tubs. Ely is the "money" person and agrees to pitch in 80% of the first-year funds necessary to get the business going. Natalie is the hot tub and solar specialist and will operate the business. One-half of natalie's first-year salary, plus a cash payment of $20,000, will fund her initial 20% share in the enterprise. In exchange for Ely's investment, the two agree that Ely will receive two-thirds of the profits of the business for five years, at which point they will be divided equally. While doling out profits in a way that is disproportionate to business ownership makes practical sense for Ely and Natalie, it is not permitted under S corporation rules. Far better for Ely and Natalie to form an LLC, which does allow them this flexibility (as long as they comply with technical tax rules).

• Limitations of S corporation tax treatment. A full discussion of S corporation taxes is beyond the scope of this book. Nevertheless, one aspect of S corporations can make a huge difference to some business investors. Generally, the tax advantages associated with an S corporation's business debts cannot be passed along to its shareholders unless they have personally loaned the company the money. This means an S corporation shareholder's tax basis in the business normally does not increase when the company takes on debt. Conversely, LLCs can give their owners the tax benefits of most business debt, regardless of the source of the funds, which means that the owners' tax basis in the business will increase when the company takes on debt. Because distributions of profit from the LLC are taxable to the owner only when they exceed the owner's tax basis in the company, this increase in basis means that, in the long run, each of the LLC owners is less likely to be taxed on profits to them. So, if a company will incur substantial debt (as would often be the case if it borrows money to open its business or buy real estate), investors who form an S corporation will be at a disadvantage relative to an LLC.

EXAMPLE: An LLC borrows $400,000 from a bank. This debt is allocated equally to four LLC owners. This means it increases each owner's tax basis in his capital (ownership) interest. This basis increase, in turn, means that each owner can receive $100,000 in distributions of profits from the LLC tax-free (distributions are only taxed when they exceed an owner's basis). By contrast, S corporation shareholders do not receive an increased basis in their shares when the corporation borrows money from a bank, so a loan of this sort would not provide a tax benefit to them.

S corporation owners do enjoy one advantage over LLCs members: they don't have to pay self-employment taxes (Social Security and Medicare taxes) on their share of business profits. S corporation shareholders normally do not have to pay self-employment taxes on any portion of S corporation profits that pass through to them at the end of each year. (If a shareholder is also employed by the S corporation, the corporation and the shareholder would each pay half of these taxes on the amount of the employee's salary only -- not on any additional distributions of profit the shareholder receives as an owner of the company.) As of this writing, the self-employment tax situation for LLC owners is not officially settled. Currently, the general understanding is that LLC members who are active in their business should pay self-employment taxes on profits that pass through to them at the end of the year, which means that they must pay more in self-employment taxes than if they had formed an S corporation. In other words, not only do LLC members have to pay self-employment taxes on any salary (or other guaranteed payments) they receive, but they also must pay these taxes on all of the company's profits that are allocated to them.

EXAMPLE: Sam owns a one-person S corporation that nets $250,000 in profits (before paying Sam's salary). Sam pays himself $100,000 as salary, and the remaining $150,000 is automatically allocated to him at the end of the year as his share of corporate profits. (Because an S corporation is a pass-through tax entity, all of the money is credited to Sam for tax purposes.) Sam pays income taxes and self-employment taxes only on the first $100,000; for the next $150,000, he pays only income taxes, not self-employment taxes. By contrast, if Sam had organized his business as a one-person LLC, his tax adviser probably would have advised him to pay self-employment taxes on the entire amount.

Disadvantages of the S Corporation Compared to the C Corporation

Because of the S corporation's ownership restrictions and its inability to issue special classes of stock, the S corporation is a lot less flexible than a regular C corporation when it comes to attracting key employees and investment capital. Because an S corporation cannot have more than 100 shareholders, it can't make a public offering of its shares, and because an S corporation can have only one class of shares, it can't easily accommodate the needs of outside venture capital firms and other investors who require special dividend or conversion rights in return for a capital investment in the company.

Registered Limited Liability Partnerships (RLLPs)

In all 50 states, professionals may set up a special type of partnership, called a registered limited liability partnership (RLLP), as an alternative to forming an LLC. In some states (like California), this new type of ownership structure was invented because state law didn't allow many professionals to form LLCs. In others, this business structure was established to help professionals in a multimember practice avoid personal liability for the malpractice of the other professionals in their firm. Unless you are forming a professional practice along with professional co-owners, the RLLP is probably not for you -- check with a lawyer to be sure.

An RLLP is basically a partnership in which all of the owners remain personally liable for their own acts (malpractice) but receive limited liability for any malpractice of other partners in the firm. Most state RLLP statutes also give the professionals personal liability protection from other tort liabilities (personal injury lawsuits) of the RLLP as well as from business debts.

Number of Partners

You need at least two partners to form an RLLP. Typically, under state statutes, the partners must be licensed in the same or related professions. Professionals that are eligible to form an RLLP usually include people who work in the legal, medical, and accounting fields, as well as in a short list of other professions in which a special "professional-client" relationship is assumed to exist. Some states allow engineers, veterinarians, and acupuncturists to form RLLPs. In some states, however, some types of licensed professionals are not allowed to form an RLLP.

Professionals eligible to form professional corporations can usually form RLLPS. The list of professionals who may form an RLLP in a particular state is usually identical to the list of professionals eligible to form a professional corporation. For example, physicians can incorporate only as a professional corporation in most states, and are also eligible to form an RLLP in those states. Call your state LLC filing office to find out which professionals are eligible to form RLLPs in your state.

Limited Liability

RLLP owners enjoy a benefit not available to the owners of other partnerships: While the owners remain liable for the financial consequences of their own malpractice, they are not liable for the malpractice of the other professionals in their partnership. In addition, in more than half of the states, a partner in an RLLP is not personally liable for any type of liability, whether it arises from a contract, a tort, or the professional malpractice of another professional in the firm. This sort of sweeping protection is known as "full shield" limited liability protection.

Look up your state's RLLP act. You can look up your state's RLLP act on the Internet through Nolo's Legal Research Center at www.nolo.com. Click "State Laws," select the name of your state, and then either do a search or browse your state's code to find the RLLP act.

Before you form or convert to an RLLP, it's important to find out how much personal limited liability protection your state RLLP statute provides. In addition to reading your state's law yourself, one good way to do this is to consult your professional trade or licensing organization; they almost surely keep up with the law in this area. Because the wording of these state RLLP statutes varies widely, it's a good idea to consult with a knowledgeable business lawyer in your state to find out just how much protection your state RLLP statute provides.

RLLP Income Taxation

Like partnerships and LLCs, RLLPs are taxed as pass-through tax entities. This means that the owners are taxed on RLLP profits on their individual income tax returns at their individual tax rates; the RLLP itself is not taxed on profits under federal tax law and in most states. In most professional firms that provide services and not goods, this makes sense, because all profits are usually available to be paid out to the professionals each year -- there is rarely any need to accumulate funds in professional service firms (as there often is in a nonservice business that needs to accumulate earnings for inventory, equipment, or future expansion).

RLLPs Compared to LLCs

For practical purposes, RLLPs are very similar to LLCs. They both have pass-through taxation and provide limited personal liability. The big difference is that RLLP professionals are protected from the malpractice of their partners, while LLC members are not. This is not a problem for the typical LLC owner -- legal liability in most businesses comes about as a result of contract disputes, accidents on the premises (for example, slip-and-fall injuries), customer or product complaints, and the like -- not as a result of an owner's direct, negligent conduct toward a client. But, of course, in a professional practice, things are very different; here, professionals are routinely sued for harm allegedly caused by the professional's own actions.

No matter how a professional sets up practice -- as a partnership, LLC, RLLP, or professional corporation -- the professional remains personally liable under state law for professional malpractice. Under RLLP statutes, however, professionals are often exempt from personal liability for the malpractice of other professionals whom they do not manage or control. This type of extra protection from "vicarious" professional malpractice is normally not provided under state LLC statutes.

One other difference between the LLC and the RLLP is in their ability to distribute profits freely. Many professional firms want the ability to distribute all net profits of the business to its owners. After all, most professional firms offer services rather than goods and do not need to keep profits in the company to accumulate inventory, buy expensive equipment, or expand the enterprise. But, technically, under most state LLC (and corporate) laws, LLCs cannot make distributions to owners if doing so would make the business insolvent -- that is, unable to pay its debts as they become due -- or would cause the business's liabilities to exceed its assets by a certain percent. An RLLP normally isn't subject to these limits. As a practical matter, however, many LLCs will not want to distribute every last penny of profits to owners each year, so these technical limitations won't matter to them.

Many states allow a professional to form either an LLC or an RLLP. Some states prohibit licensed professionals (such as doctors, lawyers, accountants, and engineers) from forming an LLC, and only permit them to form an RLLP (or, alternatively, a professional corporation). In California, licensed professionals are prohibited from forming LLCs, and only lawyers, accountants, and architects can form RLLPs. So, if your practice is not one of these three professions, you have to form a professional corporation in california to limit your legal liability. Note that the rules regarding professionals are subject to change. Check with an attorney before deciding on the proper entity for your professional practice.

RLLPs Compared to Professional Corporations

The requirements for forming a professional corporation under state law are very similar to the requirements for forming an RLLP. For example, under typical state statutes, professional corporations, like RLLPs, must be owned by licensed professionals, must carry state-mandated amounts of professional malpractice insurance, and must adopt a name that meets the requirements of the state licensing board that regulates the profession.

In most states, an RLLP provides the same basic limited liability protection for professionals as a professional corporation. Modern RLLP statutes, however, typically contain explicit language that makes it clear that professionals are protected from tort, contract, and vicarious malpractice liability. State corporate statues sometimes are not so explicit. Before making the choice, review the full range of legal liability protection provided under your state's professional corporation statutes (versus its RLLP laws).

A major difference between RLLPs and professional corporations is their tax treatment. Professional corporations and their shareholders are subject to two levels of taxes -- corporate-and individual-level income taxes -- just like regular corporations, plus they have to contend with special corporate tax provisions. For example, the net profits of a "professional service corporation," a category defined to include many types of professional corporations formed under state law, are taxed at a flat 35% corporate tax, not at the graduated corporate tax rates that apply to the net profits of regular corporations. And professional service corporations also get lesser tax breaks, such as a smaller accumulated business income tax credit, which means they can become targets for additional tax penalties for retaining net profits in the corporation.