Four Types of Business Entities

This article discusses the primary local, state and federal legal issues that you should consider in connection with starting your own business. There are four types of business entities most commonly used to operate a business:

1. Sole Proprietorship
2. General Partnership
3. Corporation
4. Limited Liability Company

1. Sole Proprietorship

A sole proprietorship is a business that has not incorporated which is owned by one person. If you start a business with no partners and do not incorporate, then your business is considered a sole proprietorship. As a sole proprietor you are required to obtain an occupational license in the city and/or county where your business is located. Generally, you must apply in person for the occupational license. In a sole proprietorship, there may be an unlimited number of employees, but there is only one owner. If there are any employees in addition to yourself, you must apply for a Federal Employer Identification Number issued by the Internal Revenue Service. This is like a social security number, but for a business. You apply for a Federal Employer Identification Number by filing Form SS-4 with the Internal Revenue Service. Technically, a sole proprietorship is not considered a separate legal entity, and there is no legal separation between you as the sole proprietor and your business. In a sole proprietorship, you are financially responsible for all liabilities of your business, and all of your personal assets are subject to seizure or lien by creditors. This is one of the major drawbacks to operating your business as a sole proprietorship.

When you file your personal tax return every year on Form 1040, you will attach Schedule C to that return to report your profit or loss from operation of your sole proprietorship. In addition to paying income tax on your earnings from your sole proprietorship, you are required to pay a 15.3% self-employment tax on those earnings. (The self-employment tax is called social security/medicare tax in the context of a corporation.) The 15.3% self-employment tax is comprised of a 12.4% social security tax and a 2.9% medicare tax. Self-employment income higher than $87,000 in the year 2003 is exempt from the 12.4% social security portion of the tax. The 2.9% medicare portion of the tax, however, is applied to all self-employment income, without an upper limit.

Note that by operating your business as a sole proprietorship, you forfeit certain tax advantages that are available for corporations. For example, with a sole proprietorship you cannot lower payments for social security tax and medicare tax (as you can with an S corporation). The tax advantages available for corporations are discussed in greater detail below.

2. General Partnership

A general partnership is a business that has not incorporated which is owned by two or more persons. The owners of a general partnership are called general partners. If you start a business with any partners and do not incorporate, then your business is considered a general partnership. A general partnership is subject to the occupational license issue discussed above in the sole proprietorship section. General partnerships are governed by Part II of Chapter 620, Florida Statutes.

In a general partnership, each partner is jointly and severally responsible for all liabilities of the business, and all personal assets of each partner are subject to seizure or lien by creditors. This is one of the major drawbacks to operating your business as a general partnership. Why would you ever want to put yourself in a position where your financial upside is limited to your percentage interest in the general partnership, but your financial risk is unlimited and affected by liabilities that arise in the ordinary course of business and from the possible negligence of one of your partners? You should never be a partner in your individual name in any general partnership. The risks are too great.

A general partnership must apply for a Federal Employer Identification Number and file a federal tax return every year on Form 1065. A general partnership is considered a pass-through entity under state and federal tax law. A general partnership does not pay tax. The annual profit of a general partnership is reported to each partner on Schedule K-1, and the partners pay income tax on their respective distributive share of the profits reported on that schedule.

3. Corporation

A corporation is formed by filing with the state standard articles of incorporation. The most common name ending for a corporation is “Inc.” or “Corp.” or “Co.” A corporation is subject to the occupational license issue discussed above in the sole proprietorship section, and must apply for a Federal Employer Identification Number. A corporation owned by one person, who is the sole shareholder, director and officer, provides the same benefits as a corporation that has many shareholders, directors and officers. Corporations are governed by Chapter 607, Florida Statutes.

As a shareholder in a corporation, you do not have personal liability for liabilities that arise in the ordinary course of business. This is one of the major benefits of operating your business as a corporation. Since each shareholder is protected against personal liability for obligations of the business, operating your business through a corporation helps give you peace of mind, in contrast to a sole proprietorship or general partnership. If your corporation is administratively dissolved for failure to file the annual report, it may be reinstated at any time by paying the applicable reinstatement fee and filing the applicable form. The reinstatement is retroactive to the date of administrative dissolution, and the corporation continues as if the administrative dissolution had never occurred. With a corporation, failure to file the annual report on time results in paying a higher filing fee.

Other benefits of forming a corporation can include lower payments for social security tax and medicare tax (with an S corporation). A corporation is taxed either as a C corporation or an S corporation. The terms C corporation and S corporation refer to the way in which the corporation is taxed. Your corporation will be taxed as a C corporation unless Form 2553 is filed with the Internal Revenue Service. To elect tax treatment as an S corporation, Form 2553 must be filed within 75 days after your corporation has shareholders, has assets, or starts doing business, whichever occurs first.

A C corporation files a federal tax return every year on Form 1120. There is a corporate level income tax on the profits of a C corporation. In addition, if a dividend is paid to shareholders from retained earnings, the dividend is included on the personal tax return of each shareholder. Thus, the profits of a C corporation are subject to potential double taxation. For this reason, you should not operate your business as a C corporation unless your business will show little or no annual profit. This can be accomplished by increasing the compensation paid by the corporation to its shareholder-employees, since such compensation is a business expense and reduces the annual profit.

An S corporation files a federal tax return every year on Form 1120S. An S corporation is a pass-through entity under Florida and federal tax law. For an S corporation, there is no Florida corporate income tax. Instead, a pro rata portion of the annual profit or loss of the S corporation is reported to each shareholder on Schedule K-1 and included on the personal tax return of each shareholder. Many businesses in Florida are operated as S corporations.

With an S corporation, the distribution of S corporation profits is exempt from the 15.3% social security/medicare tax that is imposed on compensation income, and you can implement a tax savings strategy commonly called “wage reduction.” With the wage reduction strategy, the shareholder of an S corporation saves $1530 for every $10,000 profit distribution ($10,000 x 15.3% = $1530) because the entire profit distribution is exempt from the social security/medicare tax. For example, assume that you are the sole shareholder and employee of a corporation that has annual revenue of $87,000 and no expenses, except the payment of your compensation. Assume also that your compensation is paid once per year on December 31. On that day, assume you receive two checks from your corporation. Assume the first check is in the amount of $77,000 and is paid to you as compensation for your work during the year. That first check is subject to the social security/medicare tax. Assume the second check is in the amount of $10,000 and is paid to you as a profit distribution. That second check is exempt from the social security/medicare tax, and you save $1530. If you implement the wage reduction strategy, remember that you must be paid a reasonable wage. Because of the tax savings, virtually all businesses benefit by operating as an S corporation rather than as a sole proprietorship.

4. Limited Liability Company

A limited liability company is formed by filing with the state standard articles of organization. The most common name ending for a limited liability company is “LLC.” The owners of a limited liability company are called members. A limited liability company is subject to the occupational license issue discussed above in the sole proprietorship section. Limited liability companies are governed by Chapter 608, Florida Statutes.

Just as with a corporation, as a member in a limited liability company, you do not have personal liability for liabilities that arise in the ordinary course of business. This is one of the major benefits of operating your business as a limited liability company. Since each member is protected against personal liability for obligations of the business, operating your business through a limited liability company helps give you peace of mind. The protection against personal liability provided by a limited liability company is equivalent to that provided by a corporation.

Also like a corporation, if your limited liability company is administratively dissolved for failure to file the annual report, it may be reinstated at any time by paying the applicable reinstatement fee and filing the applicable form. The reinstatement is retroactive to the date of administrative dissolution, and the limited liability company continues as if the administrative dissolution had never occurred. With a limited liability company, failure to file the annual report on time results in paying a higher filing fee.

A limited liability company is considered a pass-through entity under state and federal tax law. For tax purposes, a limited liability company with two or more members is treated like a partnership and does not pay tax. A limited liability company applies for a Federal Employer Identification Number by filing Form SS-4, and files a federal tax return every year on Form 1065. The annual profit of a limited liability company is reported to each member on Schedule K-1, and the members pay income tax on their respective distributive share of the profits reported on that schedule. Note that a single member limited liability company is a “disregarded entity” for federal tax purposes, and the profit or loss from operation of such an LLC is reported on Schedule C, which is attached to the member’s Form 1040 personal tax return every year. It is possible to have an LLC taxable as an S Corporation. This is accomplished by completing IRS form 8832, selecting the box for “association taxable as a corporation,” then filing IRS Form 2553.

If the owners of your business desire to pursue different tax planning strategies, you can accomplish that goal by forming a limited liability company to operate your business, which can be owned by entities that are owned by the individual owners. For example, in a three member LLC, one member may be an LLC taxable as a partnership and the other member may be an S corporation. Those member entities are owned by the individual owners. This structure enables each individual owner to pursue a different tax planning strategy: the individuals who own the LLC can make non-pro rata distributions of profit (subject to the substantial economic effect rule), and the individual who owns the S corporation can pursue the wage reduction tax strategy discussed above in the Corporation section. All individuals can achieve their own tax planning goals.

Documentation that an attorney prepares in order to close a business transaction.

1. Bill of Sale
2. Non-Lien Affidavitt
3. Seller’s/Buyer’s Affidavit
4. Seller’s/Buyer’s Corporate Resolution
5. Cooperation Agreement
6. Affidavitt of transfer of fictitious name, yellow pages advertising and telephone
7. Tax Reporation Agreement
8. Assignment of Trade Name
9. Assignment of Customer Contracts and Accounts
10. Assignment of Purchase and Sale Contract (If to a Corporation)
11. Convenant Not to Compete
12. Promissory Note
13. Security Agreement
14. UCC-1 Financing Statement
15. Assignment of Lease
16. Collateral Assignment of Lease
17. Employment Agreement
18. Purchase Price Allocation
19. Inventory List/Adjustment Worksheet
20. List of Vendors/Deposits
21. Closing Statement

Information provided by Gregory Loomar P.A. 954-433-2345

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