Articles & White Papers
CHOOSING YOUR BUSINESS ENTITY
by James A. Castleman, Esq.
What the heck is an LLC anyway? And, why should you care?
Whether you have been in business for fifty years, or whether you are just thinking about starting your own business, one of the most crucial decisions that you can make is the type of entity that you are going to use for your business operations. The decision can affect exposing your other assets to liabilities of the business, it can affect how much you have to pay in taxes, it can affect your ability to transfer the business to members of your family or to someone that might want to buy your business, and it can affect what happens to your business when you die. You may be a top notch craftsman or service provider, sales person, and number cruncher. But, have you made the right business decision for your particular business and for your particular family situation?
There are many choices of business entities available to you in Massachusetts (and in most other states as well). Each one has its own unique characteristics regarding ownership, potential personal liability, being able to exercise control, transferability of interests, and tax ramifications. There is no one correct choice to be made for everyone. But, you should be aware of what your choices are, and you should be able to make an intelligent decision about what fits you best. The following is a summary of the various types of entities that may be utilized. But, it is only a summary. And, you should make a decision only after consulting with your attorney and your accountant.
A sole proprietorship is the simplest type of business entity. It is a single person operating a business for himself.
The advantage of a sole proprietorship is its simplicity of operation. It is the type of entity that many, if not most, businesses start out as. If you operate the business in your own name, there is no specialized registration that must be made with the state, other than, of course required licensing that may be required for a particular type of business. There is nothing to be filed with the Secretary of State and there are no annual statements to be filed. There are no filing fees to establish the entity, and no annual filing fees or minimum tax payments.
One of the big drawbacks of a sole proprietorship is that there is personal liability of the owner for all obligations of the business and for all actions of the owner and his employees. Any money borrowed for the business must be borrowed in your own name. And, if one of your employees is negligent in the way that he performs his job, then you can be held personally liable for whatever injuries or damages result from your employee’s actions.
The liability issue may not be entirely as bad as it first sounds, however. After all, no matter what type of business entity you have, chances are that lenders will insist that you personally guarantee the obligations of the business anyway. Also, no matter what type of business you have you are still liable for your own personal negligent actions. And, you should always have plenty of liability insurance to cover negligence of you and your employees.
With a sole proprietorship you control the entity with absolute power. No one else has a say in it, and your decisions are final.
To some degree, transfer of your interest in a sole proprietorship is relatively simple. After all, you control the entity and can do whatever you want with it. On the other hand, it is impossible to take in a partner or start transferring control to members of your family without changing the type of entity. When you die, the business ends. You may be able to leave it to members of your family, but it will have to pass through “probate”, and there may be complications on the transfer of your business interest.
With regard to taxes, you are personally taxed on all of the profits, and you get the advantage of being able to personally deduct costs of operating the business and any depreciation associated with the business. This can be good or bad. There is no way to spread the tax liability around. On the other hand, there is no minimum tax due to either the state or federal government.
It used to be that a big disadvantage of a sole proprietorship was the inability to set up a flexible retirement plan or to be able to deduct the cost of medical insurance payments or the cost of other similar “welfare benefit” plans. Because of changes in the law over the past few years, however, this is less a problem than it used to be.
Conventional wisdom is that anybody that runs a significant business as a sole proprietorship has to be out of their mind. Yet, one of the biggest and best known real estate developers in Massachusetts operates most of his businesses as a sole proprietorship. That, of course, doesn’t mean that he is not out of his mind.
A general partnership is two or more people who operate a business for profit together. A general partnership has many of the same attributes as a sole proprietorship. There is still individual personal liability for contracts, to pay back money, and for negligent actions of the owners and their employees. The partners jointly exercise full control over the business. Transfer of a partnership interest is somewhat more difficult than transfer of a sole proprietorship; in fact, if a partner dies, the partnership generally ends. For tax purposes, the individual partners are taxed on the profits of the business and are personally allowed the deductions of the costs of operating the business. While a partnership tax return must be filed with the federal and state governments, it is mostly just an “information” return, and does not mean that there is a separate tax imposed on the partnership. There are no requirements to make special filings with the state, or to file annual reports with the Secretary of State.
There is no requirement to have a written agreement to form a partnership. But, if you do not have a written agreement, then a statute called the “Uniform Partnership Act” governs what your rights and liabilities are. If you do have a partnership, then it is strongly recommended that you also have a written partnership agreement. The agreement can set out which partner is liable for what, can make a determination whether one partner is entitled to a larger percentage of the profits, can determine how deadlocks on decisions between the partners ought to be resolved, can make for a much easier transition upon the death of a partner, and can otherwise make the relationship between the partners as good as possible.
If you operate your business as a partnership, I cannot overemphasize the importance of having a written partnership agreement. From a legal perspective, some of the most difficult situations that I have had to deal with for clients over the years have involved partnerships when one of the partners drops dead. Who now has the right to operate the business? Does the survivor now have to have the decedent’s heirs - who know absolutely nothing about running the business - as new partners? Who owns what? Who owes what? Unless you want to pay your lawyer a lot of money, you do not want to be in that situation.
Except for some very particular circumstances, limited partnerships do not often make sense for ownership of most businesses. Generally, their purpose is to allow business operators to raise funds for operation of the business, with an obligation to pay back the investors only if there is a profit. Structurally, they have one or more general partners who have unlimited liability for contracts that the partnership makes and for negligent acts of the partnership, as well as limited partners who invest money in the entity, and whose liability is limited to the amount of their contributions.
Limited partnerships lend themselves well to certain types of real estate developments and investment enterprises. This is because of certain favorable tax advantages unique to this type of entity, combined with the ability of the general partners to raise money from investors to whom they have no personal obligation for repayment, while allowing the limited partners to make an investment in which they have the potential to make a significant profit. A formal written partnership agreement is a requirement for a limited partnership.
A business corporation is a separate entity, treated discretely from its owners, created under the umbrella of a state’s enabling statutes. Formal Articles of Organization must be prepared and filed with the state, annual statements must be filed with the state, a separate annual tax return must be prepared and filed with both the federal and state governments, and (at least in Massachusetts) a minimum tax must be paid to the state Department of Revenue. Accounting is more complex than with a sole proprietorship or partnership. Annual meetings or actions by mutual consent are required by law, and there is much more formality than with a sole proprietorship or partnership.
All of that being said, there are certain significant advantages to corporate form. First, there is great flexibility as to control. The stockholders own the corporation according to their percentage ownership of stock. So, as an instance, someone may start a business and be the sole stockholder of the corporation. Over the years, he may take in “partners” and give them gradually increasing control by giving them or selling to them some of his shares of stock. And, there can be “classes” of stock with different rights. One class of stock may have a greater right to profits, and another class of stock may have a greater right to control. Except for restrictions agreed upon between the stockholders, a stockholder is free to sell or otherwise transfer his shares of stock to whomever he wants. If a stockholder dies, the corporation continues in existence without interruption.
One of the major advantages to having a corporation is protection from personal liability. Generally, a stockholder has no personal liability for contracts made by the corporation or for negligent actions of the corporation or of its employees. This is not as quite as good as it may seem, however. As an example, if a bank is going to lend money to a small corporation, then it almost certainly will also require a personal guarantee by the stockholders of the debt. Also, even if you run your business as a corporation, you are personally liable for your own negligent actions, even if you are not personally liable for the actions of other employees or other stockholders. And, no matter what type of entity you have, you should always have sufficient insurance to protect yourself and the business anyway.
The taxation of corporations is a complex matter, and how you are taxed will depend on whether you are a so-called “C” corporation or an “S” corporation. A “C” corporation is generally separately taxed for any profits of the business, and those profits are not directly passed through to the stockholders. This can allow flexibility for tax planning purposes, but may also present a problem and payment of excessive taxes if the business is particularly successful or if it is sold. It is also a problem if the business has losses, as these losses cannot be passed through to the stockholders.
An “S” corporation is treated more like a sole proprietorship or partnership for tax purposes, although not entirely so. Generally, the income, gains, losses, and deductions of an S corporation pass through to the stockholders. But to offset that, there is somewhat less flexibility for tax planning purposes, there are limits on the number of stockholders that can own stock in the corporation, and there are limits on the classes of stock that can be set up for the corporation. Notably, corporations are generally given the most flexibility for setting up retirement, health insurance, and other “welfare benefit” plans.
Traditionally, the corporation has been the preferred form of entity for business ownership. This may be particularly true for businesses engaged in activities that have the potential to cause personal injury if services are not properly performed, because of the layer of protection for negligent acts that could cause death or serious injury, while allowing great flexibility for tax planning purposes and allowing easy transfer of ownership from one generation to another.
Limited Liability Company
Limited liabilities companies, or LLC’s , are a relatively new form of entity. But, they have become quite popular in a short period of time. Like corporations, they must be established by a formal Certificate of Organization that must be filed with the state, and they are governed by a particular state’s statutes. LLC’s are extremely flexible, and depend on a separate “operating agreement” between the owners for determination of ownership, control, and transfer issues. LLC’s have the same advantages for protection from personal liability as corporations, but they can elect to be taxed either as a corporation or as a partnership (or as a sole proprietorship for a one person LLC).
Because of their great flexibility, LLC’s have become a predominant choice of entity very quickly. They can have one owner, or they can have many owners. They can have different classes of members with different control rights or different rights to share in the profits. They do not end on the death of an owner, and an ownership interest can be freely transferred to others. Yet, the operating agreement can limit that transferability by agreement between the owners, thereby protecting the other owners upon the death or retirement of one of the individual owners.
Miscellaneous Business Entities
There are also a few lesser known and lesser used business entities available, including Massachusetts Business Trusts with transferable shares, and other types of Trusts. These have their own attributes, but are rarely used today for ownership of most businesses. If you also own the real estate in which your business is operated, however, a trust may be the right form of ownership for the real estate. Again, this decision should be made after consultation with your lawyer and your accountant.
If you have made it this far and your head is not yet spinning, then hopefully, you have learned something about different types of entities that are available for operation of your business. Ultimately, the choice depends upon your individual situation, including your perception of personal liability, how much control you want to exercise, what you want to happen upon death, and what the particular tax ramifications are for you.
Because of the nature of the many business and the potential for significant harm resulting from their operation, it is suggested that either a corporation or an LLC is a better choice for operation of those businesses. There are costs involved in setting up and operating these entities, and the protection is not as broad as some may think. Yet, because of the potential of huge liability in the work that you do, the cost does not seem that great a trade off for peace of mind.
James A. Castleman is a managing member of the law firm of Paster, Rice & Castleman, LLC, in Quincy, Massachusetts. The firm converted from a general partnership to an LLC on April 1, 2007.