You may have noticed that various real estate acquisition firms, developers, builders, landlords, tenants, and leasing and management firms conduct business in a wide range of entities, but why do they do so and what are the important issues to consider when choosing an entity for your business? The factors you should always consider before forming an entity are as follows: (i) limiting your exposure to liability and risk, (ii) minimizing taxation, and (iii) maintaining flexibility in management, ownership structure and compensation. When you are just starting out, this part of the process may not seem important, but being organized from the beginning can save you a lot of complications and money down the road. This article explores and compares the benefits and disadvantages of sole proprietorships, the different forms of partnerships, the different forms of corporations, and limited liability companies (“LLC’s”).
I. SOLE PROPRIETORSHIPS
A. Formation and Flexibility: This is how many people do business, which does not require any formal filing with the State Corporation Commission (“SCC”). The business is owned and managed by one person who receives all of the profits and bears all the losses. This form of entity is the most simple business entity and has the least administrative burden.
B. Personal Risk and Liability: Although flexible, one major downside of this approach is that you have unlimited personal liability for any lawsuits or damages that arise from accidents, unpaid bills, or other problems affecting your business. In other words, the winner of a lawsuit against a sole proprietor not only collects money from the business but can also ask a court to force the owner to sell personal property, such as the owner’s house, car, etc. The substantial exposure of the owner to personal liability is the primary reason why these entities are not favored.
C. Taxation: From a tax standpoint, your business will file a Schedule C to be attached to your individual 1040 tax return. In addition, you also have to pay self-employment tax of approximately fifteen percent (15%).
The two types of partnerships with which you should be familiar are: (i) general partnerships (“GP’s”) and (ii) limited partnerships (“LP’s”).
A. General Partnerships
1. Formation and Flexibility: GP’s do not require any formal filing with the SCC, but the partners may file a statement of partnership authority under Section 50-73.93 of the Code of Virginia, if they so desire. GP’s, from a managerial standpoint, operate much like a sole proprietorship, but consist of two or more owners who make business decisions together and also share profits, losses, and liability according to the agreement of the partners.
2. Personal Risk and Liability: The partners’ exposure to liability for debts and obligations of the GP remains unlimited, similar to sole proprietorships. More importantly, each partner can also be liable for debts and obligations incurred by the other partners in the course of the business.
3. Taxation: Tax treatment in GP’s can be advantageous, because, rather than being taxed as a separate entity, the GP’s income and losses flow straight through to the partners and are reported on each partner’s individual returns. However, self-employment tax still must be paid in GP’s.
B. Limited Partnerships: Although LP’s receive similar tax treatment as GP’s, LP’s differ from GP’s in two basic respects: (i) formation and (ii) personal liability.
1. Formation and Flexibility: For a LP to exist as an entity, it must file a certificate with the SCC in order to be validly registered.
2. Personal Risk and Liability: LP’s may be more attractive than GP’s, because owners in LP’s invest only their capital in the entity, which is managed by a general partner. In other words, the liability of a limited partner for partnership debts is limited to the extent of the capital he has agreed to contribute, thereby shielding the personal assets of each limited partner from liabilities of the LP. However, this capital contribution of the limited partner may still be a substantial sum. Unless otherwise provided in the LP’s partnership agreement, the general partner of a LP has the same rights, powers, and unlimited liability as a partner in a general partnership. For this reason, it is important that a limited partner not hold himself out to third parties as a general partner, having substantial control of the business, because Virginia courts have found such limited partners to be liable in the same scope as the general partner. The LP is somewhat cumbersome and is not used as frequently as they were prior to the proliferation of LLCs.
The two types of corporations with which you should be familiar are: (i) “C” corporations (“CC’s”) and (ii) “S” corporations (“SC’s”):
A. “C” Corporations:
1. Formation and Flexibility: CC’s, which must be registered with the SCC, must adhere to more formalities, because CC’s are owned by stockholders who elect directors to (i) oversee the operation of the CC and (ii) elect officers who run the CC on a day-to-day basis. Many company decisions require resolutions by the directors and/or shareholders in order to be effective, and therefore record keeping for CC’s is generally more cumbersome and complicated than other forms of business, such as partnerships and LLCs.
2. Personal Liability: The largest advantage of CC’s is limited personal liability to the stockholders. Unlike sole proprietorships and GP’s (but not LP’s), the claims of creditors are limited to the assets of the CC, and stockholders cannot have their personal assets used to pay the CC’s debts.
3. Taxation: When it comes to taxation, corporate income is actually taxed twice! The CC must pay corporate income tax on its earnings and later, when the CC distributes its earnings as dividends to stockholders, the stockholder must also include the dividends as personal income on its tax returns. This effect is generally undesirable for small businesses.
B. “S” Corporations: SC’s share the benefits of CC’s with respect to limitation on personal liability, but differ from CC’s in two critical respects: (i) Formation and Flexibility and (ii) Taxation.
1. Formation and Flexibility: Although a SC is formed like a CC, it only becomes a SC when it makes a “S election” by the timely filing an IRS Form 2553 with the tax authorities. SC’s must also meet strict criteria, including, but not limited to, the following: (i) the number of shareholders must be 100 or fewer, (ii) there can only be one class of stock, (iii) all of the SC’s stockholders must be individuals, trusts, estates, or charitable organizations exempt from tax under Section 501(a) of the Internal Revenue Code, and (iv) the corporation must be a domestic corporation. No stockholder can be a partnership, corporation, or nonresident alien. Such restrictions can be a significant drawback.
2. Taxation: Stockholders of a SC enjoy pass-through taxation whereby income is taxed only once as personal income to the stockholders and reported on their individual returns. Both profits and losses pass through directly to stockholders. If there are losses in the early years (or later years), these losses can be offset against the other income the individual might earn. The other benefit of SC’s is that you can limit and manipulate the amount of taxes subject to payroll taxes and/or self-employment taxes. By paying employee benefits out of the SC, you get deductions but avoid paying self-employment taxes like you would in a sole proprietorship. You can also control payroll taxes to some degree by splitting income between wages and dividends, because dividends are not subject to payroll taxes.
IV. LIMITED LIABILITY COMPANIES
A. Formation and Flexibility: LLC’s must be registered with the SCC by filing Articles of Organization (“Articles”). LLC’s are operated by the members, unless management is delegated to one or more “managers” as provided for in the LLC’s Articles or operating agreement. All members of the LLC can take an active role in the operation of the business without exposing themselves to personal liability, which cannot be done in GP’s. On the other hand, you can also limit or prevent other members’ right to vote on management affairs, and have a single manager direct the LLC, if you prefer to retain control.
B. Personal Risk and Liability: LLC’s, like corporations, protect members from the claims of the LLC’s creditors by limiting liability for business debts to the value of the members’ investment in the business (which still may be significant), and members cannot have their personal assets used to pay the LLC’s debts.
C. Taxation and Compensation: You may choose to have your LLC taxed like a GP or SC, with a single level, flow-through taxation without having to meet the strict criteria and formalities imposed on SC’s (but self-employment tax may still apply). Although it should be possible for a member-manager to have some of its income treated as non-self-employment income, to the extent it represents a return on its investment in the LLC, rather than the fair market value of its services, there is no authority as of yet to substantiate such a position. There is, however, an emerging trend that limited members who take a passive role in LLCs may treat their distributions as a return over capital contribution rather than a salary. Another benefit of the LLC is the flexibility in allocating profits and losses. There is no restriction on how to do this. You can compensate a member on any number of criteria, such as the overall profitability of the LLC, the profitability of a division, or the discretion of the manager or managing member. The value of this flexibility is that you can make someone a member and customize their compensation and incentives.
Choosing the right entity will, of course, depend on a number of factors, including, but not limited to, the nature of your business, your long-term goals, and the company’s finances. For those entities that require formal filings, some individuals choose to form the companies themselves, but you are better off getting a lawyer to do it. Please note that the information contained herein reflects a general overview of Virginia law, and while most states are similar, there can be variances among different jurisdictions. If you were to file incorrectly, you could find yourself in a bind at tax time. It is always a good idea to consult an attorney experienced in these matters, and the more specific your business plan and your preparation, the easier it will be for your lawyer to help you form the entity that is right for your business.