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@212 CHAP 2
┌────────────────────────────────────────────────┐
│SELECTION OF LEGAL ENTITY -- OVERVIEW OF CHOICES│
└────────────────────────────────────────────────┘
@IF901xx]Your business has not yet started up. Thus you still have an
@IF901xx]opportunity to select the most favorable type of legal entity
@IF901xx]for @NAME when it comes into being.
@IF901xx]
@IF901xx]The following outline and summary will give you a fairly
@IF901xx]detailed overview of which type of entity is likely to be
@IF901xx]best for your particular business, which you have indicated
@IF901xx]is in the field of @BUSTYPE.
@IF901xx]
@IF900xx]Your firm, @NAME, has already selected
@IF900xx]a form of doing business, which is a @ENTITY.
@IF900xx]
@IF900xx]However, it is possible that your choice of legal entity is
@IF900xx]not the optimum alternative for your particular business and
@IF900xx]personal needs. The following outline and summary will give
@IF900xx]you some basic guidance as to whether you should explore the
@IF900xx]possibility of switching to some other legal form of business
@IF900xx]organization at this point in the game.
@IF900xx]
Choosing the "best" legal form or entity for your business
is rarely an easy decision to make. Each form of business,
sole proprietorship, partnership, and corporation, has its
own benefits and shortcomings, which vary in degree depending
on the kind and size of your business, your tax situation,
profitability, personal predilections, and numerous other
factors, some of which may seem important to you, others of
which may not. Thus there is often no "right" answer as to
which legal entity you should select for operating your
business.
The following is a thumbnail sketch or overview of some of the
major advantages and disadvantages of sole proprietorships,
partnerships, and corporations. Where there are differences
between a general partnership and a limited partnership, or
between a regular ("C") corporation and an S corporation,
separate comments are shown for each. Otherwise, the
comments below regarding partnerships apply to both general
and limited partnerships, and the comments regarding
corporations relate to both regular and S corporations.
Because every state has by now adopted legislation permitting
the creation of a new kind of legal entity, called a "limited
liability company" (LLC), which is much like a partnership,
but with limited liability for all its owners, the following
discussion also includes consideration of such "LLCs" in
@STATE.
@CODE: CA
However, note that any business required to obtain a license
from the state, such as physicians, dentists, beauty shop
operators, or auto mechanics, is prohibited from forming an
LLC under California's LLC law.
@CODE:OF
As a general rule, it seems that some types of businesses
are much more likely than others to benefit from adopting a
certain legal form, as in the case of the following (press
<Enter> key for details on highlighted words):
.ΣProfessional service firmsΦ(law, accounting, etc.); \113
.ΣCapital-intensive firmsΦneeding to accumulate capital; \114
.ΣReal estate rentalΦbusinesses, in general; and \115
.ΣAuthors, inventorsΦand software developers receiving \116
royalty income for licensing intellectual property.
SIMPLICITY IN OPERATION AND FORMATION:
.ΣProprietorshipΦ Simplest to establish and operate. \110
.ΣGeneral PartnershipΦ Relatively simple, informal, but \111
is usually desirable to have formal
written agreement between the
partners.
.ΣLimited PartnershipΦ More complex and expensive than \112
other unincorporated forms of
business to establish. Requires
written agreement, filing of
limited partnership certificate.
Managed by general partners only.
.ΣLim. Liability Co.Φ A new type of entity, which your \406
lawyer may not yet be very familiar
with. Requires written articles of
organization, roughly comparable to
corporation or limited partnership
in terms of complexity in formation.
Can be formed under the state laws
of @STATE.
.ΣRegular CorporationΦ Requires the most formality in \135\231
establishment and operation,
generally.
.ΣS CorporationΦ Same as regular corporation, but \234
requires close oversight by a
tax advisor, an additional cost.
LIABILITY FOR DEBTS, TAXES & OTHER CLAIMS:
. Proprietorship Owner has unlimited personal
liability.
. General Partnership Partners all have unlimited
personal liability.
. Limited Partnership General partners are personally
liable; limited partners are
liable only to the extent of their
investment, generally.
. Lim. Liability Co. "Members" (owners) not generally
liable for company's debts, under
the state laws of @STATE.
But may have to guarantee loans,
as a practical matter, if company
is to be able to borrow money.
Also, corporate officers may be
liable for failure to withhold
and pay over to IRS, withholding
taxes on employees' wages.
. Corporation Stockholders not generally
liable for corporate debts, but
often have to guarantee loans,
as a practical matter, if the
corporation is to borrow money.
Also, corporate officers may be
liable for failure to withhold
and pay over to IRS, withholding
taxes on employees' wages.
FEDERAL INCOME TAXATION OF
BUSINESS PROFITS:
. Proprietorship Taxed to owner at individual
tax rates of up to 39.6%.
. Partnership Taxed to partners at their
individual tax rates.
. Lim. Liability Co. Taxed to owners at their individual
tax rates, if organized so as to
be taxed as a partnership for
federal income tax purposes.
@CODE: AK FL PA
(Note, however, that for @STATE
state income tax purposes, an LLC
is taxed as a corporation.)
@CODE:OF
. Regular Corporation Taxed to corporation at rates
up to 34%, generally (marginal
rate is 39% at income levels of
between $100,000 and $335,000;
rate rises to 35% above $10
million of taxable income).
. S Corporation Taxed to individual owners at
their individual rates (but
certain gains are taxable to
the corporation as well).
DOUBLE TAXATION IF PROFITS ARE WITHDRAWN
FROM THE BUSINESS:
. Proprietorship No.
. Partnership No.
. Lim. Liability Co. No, generally, if treated for tax
purposes as a partnership.
. Regular Corporation Yes. (But major exception exists
forΣreasonable compensationΦ that \105
is paid to owners who are employees
of the corporation.)
. S Corporation No, in general.
DEDUCTION OF LOSSES BY OWNERS:
. Proprietorship Yes.
. Partnership Yes. Limited partner's deductions
generally cannot exceed the amount
he or she has invested in a
limited partnership interest
(except for real estate, in some
instances).
. Lim. Liability Co. Yes, generally, if treated as a
partnership for tax purposes. Tax
treatment not totally resolved yet,
but may actually have advantages
over limited partnerships for
holding real estate.
. Regular Corporation No. Corporation must carry over
any initial losses until able to
offset them against future profits,
if ever.
. S Corporation Yes, in general, for federal tax
purposes. Loss for a shareholder
is limited to investment in his
or her stock, plus amount loaned
to corporation.
SOCIAL SECURITY TAXES ON EARNINGS OF
OWNER FROM THE BUSINESS:
. Proprietorship 15.3% of owner'sΣself-employmentΦ \262
earnings in 1997, up to $65,400
of income, plus 2.9% of S/E
income over $65,400. (ALL S/E
earnings are subject to the 2.9%
Medicare tax in 1994 and subsequent
years.) One-half of the S/E tax
is deductible for federal income
tax purposes.
. Partnership 15.3% of each partner's share of
self-employment earnings from
the business in 1997, on up to
$65,400 of such earnings, plus
2.9% on excess over $65,400
(cut-off was $62,700 in 1996).
. Limited Partnership 15.3% of each general partner's
share of self-employment earnings
from the business in 1997, on up
to $65,400 of such earnings, plus
2.9% on excess over $65,400. (The
earnings of limited partners are
not subject to S/E tax, generally.)
. Lim. Liability Co. Same as partnership, if LLC is
is organized in such as way as to
be recognized as a partnership
for tax purposes.
. Corporation Owner/employee of corporation
pays 7.65% on his or her salary
and corporation also pays 7.65%.
TotalΣSocial Security (FICA) taxΦ \258
is 15.3% of up to $65,400 of salary
in 1997 (plus 2.9% on excess over
$65,400). The cut-off amount was
$62,700 in 1996.
UNEMPLOYMENT TAXES ON EARNINGS OF
OWNER FROM THE BUSINESS:
. Proprietorship None.
. Partnership None.
. Lim. Liability Co. None, if treated as partnership.
. Corporation Yes. ΣUnemployment taxesΦ (state \260
and federal) apply to salaries
paid to owners.
RETIREMENT PLANS:
. Proprietorship Keogh plan. Deductions, other
features now generally the same
as for corporate pension and
profit sharing plans. But a
participant who is owner cannot
borrow from a Keogh plan.
. Partnership Keogh plan. Same as for sole
proprietorship except that the
prohibition on borrowing from
plan applies to any 10% or
greater partner.
. Lim. Liability Co. Same as for partnership, if
recognized as partnership for
tax purposes.
. Regular Corporation Corporate retirement plans no
longer are significantly better
than Keogh plans. Deduction
limits same now as for Keogh.
But participants can borrow from
corporate plan, within limits.
. S Corporation Plans now essentially identical
to regular corporate retirement
plans, except that "shareholder
employee" (owning 5% or more of
the stock) of S corporation can't
borrow from retirement plan.
TAX TREATMENT OF MEDICAL, DISABILITY, AND
GROUP-TERM LIFE INSURANCE ON OWNERS:
. Proprietorship Not deductible, except that part
of medical expenses may be an
itemized deduction on owner's
tax return, including medical
insurance premiums. But 30% of
medical insurance on owner is
now allowed as a deduction in
computing adjusted gross income.
. Partnership See proprietorship, above.
. Lim. Liability Co. Same as partnership, if treated
as partnership for tax purposes.
. Regular Corporation Corporation may be able to deduct
theΣmedical insuranceΦpremiums \241
or reimbursements paid under
a medical reimbursement plan.
Generally not taxable to the
employee, even if employee is an
owner, if plan is not considered
discriminatory. Similar treatment
is provided forΣdisabilityΦ \240
coverage and up to $50,000 of
coverage (per employee) for
Σgroup term life insuranceΦplans. \242
. S Corporation Fringe benefits for 2% shareholders
may be deductible by corporation,
but such expense will be treated
like additional (taxable)
compensation to shareholder
employees who own more than 2%
of the stock of the company.
(But may not be subject to FICA
tax in the case of medical
insurance, if such coverage is
provided to employees generally
by the S corporation.)
TAXATION OF DIVIDENDS RECEIVED
ON INVESTMENTS:
. Proprietorship Dividends received on stock
investments are fully taxable
to owner.
. Partnership Dividends taxable to individual
partners. See proprietorship,
above.
. Lim. Liability Co. Dividends taxable to individual
members, if treated as a
partnership for tax purposes.
. Regular Corporation Dividends are taxable to corporation.
But aΣspecial deductionΦis allowed \245
for 70% of the dividends received,
generally, an important tax
advantage (unless the stock is
purchased with borrowed money).
. S Corporation Dividends are taxable to the
individual shareholders of the S
corporation, as in the case of
dividends received by a partnership.
