The U.S. government began taxing entities with the introduction of the Income Tax Act of 1894. The term "entity" is generally defined as an organization with a recognized legal existence. Whether an organization is an entity separate from its owners for federal income tax purposes is a matter of federal tax law (Reg. Sec. 301.7701-1(a)(1)). Over one hundred years since the introduction of the 1894 Income Tax Act, the taxation of business entities continues to heavily influence investing entrepreneurs' choice of entity when forming new business enterprises.
The 16th Amendment to the U.S. Constitution provides that the imposition of income tax is a constitutional act: "The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration." (U.S. Const. Amend. XVI).
This clause authorizes that taxation of income not be limited to individuals, but include corporations and businesses as well (U.S. v. Stillhammer, 706 F.2d 1072 (10th Cir. 1983)). Thus, business planning requires the development of careful tax planning strategies to ensure the benefit of a business in future years.
While there are many varieties of entities from which to choose when setting up a business, the most common are the (1) sole proprietorship, (2) general partnership (GP), (3) limited partnership (LP), (4) limited liability partnership (LLP), (5) limited liability company (LLC), (6) qualified joint venture, (7) S corporation, and (8) C corporation. Because choice of entity decisions are based on the consideration of numerous Internal Revenue Code provisions, as well as on the personal objectives of the persons creating the business entity, a number of tax and non-tax based factors must be taken into consideration when determining which type of entity for form.
Entity Characteristics
Generally, the presence or absence of the following characteristics will determine of the type of entity in which a business is to be conducted:
(1) Associates: Is there one owner or multiple owner? Are the owners equal? Are some allowed preferential distributions upon the termination or liquidation of the entity?
(2) Objective to carry on a business and divide profits: Is there a legitimate profit motive in carrying on the business?
(3) Transferability of Interests: Can interests in the entity be sold or transferred, or are there any restrictions on the transferability of such interests?
(4) Continuity of Life: Does the entity have a set term of years in which it stays in existence or does it go in perpetuity?
(5) Centralized Management: Generally there is no centralization of continuing exclusive authority to make management decisions, unless the managers have sole authority to make the decisions. For example, in the case of a corporation or a trust, the concentration of management powers in a board of directors or trustees effectively prevents a stockholder or a trust beneficiary, simply because that person is a stockholder or beneficiary, from binding the corporation or the trust.
(6) Limited Liability: Are the owners liable for the debts of the entity? Or are the owner's assets beyond the reach of the entity's creditors?
One of the most important nontax factors in selecting a business entity is the limited liability protection offered by the entity. Generally, business owners wish to protect their personal assets from a creditor's claims against a business. To achieve this protection, a business owner should consider organizing a business in a state which limits the owner's liability to the amount of capital they contribute into the entity.
Shareholders in either a subchapter C or S corporation and members of LLCs are generally afforded the broadest form of personal liability protection. Further, partners in a LLP are generally protected from the debts arising from torts, but are generally liable for certain partnership obligations.
While many states allow professionals to operate their business practice as a C or S corporation, LLC or LLP, such professionals generally remain personally liable for their own malpractice and for the acts of persons working under their direct control.
Generally, business investors can insulate their personal assets from business debts by operating as an LP. In an LP, all partners (other than limited partners) are jointly liable for any business obligations and jointly and severally liable for any obligations arising from another partner's wrongful acts or breach of trust. However, under the Revised Uniform Limited Partnership Act (RULPA), limited partners are generally not liable for partnership obligations exceeding their capital contributions to the partnership (RULPA Section 303(a)).
Any persons operating a business as a sole proprietorship or GP have no personal liability protection against business creditors' claims and, as such, their personal assets may be at risk.
In setting up an entity, owners must consider how their choice of entity will affect their ability to sell or transfer their ownership interests in the business. Partnership interests, other than LP interests, are not easily transferable since all general partners must consent to the transfer. This limitation protects ongoing partners against any unwanted new partners whose actions can bind the partnership. While a partner can assign rights to his share of profits and capital, the Uniform Partnership Act (UPA) provides that the assignee is not considered a partner and cannot participate in the management of the partnership without the consent of all partners (UPA Section 27).
This constraint on transferability does not affect LP interests. Limited partners can freely assign their interests and the assignee may obtain the assignor's right to share in the partnership profits (RULPA Sections 702, 704).
Shareholders of a corporation may transfer their shares in the business entity without consent, and such transferee obtains all the rights and interests in the business which the transferor held. However, if the corporation is closely held, a shareholder's right to transfer shares is generally subject to contractual or statutory restrictions which may preclude transfers which affect the control of the corporation.
In an LLC, the transfer rights are generally governed by the business' operating agreement, and thus may afford great flexibility in business interest transferability.
Business owners must consider how the entity form selected affects the operation and control of the business. Corporations are directly managed by a board of directors who are elected by shareholders. Shareholders do not hold direct control over the corporation or managerial decisions (with the exception of shareholders in a closely held corporation who may hold direct control of the business operations by serving as directors and officers).
In a general partnership, the management and control arrangements are more flexible than those associated with a corporation since partners can specify each person's role in the business operations in the partnership agreement. Such agreements may grant partners certain controls over the business affairs, or may limit such controls.
In a limited partnership, management and control is more stringent. General partners govern the central management of the business while limited partners act solely as business investors. The limited partnership requires such management restrictions to protect limited partners from becoming personally liable for any business obligations. Still, while limited partners cannot directly participate in the partnership's business affairs, they can vote on certain partnership business activities (RULPA Section 303(b)).
Every member of an LLC may directly participate in the management of the business venture without losing limited liability protection.
