Velvet Veil or Iron Curtain? Picking the Right Limited Liability Entity
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Most startups and small business owners have some inkling that the very next step after having an idea is forming a business entity. The benefits of choosing the right business entities are many. They can include:
- More favorable taxation.
- Greater credibility in the business sphere.
- Separation of personal assets from business liabilities and debts.
The aim of this post will be to present the three most common limited liability business entity options. We'll also explain their benefits and functions in as user-friendly a form as possible. Remember that the "black letter law" (well-established legal rules) of business organizations varies by state. So, this post will attempt to just lay the universal groundwork. Let's begin:
What is limited liability?
When a private individual owes a creditor, even if the debt is not secured by collateral, the creditor can sue the debtor to collect on the debt. The court can then attach the debtor's property in the debt settlement and transfer that property to the creditor.
So, what does that mean in the business context? Well, if you're doing business under your own name:
- In a sole proprietorship.
- Or as an entity that doesn't offer limited liability protection.
That means you could be sued to collect on your business expenses. Your bank account, car, and even your home could be at risk in a sole proprietorship.
Limited liability protection can help protect you by limiting what your business's creditors can collect to just your business assets. In other words:
As the business owner of a limited liability entity, you’ll only risk losing what you put into the business.
This includes any profit that the business generates. But you won't lose the shirt on your back or anything else that you don't explicitly transfer from personal ownership to the business.
Keep in mind that limited liability means "limited" liability. Members aren’t necessarily shielded from intentional wrongful acts. And this includes those of their employees.
All businesses are not created equal, however. Not all business structures, like sole proprietorships, offer limited liability protection. And those that do all require some formalities to be adhered to. This article aims to outline each type of limited liability entity.
It also helps lay out which ones offer you the protection you need.
(1) Limited liability companies (LLC)
The most common form of limited liability business organization for a small business is the LLC. An LLC attempts to combine:
- The limited liability protection of a corporation,
- With the ease and freedom of operation of a general partnership.
The owners of an LLC are known as "members" and depending on state law:
The members can consist of a single individual, two or more individuals, or other LLCs.
Advantages of an LLC include:
- Limited liability: Members are protected from personal liability for business decisions or actions of the LLC.
- Less recordkeeping: An LLC's operational ease is one of its greatest advantages. Compared to an S-Corporation, there is less registration paperwork. Startup costs are lower, and no mandatory record keeping requirements are generally required.
- Operational control: Unlike with a corporation, very few rules regulating an LLC's operation are up to state statute. Greater freedom is given to the founding members. With no shareholders to be responsible to, the members are free to run the LLC more or less as they see fit.
- Of special importance is the fact that there are fewer restrictions on profit sharing within an LLC. So members distribute profits however they agree. Members might contribute different proportions of capital and sweat equity. Consequently, it's up to the members themselves to decide who has earned what percentage of the profits or losses.
- Pass through taxation: An LLC is not taxed as a separate business entity in the way that a C-corporation would be. Instead, members are taxed on their share of LLC income as personal income. This means that personal profits from an LLC are not “double taxed.”
In short, an LLC is a good choice of business organization form for a small business that the owners wish to be able to exert full control over.
Technically speaking, a C-corporation is just a privately held corporation whose shareholders have all signed Form 2553 with the IRS. This alters the way the corporation is taxed under Subchapter S of the Internal Revenue Code.
This allows for pass-through taxation:
Which means that the shareholders are taxed on profits and losses individually. This is without the entity being taxed individually.
As a corporation, S-corporations come with an increased level of necessary formality. This includes:
- A scheduled director and shareholder meetings.
- Minutes from those meetings.
- Proper maintenance of records of adoption and updates to by-laws and stock transfers.
Advantages of an S-corporation include:
- Protection from Personal Liability: In an S-corporation, shareholders are insulated from personal liability regarding the company's decisions or actions. This means their personal assets are generally safe from the company's liabilities and debts.
- Advantageous Taxation for Shareholders: Shareholders of an S-corporation who work as employees pay employment tax only on their salary, not on all net business income. Profits distributed as shareholder dividends are taxed at a potentially lower rate, which can result in tax savings. It's important to note that reasonable compensation must be paid to shareholder-employees to avoid reclassification of distributions as wages by the IRS.
- Eligibility for Business Expense Deductions: Shareholders who are also employees can claim certain expenditures as business expenses, potentially reducing taxable income. For shareholders owning 2% or more of the shares, these benefits are considered taxable income, but they still present tax planning opportunities.
- Continuity of Business: An S-corporation enjoys a separate legal existence from its shareholders. This means the business remains unaffected by changes in its shareholder composition, such as when a shareholder departs or sells their shares. This separate identity enhances the stability and continuity of the business, providing clear legal separation between the owners' personal affairs and the company's operations.
- Pass through taxation: An S-corporation is not taxed as a separate business entity like a C-corporation. Instead, shareholders are taxed on their share of corporate income as personal income. This means personal profits from an S-Corporation are not “double taxed.”
In short, an S-corporation is a good choice for a larger and more established business that is ready and able to comply with all necessary corporate formalities. But that'd also want to retain the advantages of pass-through taxation.
(3) Limited partnership
A limited partnership is a special kind of partnership composed of two types of partners. These are:
- General partners
- Limited partners
This contrasts with a sole proprietorship. Here, a single individual bears all the responsibility and liability.
General partners in a limited partnership are responsible for managing the business. They're jointly and severally liable for the liabilities of the business. Unlike in a sole proprietorship, where the individual and the business are legally the same:
This means that general partners don't have limited liability protection. Each general partner could potentially be liable for the debts of the business with their personal assets.
Limited partners, also known as "silent partners," have limited liability protection. However, they may not participate in the limited partnership's management or day-to-day business operations.
They're essentially investors. They're similar in some ways to the shareholders in a corporation in that they are part-owners of the business entity. But they don't have any management power.
Advantages of a limited partnership include:
- Limited liability protection: The limited partnership structure offers liability protection up to the investment amount for the company's limited partners.
- Full oversight: The general partners have complete management control of the limited partnership. This can make the limited partnership very nimble. It also makes it possible to change business strategy quickly without the need for voting or other formalities.
- Investment potential: Limited partnerships can generate capital injections without altering the management structure. This is done by adding more limited partners. As the limited partners don't participate in management, a successful limited partnership can be an enticing investment opportunity for certain wealthy individuals or financial funds that don't have the time or inclination to actively manage the operation of their investments.
- Pass through taxation: A limited partnership is not taxed as a separate business entity in the way that a c-corporation would be. Instead, members are taxed on their share of the limited partnership income as personal income. This means personal profits from a limited partnership aren't “double taxed.”
In short, a limited partnership is a good choice of business organization for a business that would want to retain autonomy as it attracts investment. However, the business would need to be sufficiently profitable to attract such investment. Limited partnerships are a common form of business organization for professional services firms such as:
- Accounting firms
- Law firms
- Consulting firms
Choosing the ideal limited liability entity for your business
In conclusion, selecting the right limited liability entity is a pivotal decision for any entrepreneur or small business owner. The options below each offer unique advantages tailored to different business needs:
- Limited liability company (LLC)
- Limited partnership
An LLC is ideal for those seeking a balance between operational flexibility and legal protection. It has benefits like fewer recordkeeping requirements and pass-through taxation.
S-corporations are suited for more established businesses ready to handle corporate formalities. This is while enjoying tax benefits and shareholder protections.
Limited partnerships cater to ventures needing to attract passive investors without altering management structures, offering limited liability for silent partners.
Ultimately, the choice depends on:
- Individual business objectives
- The desired level of control
- Tax considerations
- The specific legal landscape of your state.
It's advisable to consult with a legal expert to understand which entity aligns best with your business goals and legal requirements.
How do you choose an entity type?
Choosing an entity type for your business involves considering various factors such as:
- The nature of the business.
- The number of owners.
- Tax implications.
- The level of desired personal liability protection.
- The need for attracting investors.
Understanding each entity type's legal and tax consequences is crucial. Consulting with a business advisor or attorney can help you make an informed decision that aligns with your business goals and personal needs.
What are the five most important factors to consider when choosing an entity type?
The five most important factors to consider when choosing an entity type are:
- Liability protection: Assessing how personal assets are protected from business debts and lawsuits.
- Tax implications: Understanding how different entities are taxed and the potential tax benefits or liabilities for each.
- Ownership and management structure: Considering how many owners there will be and how the business will be managed.
- Funding and capital raising needs: Evaluating the ability to raise capital and attract investors.
- Recordkeeping and compliance requirements: Recognizing the level of recordkeeping, reporting, and regulatory compliance each entity type demands.
Why choose a limited liability company?
Choosing a Limited Liability Company (LLC) is often preferred for its blend of flexibility and protection. An LLC offers personal liability protection. This shields personal assets from business debts and legal issues. It also provides tax flexibility, allowing pass-through taxation to avoid double taxation. You also have the option to be taxed as a corporation if beneficial.
LLCs also offer management flexibility and fewer recordkeeping and reporting requirements than corporations. This makes LLCs suitable for small to medium-sized businesses seeking simplicity alongside legal protection.
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Joshua J. Brouard brings a rich and varied background to his writing endeavors. With a bachelor of commerce degree and a major in law, he possesses an affinity for tackling business-related challenges. His first writing position at a startup proved instrumental in cultivating his robust business acumen, given his integral role in steering the company's expansion. Complementing this is his extensive track record of producing content across diverse domains for various digital marketing agencies.
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