Choice of Entity (Part II): An Example

July 7, 2011
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In Part I of our business entity discussion yesterday, we touched upon the biggest concerns of most business owners and used them in a mini-chart describing six major business entities.

Today, we’ll work through the six main entities again through an example that will hopefully further clarify the subject further.

NOTE:  Remember that the presented scenario is greatly oversimplified so that the concepts could fit into one post.  Real life is rarely so cut-and-dried (for example, see the tax complexities mentioned in the “S Corporation” discussion below).

Sole Proprietorship

  • Definition:  When one person starts to offer goods or services to the public and goes on without setting up any time of structure for the business, it is usually a sole proprietorship.
  • Example:  John Doe decides to do handyman work around his neighborhood.

General Partnership

  • Definition:  Similar to a sole proprietorship, except two or more people are in business together for the purposes of making a profit.
  • Example:  John Doe’s handyman business grows, so he takes on a partner, Frank Shepherd.  They call themselves “D & S Services”.

Limited Partnership

  • Definition:  A limited partnership must have at least two partners:
    • The general partner (“GP”) – controls the business and is personally liable for all partnership liabilities.  The GP controls and retains liability of the limited partnership whether she owns 100% or 1% of the limited partnership.
    • The limited partner – investors in the business, but who have no control and liability only up to their individual investment in the partnership.
  • Example:  John & Frank need more money to pay for supplies, and ask their spouses for help.  Their spouses want limited liability and don’t want to be involved in the day-to-day activities.  The spouses give John & Frank the required money in exchange for limited interests in the partnership.
    • They file with the state, and now call themselves “D & S Services, LP”.
    • Because of their large investment, John and Frank’s spouses can now own a majority of the business.  In that case, while John and Frank would be minority owners, they would still control the entire business because they are the general partners.

C Corporation

  • Definition:  A general corporation becomes its own entity separate from the owners.  It is owned by the shareholders, and run by the board of directors.  It is controlled by whoever has a majority of the shares of the company stock.
  • Example:  Business is booming.  John and Frank now do handyman work throughout the region and wish to hire more employees and expand into other states.  They file with their state as “D & S Services, Inc.”, electing themselves and their spouses as the board of directors.  They issue stock to other investors in exchange for additional cash, but maintain control by keeping at least 51% ownership amongst John, Frank, and their spouses.

S Corporation

  • Definition:  A corporation meeting certain requirements may elect to run itself as an S Corporation.  The benefit of doing so is to avoid “double-taxation” – profits and losses flow directly to the individual stockholders rather than first being subject to tax within the separate corporate entity.  However, making the “S” election could trigger certain tax consequences (such as LIFO recapture tax, excess net passive income tax, or a tax on built-in gains).
  • Example:  D & S cannot fully deduct its equipment and vehicle purchases, and instead must depreciate these expenses.  As a result, D & S must claim a profit on its business.
    • Because D & S owes corporate taxes on its profits and John and Frank owe income taxes on salaries paid to them by D & S, they are double-taxed.
    • After thorough and careful consideration with tax experts, all shareholders of D & S elect S Corporation status for the next year.
    • D & S earns the same profit, and John and Frank earn the same salary.  However, now D & S’s pays no corporate tax, and all D & S profits flow through to all of its owners.  Less federal taxes are paid as a result (although this result is not guaranteed).

Limited Liability Corporation

  • Definition:  The limited liability corporation (“LLC”) attempts to take the best of all of the features discussed above and combine it into one entity.  All owners (called “members”) have limited liability only up to their individual investments, the LLC can select how it is taxed, and control can be exercised as in a limited partnership (where 1% owners can control the entire business).
  • Example:  Instead of filing for the limited partnership earlier, John and Frank opted to create the D & S Services LLC.  They can now:
    • Own a tiny percentage of the LLC and still control it, as in a Limited Partnership.
    • Have limited liability in the LLC’s obligations, as in a C Corporation or S Corporation.
    • Pay no tax at the entity level and income will flow through to them and any other owners (aka “members”) of D & S Services LLC, as in a Limited Partnership or S Corporation.
  • If instead, D & S is an S Corporation considering a conversion to an LLC, the S Corporation will be treated as if it were liquidated, so significant capital gains taxes may be due.  In many cases, such as in long-held medical practices, converting from an S Corporation to an LLC may not be worthwhile.

In future posts, we’ll look more closely at what estate planning has to do with all of this, including strategies, advantages and disadvantages of holding one entity over any other.

 Choice of Entity (Part II):  An Example
 Choice of Entity (Part II):  An Example

Scott

Scott R. Zucker, Esq. is the owner of The Zucker Law Firm PLLC, located just outside the Capital Beltway in Annandale, within five miles of the City of Fairfax, the county seat of beautiful Fairfax County, Virginia. The firm focuses mainly on estate planning services for Virginia, Maryland and Pennsylvania clientele, and seeks to do so in an affordable and approachable way. People interested in learning more can contact Scott by phone or email.

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