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A study on different kinds of Business Entities and their advantages and disadvantages

Introduction

A business entity is a commercial, corporate and other institution that is formed and administered as per commercial law in order to engage in business activities, usually the sale of a product or a service. There are many types of business entities defined in the legal systems of various countries. These include corporations, cooperatives, partnerships, sole traders, Limited Liability Company and other specifically labeled types of entities. Some of these types are listed below, by country. For guidance, approximate equivalents in the company law of Englishspeaking countries are given in most cases, e.g. public limited company Ltd. limited partnership, etc. However, the regulations governing particular types of entity, even those described as roughly equivalent, differ from jurisdiction to jurisdiction. When creating or restructuring a business, the legal responsibilities will depend on the type of business entity chosen. In order to carry on a trade or business, a type of business entity must be chosen. For all practical purposes, the four major business entities for the current 2000 year are: sole proprietorship, partnership, corporation, and limited liability company. For the purposes of this discourse, all references will be made to the active conduct of a business, rather than passive or limited-activity types.

The most efficient way of selecting a business entity revolves around trying to match the needs (present and future) of the business and its owners in legal, financial, and tax-related areas. In other words, this selection process becomes a form of a needs analysis study. In some cases, it is relatively easy; in fact the choice may be practically automatic. In other cases, it can be quite complex to coordinate the current and future needs of both the business and its owners. There are a number of variables that should be addressed in this process to help delineate it. Further, the advantages and disadvantages of each type of entity from a legal and tax perspective play important roles in the overall planning process. Definitions Of The Four Major Types Of Business Entities A good starting point is to first know what each of the entity choices represents: SOLE PROPRIETORSHIP: This is a self-employed individual who operates a trade or business where all the tax consequences fall to that proprietor, including all liabilities, debts, profits, and losses. PARTNERSHIP: An organization or association of two or more participants who carry on a trade or business together, and allocate the ownership and profit/loss aspects according to their contractual terms. This partnership is a separate entity for tax filing purposes, but not tax paying. Rather it is a form of a conduit where income, losses, credits, and certain deductions are passed along to the partners' tax situation instead. There is no liability protection for the general partners.

CORPORATION: A separate, legal entity formed through a state charter using articles of incorporation. It is authorized to perform primarily all the business activities an individual can, including such things as filing and paying taxes, signing contracts, and making loans. It is formed through the issuance of stock or securities. There are two main types: Regular ("C") or Subchapter S ("S"). LIMITED LIABILITY COMPANY(LLC): This is a hybrid, or combination, with some of the features of a partnership and the limited liability aspect of a corporation. To qualify as an LLC, it can't have at least two of the main components of a corporation: continuity, centralized
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management, transferability of ownership. Thus, the two most significant features of an LLC are that it affords the partners some degree of limited liability protection, yet it still acts as a conduit like a regular partnership. This choice is not available in all states, but the majority allow it.

While the list of determining factors for making the best choice for the type of business entity can be quite long, an overview of the more common ones that tend to affect the vast majority of businesses is in order. In effect, the business owner selects the features or attributes of the entity that best suit the current and future combined needs of business and owner. This is not always easy since many factors are not always so "black and white," but, rather, fall into the "shades of gray" category. Nevertheless, the following represents a list of the more common significant factors to compare the business entity types:

LIABILITY OF OWNERS Sole Proprietorship: Unlimited liability for business actions Partnership: Unlimited liability for business actions Corporation: Possibly limited to assets in corporation LLC: Possibly limited to assets in company

TREATMENT OF INCOME/LOSSES Sole Proprietorship: Taxable to individual proprietor Partnership: Taxable to partners Corporation: Taxable to regular "C" corporation; taxable to shareholders for "Sub S" corp on federal(and most states) level

LLC: Taxable to partners CONTINUITY OF EXISTENCE OF BUSINESS Sole Proprietorship: Ends with death of proprietor Partnership: Ends with death, bankruptcy of partner or more than 50% change of ownership Corporation: Continues indefinitely LLC: May end with death, bankruptcy of partner, or change of ownership TRANSFERABILITY OF INTEREST Sole Proprietorship: Relatively easy transferability Partnership: May require partner's approval Corporation: Easy unless restricted by agreements LLC: May require partner's approval CHOICE OF TAX YEAR Sole Proprietorship: Proprietor's tax year which is usually on a calendar year basis Partnership: Usually calendar year unless business purpose is met Corporation: Can be calendar or fiscal for most "C" types. Must be calendar for "Sub S" types unless business purpose and special permission is granted LLC: Usually calendar unless business purpose is met EASE OF SETTING UP Sole Proprietorship: Very easy, no state charter, or legal agreements usually required, few administrative, filing headaches Partnership: Reasonably easy, but agreements are generally recommended, state and federal tax identification numbers needed
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Corporation: More difficult and costly, often requiring state applications, legal paperwork, fees, state and federal tax identification numbers to be filed LLC: Somewhat more difficult than a regular partnership to qualify for LLC status; agreements generally recommended, state and federal tax ID numbers required OWNERSHIP LIMITATIONS Sole Proprietorship: Only the individual proprietor can own Partnership: No limit Corporation: No limit for "C" types; maximum of 75 qualified shareholders for "Sub S" types LLC: No limitations EASE OF SHIFTING OF FUNDS IN AND OUT OF BUSINESS Sole Proprietorship: Very easy; draw account is used Partnership: Easy; partner's draw or capital account used, but must be tracked Corporation: More complicated for deductibility purposes, liability protection, etc. LLC: Easy; partner's draw or capital account used, but must be tracked MINIMUM RECORDKEEPING REQUIREMENTS Sole Proprietorship: Easiest of the four entities; no balance sheet requirements, no accounting to other owners, partners Partnership: Fairly complicated, especially if partners' capital accounts are tracked Corporation: Complicated; balance sheet requirements, minutes of meetings, resolutions, other "arms length" requirements to be met LLC: Fairly complicated, more so than regular partnership to keep qualifications as LLC intact

MANAGEMENT TYPE Sole Proprietorship: A centralized system with sole owner Partnership: Not centralized; partners' agreements usually required Corporation: Centralized with appointment by board of directors LLC: Not centralized; partners' agreements usually required

AVAILABILITY OF QUALIFIED RETIREMENT PLANS Sole Proprietorship: Deductible retirement plan available Partnership: Deductible retirement plan available Corporation: Deductible retirement plan available LLC: Deductible retirement plan available

PASSIVE LOSS DEDUCTIBILITY Sole Proprietorship: Can't offset ordinary business income Partnership: Can't offset ordinary business income Corporation: May be able to offset ordinary income for "C" types; not for "Sub S" types LLC: Can't offset ordinary business income

POSSIBLE DOUBLE TAXATION ISSUE Sole Proprietorship: No double taxation problems

Partnership: No double taxation problems Corporation: Double taxation possibility for "C" type; no double taxation for "Sub S" LLC: No double taxation problems

POSSIBILITY OF TAX-SAVING FAMILY INCOME SPLITTING TECHNIQUES Sole Proprietorship: Very possible, if owner is employing offspring, especially those under 18 Partnership: Definite possibilities to shift income to family members in lower tax brackets Corporation: Limited possibilities for "C" type;more possibilities for "Sub S" type LLC: Definite possibilities to shift income to family members in lower tax brackets DEDUCTIBILITY OF VARIOUS FRINGE BENEFITS Sole Proprietorship: Limited, especially in health, accident, life insurance, medical reimbursement, death benefits Partnership: Limited similar to sole proprietorship Corporation: Much more fringe benefit possibilities, especially for "C" types; some restrictions on "Sub S" types LLC: Limited similar to partnership or sole proprietorship

ABILITY TO RETAIN EARNINGS TO DEFER INCOME TO OWNERS Sole Proprietorship: Cannot retain earnings; taxable to owner in year posted

Partnership: Cannot retain earnings; taxable to partners in year posted whether or not they are distributed Corporation: "C" types can retain earnings up to certain limits; "Sub S" types cannot retain; they are taxable to the shareholders whether distributed or not LLC: Cannot retain earnings; taxable to partners in year posted, whether they are distributed or not

LEGALITY ISSUES FROM A STATE PERSPECTIVE Sole Proprietorship: Legal form of business in all states Partnership: Legal form of business in all states Corporation: "C" types recognized in all states; "Sub S" types not recognized for income tax purposes in all states, but recognized as a legal entity in all LLC: Not recognized similarly in all states, so formation, filings, and limited liability protection may be questionable especially if operations of business extend to multi-states TAX RETURNS TO BE FILED Sole Proprietorship: Certain business schedules get included on individual 1040 form, but no independent, stand-alone return is filed Partnership: Federal Partnership Tax Return, Form 1065 must be filed Corporation: Federal Corporation Tax Return, Form 1120 for "C" type; Federal Form 1120S for "Sub S" type

LLC: File similar to partnerships, Form 1065 General Advantages/Disadvantages Of The Four Entity Types As can be seen, while the four main entity types have some common denominators, they are mostly intended to fulfill different business and individual needs. There are advantages and disadvantages within each of these entities:

SOLE PROPRIETORSHIP: This is usually the easiest type of entity to set up or terminate. Losses from the business can offset income from other sources. Management is totally centralized since there is only one legal owner. Recordkeeping may be a bit easier. Taking money out of the business is very easy.

However, there are some notable disadvantages, also: There is no way to "retain" earnings like other business forms; the owner has no limited liability protection; continuity and transferability of interest is limited; and certain deductible fringe benefits are not available as with other forms of business.

CORPORATION: Advantages include limited liability protection to owners, easy transferability of

ownership, continuity even if original owners no longer exist, easier estate tax planning opportunities, more possible tax-free fringe benefit plans, and more flexible pension plans. In addition, it allows for a number of owners to participate. Obviously there can be numerous advantages.

The disadvantages can be equally as numerous. A corporation is usually more difficult and costly to set up or terminate. Much more planning is required to avoid double taxation issues. Recordkeeping can be quite complicated to preserve the limited liability feature. Taking money out of the corporation can also get tricky. Finally, tax return filings tend to be more involved.

GENERAL PARTNERSHIP: If there is more than one owner, it is the easier of the entity types to set up. Active losses can be used to offset other income for the owners. Some degree of income tax and estate tax planning is possible since ownership percentages can be transferred fairly easily.

The disadvantages are similar in scope to a sole proprietorship: No limited liability protection exists; the partnership usually ends upon the termination of a majority partnership interest, so continuity is limited;
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earnings cannot be retained, and tax-free fringe benefits are limited. LIMITED LIABILITY COMPANY: This entity has some of the better aspects of a partnership coupled with that of a corporation. It has limited liability protection, yet allows for the "flow through" of income and losses to the partners so there is less chance for double taxation. Unlike the "Sub S" corporation with its limitations on the number of shareholders, and the type and status of these shareholders, there is much more flexibility here. Income and losses can be allocated more easily as well.

However, the disadvantages center around the fact that these LLC's are still relatively new, and the states have varying rules and regulations concerning their operation, legal status, and degree of limited liability protection available. In addition, like a general partnership, tax-free fringe benefits are restricted. From a qualifying perspective on the federal level, there is always the possibility that the LLC will be challenged on its qualification. This could lead to a disastrous situation where it is re-classified as a corporation, and a double taxation event could occur.

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Sole Proprietorships

Main Advantages
o o o o

Easy to create and maintain. Business and owner are legally the same entity No fees associated with the creation of the business entity Owner may deduct a net business loss from personal income taxes

Main Disadvantages
o

Owner is personally liable for any debts, judgments or other liabilities of the business

Owner must pay personal income taxes for all net business profits

General Partnerships

Main Advantages
o o o

Easy to create and maintain No fees associated with creation of the business entity Owners may report their share of net business losses on personal income taxes

Main Disadvantages
o

All owners are jointly and personally liable for any debts, judgments or other liabilities of the business

Owners must pay personal income taxes for all net business profits

Limited Partnerships

Main Advantages

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Easy to attract investors as they are only liable for their total amount of their investment into the business

The limited partners enjoy limited liability for any debts, judgments or other liabilities of the business

o o

The general partners are more free to focus their attention on the business General partners are able to raise cash without diminishing their control of the business

Limited partners can leave the business without dissolving the limited partnership

Main Disadvantages
o

General partners are jointly and personally liable for any debts, judgments or other liabilities of the business

o o

Can be more expensive to create than a general partnership Mainly suited to businesses such as real estate investment groups or in the film industry

Regular Corporation

Main Advantages
o

Owners of the business enjoy limited liability for the business' debts, judgments and other liabilities

o o

Some benefits may be deducted as business expenses With good accounting, owners and business may be able to pay lower taxes by splitting the business profits among owners

Main Disadvantages
o

More expensive to establish than a sole proprietorship or partnership

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o o

Complicated paperwork that must be filed with the secretary of state Corporation must pay its own taxes as a separate tax entity

S Corporation

Main Advantages
o

Owners of the business enjoy limited liability for the business' debts, judgments and other liabilities

Owners share the net profits of the business and report their share on personal income taxes

Owners share the net business loss and can offset other income by reporting this loss on personal income taxes

Main Disadvantages
o o

More expensive to establish than a sole proprietorship or partnership Paperwork is more complicated than the paperwork required for a LLC, but similar advantages

The ownership interest of the various owners determines their respective incomes from the profits of the business

Some benefits are only given to owners that have more than 2% of the business' shares

Professional Corporation

Main Advantages
o

Owners are not personally liable for the malpractice of other owners

Main Disadvantages
o

More expensive to establish than a sole proprietorship or partnership

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o o

The paperwork and filings may be onerous to owners Every owner must be in the same profession as all other owners

Nonprofit Corporation

Main Advantages
o

Corporation does not pay income taxes on money it receives for a charitable purpose

Donors that give for a charitable purpose may deduct their donations from income taxes

Some benefits may be deducted as business expenses

Main Disadvantages
o

The full tax benefits and advantages can only be utilized by businesses that have been incorporated for a charitable, educational, scientific, religious or literary purpose.

If property is transferred to the nonprofit corporation, the property must stay with the corporation. Even if the corporation ends, the property must go to another nonprofit

Limited Liability Company (LLC)

Main Advantages
o

Owners of the business enjoy limited liability for the business' debts, judgments and other liabilities, even if the owners engage in significant control of the business

The business profits and losses can be allocated to the owners along different lines than ownership interest (for example, a 10% owner may be allocated 30% of the business' profits)

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Owners can choose how the LLC will be taxed, either as a partnership or a corporation

Main Disadvantages
o

More expensive to establish than a sole proprietorship or partnership

Professional Limited Liability Company

Main Advantages
o

Allows state licensed professionals to enjoy the same advantages as a LLC

Main Disadvantages
o o

Same disadvantages as a LLC All members must belong to the same profession

Limited Liability Partnership

Main Advantages
o

Business entities associated with things like law, medicine and accounting normally use this

o o

Partners are not liable for the malpractice of other partners Partners take their share of loss or gain on their personal income taxes

Main Disadvantages
o

Partners remain personally liable for obligations to business creditors, landlords and lenders

o o

Not every state allows limited liability partnerships Often limited to only a select few professions

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