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business planning choice of entity
 
When organizing a new business enterprise, one must determine the most beneficial legal structure for state law purposes and the most beneficial tax structure for state and federal tax purposes. There are multiple forms of legal entities to operate a business or hold assets. Some of the popular forms of ownership include a sole proprietorship, a general partnership, a limited partnership, a limited liability company, a “C” corporation and an “S” corporation.

In 1996, the IRS simplified entity classification with the check-the-box regulations. The regulations generally allow unincorporated organizations to elect to be treated as (1) associations taxable as a corporation or (2) partnerships. Entities that are trusts or that are organized as corporations under state law are excluded from the check-the-box rules. Entities that do not elect a specific classification fall into the default rules. Under the default rules, non-corporate organizations with more than one member are treated as partnerships and single member entities are disregarded for federal income tax purposes.

Sole Proprietorship

A sole proprietorship is the simplest form of engaging in business since there is actually no separate legal entity required to be formed and to which assets are transferred. All profits of the proprietorship are taxed directly to the proprietor by filing Schedule C to Form 1040. Since the proprietor is subject to unlimited personal liability for the debts of the proprietorship, a sole proprietorship is never recommended as an appropriate form of engaging in business. “S” corporations or single member limited liability companies are more favorable entities to operate a business or hold assets.

General Partnership/Joint Venture

A general partnership is basically an association of 2 or more persons who organize as co-owners to carry on a business for profit. Persons include individuals, other partnerships or corporations. No formal documents are required to be filed with the state to form a general partnership. For state law purposes, a partnership is recognized as an entity separate from its partners. However, for federal income tax purposes, all income, deductions and other tax attributes are allocated to the partners in accordance to the partnership agreement and if none exists, according to state law. Accordingly, the partnership will file a U.S. Partnership Income Tax Return (Form 1065) and report all of its income, deductions and tax attributes and then issue a Form K-1 to each of the partners, carrying out such tax attributes to the partners to be reported on their tax returns. This is why partnerships are often referred to as pass-through entities. All partners of a general partnership have unlimited personal liability for the debts of the partnership. An alternative structure for liability protection purposes is a limited liability company (“LLC”) or a limited liability partnership (“LLP”).

Limited Partnership

A limited partnership is an association of 2 or more persons who organize as co-owners to carry on a business for profit. Persons include individuals, other partnerships or corporations. To form a limited partnership, a formal document must be filed with the state of formation. For state law purposes, a partnership is recognized as an entity separate from its partners. However, for federal income tax purposes, all income, deductions and other tax attributes are allocated to the partners in accordance to the partnership agreement and if none exists, according to state law. Accordingly, the partnership will file U.S. Partnership Income Tax Return (Form 1065) and report all of its income, deductions and tax attributes and then issue a Form K-1 to each of the partners, carrying out such tax attributes to the partners to be reported on their tax returns. This is why partnerships are often referred to as pass-through entities. The limited partnership must have one or more limited partners and one or more general partners. The liability of the limited partners for partnership debts is limited to the extent of the partnership assets. The general partner is personally subject to the debts of the partnership. Accordingly, it is often recommended to use a corporation or limited liability company to serve as the general partner to accomplish complete liability protection. Also, a limited partnership can file a limited liability limited partnership qualification to shield the general partner from liability exposure. A Family Limited Partnership (“FLP”) is simply a limited partnership formed under state law. It is referred to as an FLP because it is often used in the family context for estate planning and family business planning purposes.

Limited Liability Partnership and Limited Liability Limited Partnership

In June of 1999, the Governor of Florida signed into law the Uniform Limited Liability Partnership Act. A limited liability partnership (“LLP”) is a partnership that has filed a statement of qualification which creates a full liability shield for general partners.

The statement of qualification must be approved by the vote necessary to amend the partnership agreement and the status is effective upon filing, unless a deferred effective date is elected.

A limited partnership may also become a limited liability limited partnership (“LLLP”) by obtaining approval of the partners necessary to amend the limited partnership agreement and following the same requirements for an LLP. Careful attention should be paid for both filings with respect to causing recourse liabilities to become nonrecourse.

The LLP filing is a must if the general partners of a general partnership are individuals, absent liability issues. Even if the general partners of the general partnership are entities insulated from liability, by merely filing a statement of qualification for a minimal fee, the partnership can add an additional layer of asset protection. Where the general partner of a limited partnership is exposed to personal liability, the LLLP filing is ideal for creditor protection from third parties. However, the individual that is serving as the general partner of the limited partnership is still exposed to liability with respect to his fiduciary obligations to the other limited partners.

Limited Liability Company

Limited liability companies (“LLCs”) are now the vehicle of choice for most closely held businesses. In Florida, the corporate tax with respect to the LLC’s income has been repealed. It is also very popular because it limits the liability of all the members to assets owned by the entity. The LLC is treated as a partnership for federal income tax purposes, absent an election to be treated as a corporation. Accordingly, the LLC will file U.S. Partnership Income Tax Return (Form 1065) and report all of its income, deductions and tax attributes and then issue a Form K-1 to each of the members, carrying out such tax attributes to the members to be reported on their tax returns. This is why LLC’s are often referred to as pass-through entities. When compared to an “S” corporation, the LLC is much more flexible in that there are no limitations on who can be a member of the LLC and profits and losses do not have to be allocated on a pro-rata basis.

Single Member Limited Liability Company

Single member LLC’s are completely transparent for tax purposes, yet offer a complete limited liability shield, comparable to a corporation, for state law creditor protection. Accordingly, the taxable income of a single member LLC is reported in the same manner as a sole proprietorship, branch or division of its single owner. However, it is quite distinct from a sole proprietorship, branch or division since it provides its owner with insulation from the state law liabilities of the business.

Although a single member LLC is totally controlled by its sole owner, an operating agreement, similar to that of a shareholder’s agreement is recommended. The operating agreement will be entered into between the sole member and the entity. The purpose of the operating agreement is to: (1) identify and segregate the precise asset that belong to the LLC, so as to carefully distinguish those assets which are subject to claims of creditors; (2) comply with formalities so as to establish that the entity is separate and apart from its owner for state law creditor protection in an effort to solidify the limited liability shield; (3) establish the ability to pay reasonable compensation to the single member for services rendered to the LLC and not to have creditors treat the payments as wrongful distributions if the payments were made when the LLC is technically insolvent.

Although there are many reasons to use a single member LLC, the most important reason to create a single member LLC is to shield personal assets from a potential creditor of the business. This is recommended for Schedule C sole proprietorships or large businesses engaged in various discrete economic activities. For the larger entity, the compartmentalization of each separate activity into single member LLC limits exposure in each business from liabilities that may arise in other areas of the business. Every economic venture entails some degree of risk and single member LLC’s can be used to encapsulate those risks.

For those individuals or entities that own real estate and wish to use a single member LLC to insulate themselves from creditors, the documentary stamp tax could pose the biggest expense. Florida imposes a documentary stamp tax upon the transfer of real property to a single member LLC in exchange for the LLC membership interest. In Miami-Dade County, there is a tax of $1.05 per $100 of consideration on the transfer of commercial property. However, if properly structured, documentary stamp tax may not apply. Even in light of these expenses, the benefit of liability insulation far outweighs the costs.

“C” Corporation

A corporation is an entity created by state law by filing what is commonly known as articles of incorporation or certificate of incorporation. A corporation creates liability protection for its shareholders. A “C” corporation is taxed as a separate person from its shareholders. All net profits that are distributed to the shareholders will be treated as a dividend and subject to a second level of tax at the shareholder level. The two levels of tax often makes a “C” corporation an unattractive vehicle to engage in business. Alternatives would be any of the pass through entities that create liability protection while only subjecting the owner to one level of tax.

“S” Corporation

For state law purposes, there is no difference between a “C” corporation and an “S” corporation, the “S” election is only for federal income tax purposes. The benefit of filing the “S” election is to eliminate the double tax consequences associated with the “C” corporation. In other words, the income is not taxed at the corporate level but passed through and taxed to the shareholders. However, there are significant limitations imposed on the operations of the “S” corporation. Two major drawbacks when considering the use of an “S” corporation are the very strict limitations on who can be a shareholder and the limitation on only being able to have one class of stock. The only permissible differences between classes of stock of the “S” corporation can be with respect to voting rights. Accordingly, if there is a business plan which contemplates different rights with respect to participation in the entity’s profits and losses, a “C” corporation, partnership or limited liability company may be preferable.

If you are interested in using any of the above referenced entities for operating your business or to hold assets to avoid liability exposure or have any questions or comments on how any of these structures would more particularly apply to your situation, please contact us.

 
 
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