PARINVEST CAPITAL can help you in making the right choices regarding incorporating your business, together with our network of tax accountants, CPA’s and foreign based tax experts, we can follow you in every step necessary to start up your business venture.

Types of Business Legal Structures

Now let’s talk about the basic advantages and disadvantages of each type of structure.

Sole Proprietorship

Simple Definition
A legal form of business that makes no legal distinction between the individual owner and the business itself.
Advantages
Administrative setup and maintenance costs are low
Relatively few regulatory requirements
Owner is only taxed once on his or her personal income tax return
Disadvantages
Owner is personally liable for the actions of the company
Can be difficult to raise capital for the business
Other comments
Typically the sole proprietorship is set up as the owner’s name (e.g. Bob Smith). The owner can choose to operate his or her business under a different name (e.g. Smith’s Lawn Care) but then must file a doing business as form with the appropriate government body.
It is possible to self-insure yourself against the personal liability assumed by this structure.

General Partnership

Simple Definition
Similar to a sole proprietorship but with multiple owners (a sole proprietorship cannot have more than one owner). Like a sole proprietorship, a partnership is not a separate legal entity from its owners.
Advantages
Administrative setup and maintenance costs are low
Relatively few regulatory requirements
Owner is only taxed once on his or her personal income tax return
Disadvantages
Owner is personally liable for the actions of the company
Each partner is responsible for the business dealings of other partners. This is very important to understand. If Partner A enters into a very bad deal under the name of the partnership, then all other Partners are responsible for making good under that contract. Consequently, selecting your partners is of crucial importance.
Other comments
The partnership agreement is the rule book of the partners. This can be drafted with the help of a qualified lawyer to help the partnership deal with such issues as:
Initial investment of partners
Distribution of profits and losses
Each partner’s responsibilities
New partner entrance into partnership
Old partner exit from partnership

Limited Liability Partnership

Simple Definition
Similar to a general partnership but with a separate classification of partners (see Other Comments section below for further explanation).
Advantages
Owner is only taxed once on his or her personal return
Liability can be limited (for limited partners see other comments below)
Disadvantages
More complex filing and administrative requirements than a general partnership
General partners still have personal liability – makes sense if there are numerous passive investors who wish to limit their liability.
Other comments
As opposed to a general partnership, a limited liability partnership has two kinds of partners, general and limited. General partners are similar to those in general partnerships they operate the business and assume liability. Limited partners, on the other hand, are merely investors and, therefore, have no control or operational power. They do have limited liability.

C-Corporation

Simple Definition
A legal form of doing business that creates a separate legal entity from the individual owners. This legal entity can act and do business on its own just as a person would do (i.e. borrow money, enter into lawsuits and contracts, etc.).
Advantages
Shareholders are not personally liable
Ownership is easily exchanged between individuals
Company does not cease to exist with the death of owners
Easy structure for which to raise capital
Disadvantages
Owners are taxed twice
High administrative costs to setup and run
More regulatory requirements than other structures
Other comments
It is important to remember that a C-corporation is considered a separate legal entity from its owners. This is the source of its relative advantages and disadvantages, especially regarding taxes and liability.

S-Corporation

Simple Definition
A type of corporate legal form that is taxed like a sole proprietorship. Its formation is subject to certain legal criteria such as a maximum number of shareholders.
Advantages
Owners are only taxed one time. Shareholders are not personally liable
Disadvantages
Higher administrative costs to setup and run than partnerships and sole proprietorships. More regulations than partnerships and sole proprietorships. Certain limitations on who can be an owner (U.S. citizens, etc.)
Other comments
S-corporations are limited to a certain number of shareholders (75), whereas a C-corporation can have unlimited shareholders.

Limited Liability Company (LLC)

Simple Definition
A hybrid legal form of business that is taxed like a sole proprietorship with the same liability protection of the corporate structure.
Advantages
Owners are only taxed one time. Shareholders are not personally liable
Disadvantages
Higher administrative costs to setup and run than partnerships and sole proprietorships
More regulations than partnerships and sole proprietorships
Limited life of entity (usually limited to 30 years)
LLC laws are not uniform and therefore doing business in multiple states as an LLC can be complex

The key factors that differentiate structures are summarized in the chart below:

Determining the type of legal structure for a new business can be daunting for entrepreneurs and small business owners. Corporations and limited liability companies (“LLCs”) are preferred business structures because, unlike sole proprietorships and partnerships, both offer liability protection. This means that the owner of a company cannot be held personally responsible for the company’s debts. The personal assets of an owner are shielded from company liabilities.

In researching the various business structures, one inevitably comes across the S corporation. S corps and LLCs are similar in that they are both “pass-through” entities for tax purposes; the income of these companies are passed through to their owners and reported on the owners’ personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners who must then pay personal income tax.)

So what is the difference between an S corporation and an LLC? And which structure is right for you?

The answer depends on your own unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you are looking to save on employment tax and your situation warrants it, an S corporation could work for you.

There are restrictions on who can be owners (called “shareholders”) of an S corporation. An S corporation can have no more than 75 shareholders. None of the shareholders can be nonresident aliens. And shareholders cannot be other corporations or LLCs.

An S corporationis operated in the same way as a traditional C corp. An S corp. must follow the same formalities and record keeping procedures. The directors or officers of an S corp. manage the company. And an S corp has no flexibility in how profits are split up amongst its owners. The profits must be distributed according to the ratio of stock ownership, even if the owners may otherwise feel it is more equitable to distribute the profits differently.

LLCs offer greater flexibility in ownership and ease of operation. There are no restrictions on the ownership of an LLC. An LLC is simpler to operate because it is not subject to the formalities by which S corps must abide. An LLC can be member-managed, meaning that the owners run the company; or it can be manager-managed, with responsibility delegated to managers who may or may not be owners in the LLC.

And the owners of an LLC can distribute profits in the manner they see fit.

Let’s say, for example, you and a partner own an LLC. Your partner contributed $40,000 for capital. You only contributed $10,000 but you perform 90% of the work. The two of you decide that, in the interest of fairness, you will each share the profits 50/50. As an LLC you could do that; with an S corporation, however, you could only take 20% of the profits while your partner would take the other 80%.

A major factor that differentiates an S corporation from an LLC is the employment tax that is paid on earnings. The owner of an LLC is considered to be self-employed and, as such, must pay a “self-employment tax” of 15.3% which goes toward social security and Medicare. The entire net income of the business is subject to self-employment tax.*

In an S corporation, only the salary paid to the employee-owner is subject to employment tax. The remaining income that is paid as a distribution is not subject to employment tax under IRS rules. Therefore, there is the potential to realize substantial employment tax savings.

One might assume that these savings could be further manipulated by reducing the salary to an extremely low amount and attributing the rest of one’s earnings to distributions—but this would be an incorrect assumption. In practice, the IRS is careful to notice whether a salary is reasonable by industry standards. If it determines a salary to be unreasonable, the IRS will not hesitate to reclassify distributions as salary.

Still, while the potential employment tax savings may make the S corporation an attractive structure for your business, bear in mind that you would then have to deal with all the paperwork associated with payroll tax. The payroll tax is a pay-as-you-go tax that must be paid to the IRS regularly throughout the year–on time, or you will incur interest and penalties. The paperwork alone can be an overwhelming task for someone who is not familiar with this; and if you expect to incur losses or otherwise experience a cash flow crunch during the year that would hinder you from paying the payroll tax when due, this could present a problem.

Owners of LLCs pay their self-employment tax once a year on April 15 when income taxes are normally due. Income tax Filings are also relatively easy for the owners of an LLC: A single-member LLC files the same 1040 tax return and Schedule C as a sole proprietor; partners in an LLC file the same 1065 partnership tax return as do owners of traditional partnerships.

The comparison chart below sums up the similarities and differences between the two business structures:

	S Corporation	Limited Liability Company
Liability Protection	Yes	Yes
Operational Control	Board of Directors/Officers	May be member-managed or manager-managed
Federal Income Tax	Pass-through	Pass-through
Flexibility/Ease of Operation	No; subject to some formalities and record keeping rules as traditional C corps	Yes
Ownership Restrictions	Yes	No
Flexibility in Profit-Sharing	No	Yes
Employment Tax	Employment/payroll tax on salary; no employment tax on dividends paid to shareholders	Self-employment tax on total net income *

There is no one, magical entity that works for everyone. A CPA or a specialized tax attorney can assist you in choosing the right structure for your business. The important thing is to consider the operational, legal and tax aspects of each structure as they apply to your unique situation.

* The self-employment tax rate for 2009 consists of two parts: 15.3% for social security and 2.9% for Medicare. In 2009, only the first $106,800 of total net income is subject to the social security portion of the tax. All of the the total net income is subject to the Medicare portion of the tax.

*For those who prefer the tax treatment of an S corp but like the simplicity of an LLC, there is an alternative worth considering: Forming an LLC that is taxed as an S corp. An LLC may make a special election with the IRS to be taxed as an S corp. This election is made on IRS Form 2553 and must be filed with the IRS before the 16th day of the third month of the tax year in which the election is to take effect.

An LLC that is taxed as an S corp is still a limited liability company from a legal standpoint (subject to the laws governing limited liability companies in the state of formation); however, for tax purposes it is treated as an S corp.

A word of caution: Certain nuances of S corp taxation can be confusing to some LLC owners, especially do-it-yourselfers and/or those who prepare their own tax returns; for example, an LLC owner might easily make the mistake of referring to an IRS publication that addresses LLCs when, in fact, such a publication would not apply to an LLC that is taxed as an S corp–and such an error could lead to negative tax consequences. It is therefore highly recommended that you consult us and our  CPAs or our other qualified tax professionals for advice and/or assistance.