Question

Your three friends are planning to go into business together. 1) Briefly discuss their options as to the form(s) of entity they might choose, but only from the standpoint of payroll taxes.

2) Those three friends now want your advice as to selecting a legal entity through which to do business, but only from the standpoint of ease of disposition (getting out) when one of them decides to retire or otherwise move on at some point. Not selling the entire business (or entity), just selling the individual ownership interest(s), regardless of whether (i) back to the entity (a redemption) or (ii) to some new equity participant(s).

3) Now that you’ve answered (2) above for your friends, it occurs to them to ask the obvious and corresponding question about ease of disposition of the entire business (or entity) to some third party. Describe the advice you would give.

Answer 1

When a person plans to set up a business, one of the first questions that crosses one's mind is to determine what business structure is suitable for the intended business. That is to say what business identity one wants to adopt for one's business out of the various options available under law. Taking this decision is necessary for tax purposes and also helps an entrepreneur to plan for the future business expansion.

1.Limited liability company

A hybrid of a corporation (with an ability to limit personal liability) and a partnership (with an ability to assess profits and losses to individuals), this type of organization provides a flexible structure to achieve these ends.

LLC's are extremely flexible, and can be used for a very wide range of businesses. Like partnerships, LLC's can be as simple or complex as the members desire. Depending on state law, an LLC can have the same limited liability for members as a corporation, or have some members with limited liability and some without limited liability (like a limited partnership), or even have no limited liability for any members (like a general partnership). Unlike corporations, some States require that their LLC's designate a date in the future at which the LLC will automatically dissolve. Some States also require that if a member dies, goes bankrupt or meets some other calamity the remaining members of the company must either dissolve or vote to continue.

A LLC functions as a limited liability corporation, but is taxed and operated in a way that is most consistent with a Partnership. However, one must ensure that a Limited Liability business does not have more than two of the four qualities that characterize a corporation (limited liability concerning assets; continuity of life; centralization of management; the ability to transfer ownership interests). If more than two of these qualities are met, the Limited Liability becomes a Corporation and is taxed accordingly.

2.Corporation

A corporation is a legal entity that has two main features: (1) limited liability, and (2) infinite life. Both of these should be attractive to an entrepreneur. As indicated, limited liability is very important because it allows people to enter into a business without putting their personal assets at risk. For example, if you bought stock in Coca Cola, you would not want to personally be sued if the company sold a tainted batch of soda. Instead, if Coca Cola goes bankrupt, its shareholders would only lose the money they put into the company.

“Infinite life” means just that. A corporation can live on as long as its shareholders keep it alive. A sole proprietorship will obviously die when that sole proprietor dies or quits the business. A corporation is owned by its shareholders, though, and will carry on even as some shareholders quit, sell their shares, or die.

Corporations have a tremendous amount of flexibility in how they are formed, but probably the most important distinction for a small business is choosing a tax treatment. A "C corporation" is one that chooses to pay the corporate income tax directly to the government (as opposed to flowing through to the owner’s personal return.) Most large companies like Xerox and Amazon are C corporations, which refers to Subchapter C of Chapter 1 of the Internal Revenue Code.

Limited liability and endless flexibility. As mentioned previously, the main reason to create a corporation is to limit the liability of the business owners. A corporation can be set up in an infinite number of ways with all kinds of formal management processes in place. Additionally, major investors who often work with corporations will not get involved if the business is structured any other way.

Double taxation and complicated setup. C corps are subject to double taxation, that means that the company is taxed once on earnings, and then shareholders are taxed again on distributions. This process has been made less painful by recent changes to the U.S. tax code, but corporations in the United States are still taxed at 21%.

3.General Partnership

Partnerships are a common business structure that can be established with very few legal requirements. One of the few requirements for creating a general partnership is the writing of a partnership agreement between yourself and the other partners. The partnership agreement states how the business will be run and how profits are to be divided between owners. It also states the requirements for selling the partnership. You must meet the sale conditions of the partnership agreement to sell your general partnership.

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Review your partnership agreement for the conditions on selling the business. Check for any restrictions that may prevent your sale.

Discuss your intention to sell your partnership share with the other partners. Your partnership agreement likely requires the approval of a sale from the other partners.

Decide if all partners want to sell the business or if only you will sell your share.

Offer to sell your partnership share to the other owners. This could be the quickest way out of the business and may be required by the partnership agreement.

Find a buyer for your partnership share and the share of any other selling partners.

Meet with the buyer and the other partners. If you are the only one selling, the partners need to agree on the transfer to the new partner. If the entire business is being sold, all partners must agree on the terms of the sale.

Sign a sale of partnership agreement that includes the sale price, the list of assets being transferred, the name of the new owner, and the signed consent of the other partners.