Question

Our reading this week covers the different types of legal entities. Please chose a legal entity type and discuss the entity’s tax and non-tax characteristics. Then, describe a situation in which a taxpayer would choose this type of entity by providing an example. Explain your rationale for choosing the specific type of legal entity and discuss the advantages and disadvantages.

Answer 1

There iare ifour ibroad igroups iof ilegal ientities:

1. limited iliability icompanies,

2. corporations,

3. partnerships, iand

4. Sole iproprietorships.

There iare iimportant iflavors iof ieach iclass iof ibusiness ientity.

1. LLC

A ilimited iliability icompany i(LLC) iis ia iunique iform iof ibusiness ientity. iLLC iowners iare icalled imembers. iThe ipeople iwho irun ian iLLC iare icalled imanagers. iHowever, ithe iorganizational idocuments ican ichange ithis iterminology. iThere iare, igenerally, ino irestrictions ion ithe inumber ior itype iof iowners iof ian iLLC.

Limited iliability icompanies i(LLCs) ihave igrown iin ipopularity ifor inew, iprivately iheld ibusinesses. iThey ihave ieclipsed iS iCorporations ias ithe ipreferred ibusiness ientity ifor istartups iand ismall ibusinesses ibased ion ihistorical iUS itax idata. iThat idoes inot imean ian iLLC iis ithe iright ichoice ifor ievery ibusiness iby iany imeans.

There iare itwo imain ireasons ipeople ichoose iLLCs. iFirst, ithey iare iflexible iin itheir imanagement istructure. iIt iis ieasy ito icreate iLLCs iwhich ihave ithe iformality iof ia icorporation iwith iofficers iand idirectors, ior iinformal imanagement ilike ia ipartnership.

Second, iLimited iliability icompanies itypically iprovide ipass ithrough itax itreatment. iPass ithrough itax istatus, isuch ias ipartnerships, imeans ithat ithe ibusiness idoes inot ipay iincome itaxes ion iits iincome. iInstead, iincome iis iallocated ito ithe imembers iwho ithen ipay itaxes ion itheir ishare.

There iare ithree itypes iof ilimited iliability icompanies:

1. member-managed iLLCs,

2. manager-managed iLLCs, iand

3. Professional iLLCs.

Not iall ijurisdictions ihave iall itypes. iThe ibundle iof irights iand iobligations imight ialso idiffer iacross ijurisdictions.

Member-managed

A imember-managed iLLC iresembles ia itraditional igeneral ipartnership. iEach imember i(owner) ican ienter icontracts ifor ithe ientire iLLC, ibinding ithe ientity. iMember-managed iLLCs iare icommon ibecause ithey iare isimple iand ithe ifounding imembers iare ithe isame ipeople ioperating ithe ibusiness.

Manager-managed

Manager-managed iLLCs iseparate ithe iownership iand imanagement ifunctions. iIn ia imanager-managed iLLC, ithe imember ichooses ia imanager i(or imanagers) ito irun ithe ibusiness. iIn ithat icase, ionly ithe imanager ican ienter ilegal icontracts ifor ithe iLLC. iManager-managed iLLCs imore iclosely iresemble icorporations iin ithis iway. iIn ifact, imanager-managed iLLCs ioften iadopt ithe iterminology iof icorporations iin ithe iby-laws iand ioperating iagreements, ireferring ito ia iboard iof idirectors iand icorporate iofficers ilike ia ipresident iand iCEO.

Professional iLimited iLiability iCompany

States iregulate ithe itypes iof ilegal ientities ithat ilicensed iprofessionals ican iuse ito iform ia ibusiness. iLicensed iprofessionals iinclude ilawyers, iaccountants, iarchitects, idoctors, iengineers, iand ithe ilike. iSome istates ihave icreated ia ispecial iLLC, icalled ithe iProfessional iLimited iLiability iCompany i(PLLC) ifor ithis ipurpose. iOther istates ido inot iauthorize iPLLCs, ibut ido ihave ialternatives ilike iRegistered iLimited iLiability iPartnerships ior iProfessional iCorporations.

It iis iespecially iimportant ito imake isure iwhich itype iof iprofessional ientities iare iavailable iin ia iparticular istate, iwhich iprofessions imay iuse ithe ientity, iand iwhat ithe irights iand iobligations iare.

Advantages

1. The iowners ihave ilimited iliability. iThe iowner's ipersonal iassets iare iprotected ifrom ijudgments iand idefaults ion icompany idebts.

2. Owners ican ichoose ihow ithe ibusiness ipays itaxes. iIt icould ibe ia iproprietorship, ia ipartnership ior ia icorporation.

3. Most istates idon't irequire iLLCs ito ihave iannual imeetings.

4. An iLLC iis inot irequired ito ihave ia iboard iof idirectors.

5. The inumber iof ishareholders iis iunlimited.

Disadvantages

1. Legal iand iaccounting icosts iare ihigher ithan iproprietorships.

2. LLCs imust ifile iarticles iof iincorporation iwith ithe istate iof idomicile.

3. Owners imust icreate ian ioperating iagreement ithat idefines imanagement iauthority iand ilimits ito imaking idecisions.

4. In isome icases, ian iLLC iwill icease ito iexist iupon ithe ideath iof ia imember, iunless iotherwise ispecified iin ithe ioperating iagreement.

2. Corporation

Corporations iare ione iof ithe ioldest iforms iof ibusiness ientity. iCorporations iare ithe ipreferred ilegal ientity ifor ibusinesses ithat iare ior iplan ito ibe ipublicly itraded. iAccessing ipublic imarkets ifor iinvestment icapital iis inot ithe ionly ireason ito ichoose ia icorporation.

There iare iprimarily ithree itypes iof icorporations ithat ibusinesses iform ibased ion isections iof ithe iInternal iRevenue iCode:

1. Subchapter iC iCorporations i(C iCorp),

2. Subchapter iS iCorporations i(S iCorp), iand

3. Non-Profit ior iNot-for-Profit iCorporations.

C iCorporation

A iC iCorporation iis ithe imost icommon ibusiness ientity ifor ilarge icompanies iand ithose iwhich iare ipublicly itraded. iWhile ithere iare imany ireasons ibusinesses ichoose ithe iC iCorporation iform iof ilegal ientity, ithe iprimary idriver iis icorporate ifinance ilaw.

As ia igeneral irule, icorporations imust ipay ientity ilevel itaxes. iThis igeneral irule iis iheavily imodified iby ithe isubchapters iof ithe itax icode ithat iapply. iS iCorporations, ifor iexample, imay iprovide ipass ithrough itax ibenefits.

Corporations iare isubject ito idouble itaxation. iDouble itaxation iis ithe iidea ithat ithe ientity iitself ipays itaxes ion iits iincome, iand ithen ithe iowners ipay iincome itaxes ion ithe idividends iwhich ithey ireceive ifrom ithe icorporation.

The ilaw iabout iraising icapital iand imanaging ifor-profit icompanies iis iwell iestablished iand igenerally ireliable. iSubchapter iC idoes iimpose idouble itaxation, ibut ithe iownership iand imanagement iflexibility imore ithan icompensates ifor ithe itax iburden.

New ibusinesses iand istart-ups imay ichoose ito icreate ia iC iCorporation iwhen ithey iknow ithey iare ion ia ipath ito imultiple irounds iof ifundraising, iwhich iwill iculminate iin ia isale iof ithe ientire ibusiness ior itaking iit ipublic.

A icorporation iis ia ilegal ientity ithat's icompletely iseparate ifrom ithe ishareholders iwho iown istock iin ithe icompany. iIt ihas ithe iauthority ito ienter iinto icontracts iand ibuy iand isell iproperty. iA icorporation ican isue iother iparties ibut ican ialso ibe isued.

Advantages

1. Owners ido inot ihave ipersonal iliability ifor idebts iof ithe icorporation. iA ishareholder ionly irisks ithe iamount iof ithe iinvestment iin ithe icompany.

2. Has imore iaccess ito ifinancial iresources. iA icorporation ican isell istock ito iraise icapital, iobtain ibank iloans ior iissue ibonds ifor ilong-term ifinancing.

3. Corporations iare ibetter iable ito iattract imore italented iand iskilled iemployees ithan iproprietorships.

4. The icorporations icontinue ito iexist iseparately ifrom ithe ilives iof iits istockholders.

Disadvantages

1. A iC iCorp iis ithe imost icomplex ibusiness istructure iand irequires ia ilawyer ito iset iup.

2. Earnings icould ibe isubject ito idouble itaxation.

S iCorporation

S iCorporations iare, iroughly ispeaking; ian iearlier iform iof ia ilimited iliability icompany iin ithat ithey icombine ithe itax ibenefits iof ia ipartnership iwith ithe iliability iprotections iof ia icorporation.

There iare iownership irestrictions ifor iS iCorps ithat ido inot iapply ito iLLCs.

Advantages

1. Avoids idouble itaxation iby ipassing iincome ithrough ito ithe iowners.

2. The istructure iof ian iS iCorp iprotects ithe ipersonal iassets iof ithe ishareholders.

3. Lenders iare imore iwilling ito imake iloans ito iS iCorps.

Disadvantages

1. Articles iof iincorporation imust ibe ifiled iwith ithe istate.

2. An iS iCorp iis ilimited ito i100 ishareholders.

3. It ican ionly ihave ione iclass iof istock.

4. Fringe ibenefits iprovided iby ithe icompany ito ishareholder-employees iare itaxable ias icompensation

Non-Profit iCorporation

There iare imany itypes iof icharitable icorporations ior inon-profit iorganizations ibased ion ithe iInternal iRevenue iCode. iThe imost iprominent iis ithe i501(c) i(3) ipublic icharity.

3. Partnership

Partnerships ican ibe iinformal ibusiness ientities, iwhich imeans ithere iare ino ifiling irequirements iand ifew, iif iany, imaintenance irequirements. iPartnerships iare inot igenerally irecognized ias ilegal ientities ifor itax ipurposes, iwhich imeans iprofits iand ilosses iare iallocated ito ithe ipartners iindividually ias ia ipass-through.

There iare inumber iof irisks ito ia ipartnership ithat iwarrant icareful iattention. iThe imost iimportant iis ithat iany ipartner iin ithe ipartnership ican ibind iall ithe iother ipartners iso ithat ieach ipartner iis iindividually iliable ifor ieach iobligation iof ithe ientire ipartnership. iThere iare icertainly iways iaround ithis iproblem iand ia inumber iof istatutory ialternatives ihave iemerged, ibut ifounders ishould ibe ithoughtful iabout ipartnership iformation.

There iare iseveral itypes iof ipartnership iunder icommon ilaw iand istate istatutes:

1. general ipartnerships,

2. limited ipartnerships,

3. limited iliability ipartnerships, iand

4. Limited iliability ilimited ipartnerships.

General iPartnership

A igeneral ipartnership iis idisregarded ifor itax ipurposes. iHowever, ipartners iare istrictly iliable ifor ithe idebts iof ithe ipartnership. iDebts iinclude ifinancial iindebtedness ifrom iany isource ias iwell ias icontractual iobligations. iA igeneral ipartnership imust ihave iat ileast itwo igeneral ipartners i(GPs).

Limited iPartnership

Limited ipartnerships ihave ia igeneral ipartner iand iat ileast ione ilimited ipartner i(LP). iA ilimited ipartner ihas ino imanagement iauthority iand icannot igenerally ibind ithe ipartnership. iThe iGP iretains iall ithe imanagement iauthority. iLimited ipartners iare iusually ifinancial ibackers iwho iparticipate iin ithe iproceeds.

The igeneral ipartner ihas iliability ifor iconduct iof ithe ipartnership, iwhereas ieach ilimited ipartner's iliability iis icapped iat ithe iinvestment iin ithe ipartnership.

Limited ipartnerships iare ipopular ifor iproject ibased ibusinesses isuch ias ireal iestate idevelopment iand iinvesting. iThe iGP iis itypically ia icorporation iwhich iseeks iout iLPs ito iraise ifinancing ifor ia iproject.

Limited iLiability iPartnership

Unlike ilimited ipartnerships, ilimited iliability ipartnerships ido inot ihave ia iseparate igeneral ipartner. iEach ipartner ihas ilimited iliability iprotection iand ithere iis ino igeneral ipartner iwith iunlimited iliability. iThe iscope iof ilimited iliability ivaries iwidely ifrom istate ito istate.

In ithis iway, ithe iLLP iresembles ian iLLC, ibecause ithe ipartners ihave ilimited iliability iand ibenefit ifrom ipass ithrough itax itreatment.

LLPs iare ioften iused iin iprofessional iindustries iwhere imalpractice iby ione ipartner imight iaffect ithe ientire ipartnership.

Limited iLiability iLimited iPartnership

The ilimited iliability ilimited ipartnership i(LLLP) iis inot iwidely iused. iLLLPs iare ialso inot iavailable iin ievery istate. iAn iLLLP iis ia isophisticated ibusiness ientity idesigned iprimarily ifor iinvestment ipurposes. iIt ishares imany iof ithe icharacteristics iof ilimited-partnerships, iexcept ithat ithe igeneral ipartner igets iadditional ilimited iliability iprotections.

A ipartnership iis ia isole iproprietorship