LLC vs Corporation vs Partnership vs Sole Proprietorship
What are they - How do they differ?

Limited Liability Company (LLC)

The LLC is a new hybrid form of doing business that combines characteristics of the corporate structure and the partnership structure. It is a separate entity like a corporation and therefore carries liability protection for all of its' members, but (if structured properly) is taxed like a partnership which has the benefit of flow through taxation.

The owners are called members and can be virtually any entity including individuals (residents or foreigners), corporations, other LLCs, trusts, pension plans etc. Many states permit one member LLCs, only two do not. Currently it is considered a questionable practice to form a one member LLC because of the IRS problems that this might create. A husband and wife are considered two members for formation purposes.

An LLC is formed by filing a form, usually called Articles of Organization, with the Secretary of State. The corporation division of most secretary of state offices handles LLCs. Most states require an annual report be filed to keep them apprised of current status, but other than that, there are no other on going reports or forms. The LLC is not a tax paying entity. Profits, losses etc. flow directly through and are reported on the individual members tax returns. The LLC files a partnership return under Subchapter K of the Internal Revenue Code.

Most states require that the LLC have an Operating Agreement of some kind and a written, carefully drafted one is the prudent practice. The operating agreement is the agreement between the members as to how the LLC will be managed and contains provisions that will qualify it for the beneficial and coveted partnership tax treatment. The other side of the coin obviously is that, if not drafted correctly, the LLC will not qualify and will be taxed as a corporation. The state statutes are basically classified as bulletproof or flexible. Bulletproof statutes require that the operating agreement have certain provisions that guarantee that the LLC will qualify for partnership taxation. Flexible statutes leave the drafting of operating agreement provisions up to the individual organizers.

The key issue to determine whether the LLC qualifies for partnership tax treatment is whether or not it is too much like a corporation. Fortunately, there is a test and it boils down to four basic characteristics that corporations have. The LLC can only have two and still retain its partnership tax status. They are limited liability, continuity of life, centralized management and, free transferability of interests. Selecting the two that your LLC will have and making sure you don't have three is the tricky part and where the importance of proper drafting of the operating agreement comes in. The IRS has approved a simplified process called "Check the Box", wherein the LLC organizer can just elect what tax treatment is preferred. Not all states have adopted "Check the Box" and currently the safest way to organize is to comply with the original guidelines with respect to corporate characteristics.

Corporation (including Subchapter S)

The corporation is a separate entity and therefore carries with it limited liability protection for its owners or stockholders. It has perpetual life and is a tax paying entity. Double taxation is a potential negative feature as earnings are taxed at the entity level and then taxed again when distributed to the stockholders as dividends.

A corporation is formed by filing Articles of Incorporation with the Secretary of State. Shares of stock are issued to the shareholders, bylaws are adopted, and a board of directors is elected. The board of directors manage the corporation and appoint officers (president, secretary, treasurer) to maintain the ongoing daily affairs. The laws require regular director and shareholder meetings be held, minutes of those meetings be kept, and any decisions made at those meetings be formalized in the form of written resolutions. Failure to maintain these records will jeopardize the corporate status and leave the stockholders vulnerable to personal attack and responsibility for tax liability and corporate debt.

The Subchapter S corporation is formed by making a special IRS election. When properly made and maintained this election allows the flow-through taxation treatment similar to that which partnerships and LLCs enjoy. The problems arise however in compliance with the stringent rules necessary to maintain the election and S status. These qualification requirements necessitate administrative and cost burdens that LLCs do not have and it is actually fairly easily to inadvertently lose S status by failure to comply with all of the rules. This can lead to disastrous tax consequences.

Corporations can be formed by one person and all owners can participate in management without jeopardizing their liability protection. An S corporation is limited to 75 owners and they cannot be corporations, nonresident aliens, general or limited partnerships, pension plans, charitable organizations or certain trusts. An S corporation cannot own more that 80 percent of the stock of other corporations and may not be part of an affiliated group.

Partnership (including Limited Partnership)

The partnership form of doing business is noted for its simplicity and ease of formation. A general partnership can be formed with nothing more than a verbal agreement. Nothing has to be filed with the state and freedom of contract is the governing principle. The down side is that the partners are joint and severally liable. This means that each partner is fully liable for the actions of the other partner.

A limited partnership is a little better in that the limited partners are not liable for partnership debt and only their investment is at risk. The down side is that there has to be a general partner who is responsible for everything and if the limited partners get involved in management they are risking their liability protection. A limited partnership files a document with the secretary of state and is governed by a limited partnership agreement.

A limited partnership is limited to 35 owners. Both general and limited partnerships enjoy the benefits of partnership taxation.

Sole Proprietorship

Operating as a sole proprietor is certainly the easiest and cheapest form of doing business. You basically open the doors and go. The temptation to operate this way is great and many succumb. The shortcomings of this form of business are great also. There is absolutely no protection between you and your business and there are no tax benefits. There are no particular record keeping requirements which is quite easy but often leads to sloppy business practice. Sloppy business creates poor decision making and sets up failure. At the very least you become a sitting duck for IRS audit and lawsuits. Planning, at the beginning, can save you money on an ongoing basis and protect the assets that you have worked so hard to accumulate.

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