Each type of entity has its own unique advantages and disadvantages. One of the most significant considerations is how the business entity will be taxed. (See Tax Treatment of Business Entities).
A business can usually change its legal structure after it is formed. However, changing the business structure sometimes causes tax liabilities that could have been avoided by initially choosing the best business form. Consequently, deciding on the form or structure of the business is one of the first important decisions the business owner makes.
The choice of the business structure should be made in consultation with your attorney, accountant, or other competent business adviser. These professionals can also help you with:
- Advise on the requirements of various statutes
- Advise on trademark and copyright issues
- Advise on non-compete issues
- Advise on employment issues
- Advise on tax issues
- Assistance in preparation of a business plan
Obtaining competent advice and services early in the process of embarking on a business venture can save both time and money by avoiding costly mistakes.
Corporations usually have a set of bylaws which govern how the corporation is run. These bylaws are not generally a public record. The bylaws are adopted by the shareholders who formed the corporation or by the board of directors elected by the shareholders. The bylaws can later be changed by a vote of the shareholders or the directors, depending upon the provisions of the articles of incorporation or the bylaws themselves.
Corporations enjoy many advantages as a business form. Perhaps the most important advantage is that a corporation’s stockholders, directors, and officers are not liable for the debts or other obligations of the corporation. Usually they are liable only for debts or other obligations which they have personally guaranteed or that result from their own negligence or misconduct.
Because it is a separate entity, a corporation is not terminated or dissolved upon the death or departure of a shareholder. As a result, upon the death of a shareholder the assets of the corporation are not tied up in the shareholders estate.
Smaller corporations are often “closely-held,” that is, the shares are owned by a small group of shareholders and have restrictions on transfer. The shareholders of smaller corporations commonly enter into a “buy-sell” agreement which limit the sale of the shares. This type of agreement ensures that if the shareholder wishes to sell his shares they will be offered back to the existing shareholders or the corporation.
A limited liability company ( “LLC”) is an unincorporated business entity that has the best characteristics of corporations and partnerships. The owners of an LLC are called members instead of stockholders or partners.
Like a corporation, an LLC shields its members from personal liability for the debts and obligations of the business, and like a partnership, the income and losses from the LLC are usually not taxed at the entity level, but instead are taxed at the individual level.
An LLC is formed by filing “articles of organization” with the Louisiana Secretary of State. The members of an LLC usually enter into an operating agreement that regulates how the LLC is governed. The provisions of the operating agreement can provide for how the LLC will be managed, what happens upon the death of a member, how a member’s interest can be transferred, and it can provide for a “buy-sell” agreement among its members.
An LLC can have an unlimited number of members and there are no restrictions on the type of persons who can be members. Some states do not allow one person LLCs , however, Louisiana does allow an LLC to have only one member. Additionally, an LLC can have more than one class of equity interest, as well as wholly owned subsidiaries whose assets, liabilities, and operating results are treated independently from those of its LLC parent.
Further, an LLC, unlike a Sub Chapter S corporation, can allocate profits, losses, and distributions disproportionate to the percentage of equity interest held in the LLC. (See Tax Treatment of Business Entities)
Because an LLC combines insulation from personal liability like a corporation with the tax advantages and managerial flexibility of a partnership, it will, in most cases, be the entity of choice for a new business. Moreover, using the LLC is not an impediment to raising capital as the LLC gives equity owners the same protection from liability they would have received as equity owners of a corporation.
The sole proprietorship is the simplest and most common form of business entity. A sole proprietorship is a business that is conducted by a single individual owner (the “sole proprietor”). Sole proprietors can conduct business under their own name by simply doing business, for example, as “Jane Jones.” A sole proprietor can also do business under a trade name (sometimes called a “fictitious name”) such as “Joe’s Grill.” If a sole proprietor operates under a trade name or fictitious name, the sole proprietor should file a form (“trade name certificate”) with the Louisiana Secretary of State. A sole proprietorship may have employees and is permitted to carry on most businesses.
- A sole proprietorship is simple to start and avoids the startup and state registration expenses required for other legal entities such as a corporations or limited liability companies. For example, additional operating expenses for other forms of business may include state registration expenses, franchise taxes, annual report fees, and additional professional fees.
- Sole proprietorships make their own decisions and avoid the conflicts that may occur among shareholders, members, or partners.
- Because a sole proprietorship is simply a single individual carrying on a business, the individual owner is personally liable for all the debts and other obligations of the business, including the actions of its employees.
- It is usually difficult to obtain an outside equity investment for a sole proprietorship.
- Raising capital to start or expand the business is limited, as a practical matter, to “debt financing” (that is, loans). This is because a sole proprietorship has only one owner and, as a result, cannot sell “equity interests” (stock or partnership interests) as is typically done by some other forms of business.
- A sole proprietorship is a greater financial risk for the business owner. The liabilities of a sole proprietor include liability for the negligent or willful acts of its employees and agents. Thus, if any employee were to negligently injure a third person in the course of the employee’s duties, the sole proprietor may, along with the employee, be personally liable for damages. If the sole proprietor had no insurance or insufficient insurance to cover the damages, the sole proprietor’s other assets (home, car, or stock portfolio) could be seized to pay the damages.
- If the business is unsuccessful and is terminated, the sole proprietor will be personally liable for payment of all of the business debts such as bank loans and unpaid bills to vendors and service providers (accountants, consultants and attorneys). If the assets of the sole proprietor are insufficient to satisfy the outstanding business debts, the sole proprietor may be forced to declare personal bankruptcy.
- Legally, a sole proprietorship is totally identified with and owned by the sole proprietor. Therefore, on the death of the owner, the business enterprise will be tied up in the owners estate, as will the the assets of the business such as equipment, accounts receivable, and real property. Because the assets used in the business are not separated from the other assets of the sole proprietor, it may be difficult to sell the business as a whole after the death of the sole proprietor. If there are disputes among the heirs, selling the business assets can be particularly troublesome.
The federal tax treatment of corporations is governed by the Internal Revenue Code. Attorneys, accountants, and other professionals usually refer to the types of corporations and their tax treatment according to the provision of the tax code that applies to that type of corporation. For tax purposes, there are two main types of corporations:
A “C” corporation is taxed at the entity level. By taxing at the entity level the corporation itself must pay income taxes. Income that has been taxed at the entity level will again be taxed if, and when, it is distributed as dividends to shareholders. This double taxation is perhaps the single greatest disadvantage to operating as a “C” corporation. However, “S” corporations may avoid much of this double taxation.
Despite double taxation, corporations do enjoy some tax-related advantages when compared to other business forms. Because the corporation and the owners each pay income taxes it may be advantageous to use a corporation in a business that requires capital to be retained to fund the purchases of equipment, machinery, and other assets. In this case the corporation and the owners combined income is divided between two taxpayers, thus potentially making the overall marginal tax rate lower.
For example, if a capital-intensive business is conducted as a sole proprietorship, an L.L.C, or a partnership, the owners would be individually taxed (possibly at the 39.6% top rate) on the earnings, even if they had to leave all or part of these earnings in the business to fund the acquisition of machinery and equipment. However, a corporation is not required to distribute earnings to its shareholders and can use them for corporate purposes. If the corporation has a lower marginal tax rate than the owners then more dollars are available for capital acquisitions. For example, if the corporation’s income is less than $50,000.00 its tax rate is 15%, if its income is over $50,000.00, but less than $75,000.00, its marginal tax rate is 25%, and if its income is over $75,000.00, but less than $100,000.00 its marginal tax rate is 34%. If these tax rates are lower than the owner’s marginal tax rate then there is more money available for capital expansion.
There are, however, limitations on the amount of earnings a corporation can accumulate before it must distribute them to shareholders or use them in the business. Otherwise, the corporation may face an additional tax on the accumulated earnings.
Certain small companies with no more than 75 shareholders and meeting certain requirements (only one class of common stock and only certain types of shareholders) can be taxed as an S corporation. An S corporation is also limited in the shares it may own in another S corporation.
If a corporation elects to be taxed as an S corporation and qualifies, it will be taxed in a manner similar to a partnership or limited liability company. That is, the income, losses, and gains will be passed through directly to the shareholders and there will be no tax “at the entity level.”
Unless it elects to be taxed as a corporation, the tax treatment of a limited liability company (“LLC”) is the same as that of a partnership or sole proprietorship. That is, the profits and losses are passed through to the members of the LLC and there is no tax at the entity level. In such a case the LLC is a tax reporting entity, it files a tax return, but it does not pay any taxes. Instead, the taxes are paid by the members of the LLC. Each member of an LLC should receive an IRS Form K-1 which will set forth the members profits and losses from the LLC. The members use the IRS Form K-1 in preparing their own tax returns and accounting for their income or loss from the LLC.
A sole proprietorship does not have any existence separate and apart from the individual sole proprietor. As a result, any income that is earned from the business is considered the income of the individual owner. The sole proprietorship itself is not separately taxed, rather the sole proprietor reports business income and expenses on his own tax return and pays taxes accordingly. The sole proprietor’s business income and expenses are usually reported on Schedule C of the taxpayers individual federal income tax return.
For more information about federal taxes go to the IRS web site.
For more information about Louisiana taxes go to the Louisiana Department of Revenue’s web site.
Whether a business is started over the kitchen table or is a multi-million dollar high-tech startup, operating a small business can raise numerous legal and financial questions. Attorneys, accountants, and other professionals, operating within their professional roles, can provide information and assistance that is vital to the success of a business enterprise.
- Attorneys usually provide information and advice on how to set up and operate various business entities and on the application of the tax laws.
- If the business entity involves more than one person, attorneys can draft agreements that can resolve important questions that might become the subject of later disagreement among partners or shareholders.
- If an existing business is to be acquired, an attorney can help analyze the advisability of the various methods of acquiring the business.
- Attorneys can draft important documents protecting the interests of the buyer and resolve potential disagreements concerning the conclusion of the transaction.
- In the due diligence phase of a transaction, attorneys gather financial and other information and can assist in determining the value of the business being acquired, and the nature of any existing and “contingent liabilities.”
In addition, a seller may wish to protect important confidential information from disclosure in case the transaction fails to occur. This can be done with a confidentiality agreement drafted by an attorney before the due diligence process begins. Generally, a confidentiality agreement is appropriate if it is drafted to protect truly confidential information only and serves as a mechanism by which such information is clearly identified.
InfoLouisiana – This site has all types of information on it about doing business in Louisiana, as well as links to other Louisiana State Government pages.
Louisana Department of Revenue and Taxation – This site has a wealth of information about Louisiana Taxes as well as the forms necessary for filing of Louisiana tax returns and frequently asked questions about Louisiana taxes.
Internal Revenue Service – This site is the official site of the Internal Revenue Service. It has all types of information about federal income taxes as well as downloadable forms for filing with the IRS.
Findlaw Small Business Center – This site has a wealth of general, tax, and legal information for the small business.
Attorney At Law
839 Kings Hwy Suite 200
Shreveport, Louisiana 71104