Types of Legal Entities and Characteristics
There are five main types of legal entities to operate your business under. As noted earlier, most businesses form either a corporation or an LLC although there are others that do exist. Typically, the main factors that play a role in this decision with most entrepreneurs and businesses are tax issues and liability. Generally, if you form a corporation or an LLC, the owners are not personally responsible for the obligations and liabilities of the entity. There are exceptions to this rule however so consult with your legal attorney to discuss these.
The main difference between forming a corporation (either an S corporation or a C corporation) compared to an LLC is the laws associated with each, management structure and costs. With corporations, you have:
- A separate legal entity created by a state filing.
- Liability protection for shareholders (owners). Typically, the shareholders are not responsible for debts of the business.
- A management structure where the shareholders elect the board and the board appoints the officers. The shareholders can be involved in holding management roles, but it is not necessary. The directors elect officers to manage the day-to-day activities of the business.
- The ability to transfer ownership easily without the consent of other shareholders.
- The same internal and external corporate laws and formalities. Corporations have standardized laws such as one that prohibits the issuance of stock in exchange for a commitment to contribute property or services (assets). If you form a corporation, you are required to adopt certain bylaws, issue stock, keep record of meeting minutes with shareholders and directors, file annual reports and pay annual fees.
With LLCs, you have:
- Flexibility in management structure.
- Voting and inspection rights of LLC members are generally nontransferable without majority consent of the other business members.
- Flexibility on what can be legally contributed in exchange for the ownership interest. With an LLC, you can purchase membership interests in exchange for assets.
Two types of corporations
There are two kinds of corporations you can form: an S corporation or a C corporation. The differences between the two are as follows:
- C corporations are separate taxable entities and there is a possibility of double taxation if the business profits that are distributed to the shareholders as dividends are reported on the shareholders personal income. Therefore, shareholders could pay taxes on the company twice. C corporations can have unlimited number of shareholders, non-US resident shareholders and can have multiple classes of stock. If the company is sold, a C corporation can only sell stock whereas an S corporation can sell assets in addition to stock.
- S corporations are known as pass-through or flow-through entities because the income or losses of the company are divided and passed through its shareholders and each shareholder is required to report the income or loss on their own individual tax return. An S corporation can only have US shareholders and one class of stock.
Other legal entities
- A limited liability company, or LLC, is a company formed under applicable state statute and offers flexibility to its members (owners of the LLC similar in concept to shareholders in corporations) in regards to management structure and taxation. A main characteristic of an LLC is the availability of pass-through taxation unless the LLC elects to be taxed as a C corporation. LLC services can protect some liability for acts and debts of the LLC to its members, but members are still responsible for debts beyond the fiscal capacity of the entity.
LLCs are run by its Operating Agreement, a document that determines, defines and allocates the rights of the members. With LLCs, the owners have the ability to draft their own rules and bylaws (opposed to corporations where the rules are set by state laws) so this document must be one of the main concerns and discussions when forming the legal entity.
- A limited liability partnership (LLP) is similar to an LLC in that all partners have a form of limited liability for business debts similar to shareholders of a corporation, but the partners have the right to manage the business directly. Similar to LLCs, LLPs allow for pass-through taxation and have flexibility in management structure.
- Limited partnership is a partnership between owners where at least one partner must be a general partner with unlimited liability and at least one partner must be a limited partner with liability limited to the amount of his or her investment. This legal entity also allows for pass-through taxation and income is not taxed at the business level. Limited Partnership is different from LLPs in that not all members are granted limited liability.
- Sole proprietorship is formed when you want no separate existence from the business. The person who sets up the company has sole responsibility for the companys debts and reports the profits on his or her personal income tax. A sole proprietor has the option of forming a LLC to have some protection of limited liability, but could still operate as a sole proprietorship for income tax purposes.
Understanding each legal entity and its characteristics and factors are crucial so we recommend that you consult with your attorney, or CPA to help you identify and determine which type of corporation will best suit your business. The present size of your company and potential growth will be considered in this process.
After you consult with a legal professional regarding incorporation services, you can easily form a corporation through many online sources, or you can go through your attorney. Regardless, whether you choose between a corporation and a limited liability company is an important decision so understand each entity thoroughly before making your final decision.