Below we discuss the History of Business Types, the Attributes of the Corporation, Double vs. Pass Through Taxation, and Modern Business Types with a table and discussion of the advantages and disadvantages of each of the various common business types.
Historically there were only sole proprietorships. Then came partnerships and then corporations. Corporations are a several centuries old phenomena. Partnerships were arrangements between two or more individuals in which they pooled resources, and split expenses and profits. At first corporations were chartered by monarchies. Historically corporations offered limited liability and partnerships did not. In other words, if the venture failed, the organizers and promoters of a corporation retained their personal assets, while the owners and organizers of a partnership could lose their personal assets to the creditors of the business venture.
From the middle of the 20th Century to the present the legal evolution of partnerships and corporations progressed increasingly rapidly. As income taxation became a significant feature of business planning in the post World War II era the advantages and disadvantages of the various types of business organization became relatively well settled for a time. Corporations offered limited liability but presented the double taxation problem. Partnerships did not suffer from double taxation but did not offer limited liability. Thus there were clear advantages and disadvantages to each form of business organization and a real and sometimes difficult choice to be made.
Some of the most significant features of the corporation were limited liability, indefinite lifetime, centralized management, and free transferability of ownership interests.
Limited liability - the owners assets cannot be attacked to satisfy the debts of the business.
Indefinite lifetime - without regard to the status of any owner of ownership interests the business would continue to exist.
Centralized management - a few of people, not the entirety of the ownership would control and manage the business.
Free transferability - one owner can sell his ownership interests to an outsider without a change in the nature of the business.
Partnerships by comparison had none of these features. There was no limited liability as explained above. The partnership would cease to exist, would be wound up, the debts paid, and residual assets distributed on the death or departure of one of the partners. Management was done by all the owners, the partners. Finally, as alluded to above, if a partner wanted to sell his ownership interest it was not freely transferable, the agreement of all the other partners was necessary, or else the partnership would be wound up, and the assets distributed.
Simply stated double taxation was and is the imposition of income tax on corporate income followed by the imposition of income tax on the individual shareholder after that income is distributed. Pass through taxations means that the income and expenses, and profit or loss, of a business are divided among the business owners and appear on their tax returns. As an example if you own a small business and are incorporated and you have gross income of $500,000.00, expenses of $400,000.00, and net income of $100,000.00, and you are incorporated, you could end up paying corporate income tax on the $100,000.00 of lets say, $34,000.00. The remaining $66,000.00 would be distributed to you and you would pay income tax of let's say $18,000.00 on that income. You would end up with $48,000.00. If the business was a partnership and you held all the ownership interests of the partnership, with pass through taxation the only tax owed would be the income tax on the distribution of the $100,000.00 business income. You would take home let's say the entire $66,000.00. Note that the estimates of tax for this hypothetical are for illustration only and are not based on tax tables or other references.
In the historical context the decision one had to make, say 45 years ago, was whether to be a partnership and not have the attributes of a corporation as set forth above or form a corporation and subject oneself to double taxation. The burden of double taxation can be onerous, so there were powerful incentives to form a partnership or lobby legislators for the creation of entities that had some of the attributes of both corporations and partnerships.
The lobbyists won. Several new types of business entity have been created in the last few decades. For the most part they incorporate the limited liability of corporation with the pass through taxation of partnerships. S Corporations, Limited Liability Corporations ("LLCs"), Limited Partnerships, and Limited Liability Partnerships ("LLPs"), all offer limited liability and pass-through taxation. Together with the more traditional business forms, C corporations, general partnerships, and sole proprietorships, these represent the primary ways in which a business may be organized.
The following chart may help in understanding the different business forms.
C and S Corporations derive their names from the Chapters of the Internal Revenue Code in which they are discussed. In other words C Corporations are discussed in Chapter C and S Corporations are discussed in Chapter S. Almost without exception, listed, publicly traded corporations are C Corporations. One of the most significant issues for the owner of a small closely held C Corporation is the fact that it does not offer pass through taxation. Sometimes this is dealt with by issuing a bonus to the owner(s) at the end of the year to ensure that the corporation does not have any profits on which it would have to pay corporate taxes. An advantage for the owner(s) of a small closely held C Corporation is that premiums paid for health insurance, covering the owner(s), by a C Corporation, are fully deductible to the Corporation and not includable in the income of the owner(s). This is not true for owners of S Corporations and some of the other business forms discussed below.
Basically the way the Internal Revenue Service sees it, pass through taxation is a benefit, one not to be granted to all business forms. Many tax laws and regulations are designed to ensure that a business is not too much like a traditional C corporation and still has pass-through taxation.
S Corporations have restrictions as to the number of shareholders, and the identity of the shareholders. One way to conceive of S Corporations is to think of them as a safe harbor for limited liability and pass through taxation. In other words if you organize as an S Corporation you don't have to worry as to whether your business that has limited liability has too many other attributes that make it like a C Corporation such that the IRS will decide to characterize it that way and remove the pass through taxation.
To qualify to elect S corporation status you must not (A) have more than 75 shareholders; (B) have a shareholder that is not a person (such as a corporation that owns the stock; (C) have a shareholder that is a nonresident alien; (D) or, have more than one class of stock.
Limited partnerships are another business form that offers limited liability and pass through taxation. Limited partnerships must have a General Partner. The General Partner manages the Limited Partnership but does not have limited liability. Sometimes this problem of no limited liability is solved by having a corporation as the General Partner. A significant issue with Limited Partnerships is that the Limited Partners may not be involved in the management of the entity. Many times the number of business owners will be relatively few and they will all be actively involved in the management of the entity. In these situations a Limited Partnership is not an appropriate business form.
LLCs and LLPs are relatively new types of business forms. Like S Corporations they combine limited liability with pass through taxation. However, they are more flexible than S Corporations. There are no restrictions on the number of owners or their identity. Many times an LLC is the most flexible and best entity type to choose.
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