All businesses, large and small, must choose an organizational structure that meets the company's needs. The decision regarding which business structure is best for your business should be made after consultation with an attorney and accountant.  In determining the proper entity choice you should consider issues regarding tax, liability, management, continuity, transferability of ownership interests, and formality of operation.

In the past, business planners were faced with a dilemma in choosing between only two organizational forms: corporations and partnerships. Partnerships offer certain tax benefits, but the partners themselves are responsible for the debts and obligations of the other partners. Corporations, on the other hand, tend to have additional tax burdens, but give the corporation's officers, directors and shareholders protection from liability. Today, however, there are a number of additional organizational forms, which offer solutions to this predicament.

A sole proprietorship is the business form most commonly used when a business has only one owner. In a sole proprietorship, a single individual owns all the business assets and is liable for any business debts.  Proprietorships are usually small business enterprises, with capital demands being met by the owner and with little or no need for outside investors.

A corporation is the most popular choice of businesses seeking investor capital. Corporations are required to pay federal, state and, in some cases, local taxes. An Arizona corporation is created by filing Articles of Incorporation with the Arizona Corporation Commission. A corporation is distinct from its owners, or "shareholders," and is treated as a separate "person" under the law with the characteristics of limited liability, centralization of management, perpetual duration, and ease of transferability of ownership interests. The corporation itself, not the shareholders, is liable for the corporation's debts. Furthermore, absent wrongdoing on their part, officers and directors are not personally liable for corporate debts.

Many people believe that there are two types of corporations: “S” corporations and “C” corporations; however, this is incorrect. The name "C corporation" is derived from the fact that regular corporations are taxed by the Internal Revenue Service under subchapter C of the Internal Revenue Code. An S corporation is organized and operated just like a regular corporation except for the special treatment afforded it under subsection S of the federal Internal Revenue Code.

With some limited exceptions the S corporation is not taxed at the corporate level. Instead it is permitted to pass income and losses through to its shareholders who report the income on their federal tax returns. A business must meet certain eligibility requirements to qualify for incorporation as an S corporation. S corporation status is established under federal income tax law and, therefore, is not necessarily available for purposes of state income tax law.

So, how do you determine whether a C corporation or S corporation is best for your business?  You should consult with your tax advisor about the best tax election for your business, but here are some common situations that may also factor into your decision:

A limited liability company (LLC) is another type of business formation designed to protect its owners from personal liability for the debts of the business. The LLC is not a partnership or a corporation but rather a hybrid of the two that has the benefits and advantages of both a corporation and a partnership but few of the disadvantages of either.  An Arizona limited liability company is created by filing Articles of Organization with the Arizona Corporation Commission. Aside from this formality, the limited liability company can be structured to operate and/or taxed as a sole proprietorship, partnership or a corporation, depending upon the wishes of its owner(s).  An owner of an LLC is called a "member."

A general partnership is the simplest form for a business to take when two or more people own the business. A partnership exists whenever two or more people co-own a business for profit and share in the profits and losses of the business. A partnership arises automatically whenever this arrangement exists, and no further formalities are necessary. Partnerships themselves pay no taxes; instead, the business "passes through" any profits or losses to its partners who report them on their personal tax returns. Because partnerships entail more than one person in the decision-making process, development of a legal partnership agreement which sets the ground rules for the partnership is important. 

Importantly,  A general partnership offers no liability protection to the partners. Each partner is personally liable for the partnership's debts and all the partners are liable for debts and obligations resulting from the wrongful acts of another partner if that partner acted in the ordinary course of partnership business or acted with the authority of the other partners.

The limited partnership is a variation of the general partnership. In a limited partnership there are two types of partners: general partners and limited partners. The general partners are the partners who manage the business and have the power to bind the partnership. Only the general partners are personally liable for the partnership debts. The limited partners are essentially passive investors. They do not participate in the management of the partnership, they may not bind the partnership and are not personally liable for the debts of the partnership. The formation of both the limited liability partnership and the limited partnership requires special formalities, such as filing with the appropriate state official.

The limited liability partnership is another variation on the basic partnership model that evolved mainly in response to the desire to reduce the exposure to personal liability for the obligations of the partnership. In order to limit the liability of its general partners, a general or limited partnership may opt to register as a limited liability partnership. The limited liability partnership resembles a regular partnership in all respects except with respect to the allocation of liability. In a limited liability partnership, each partner is protected from personal liability arising from negligence, malpractice or improper conduct of other partners, agents or employees of the partnership, but not from his or her own actions of negligence, malpractice or improper conduct.

The advantages and disadvantages of the organizational forms described above must be considered when choosing the appropriate organizational form. For one, certain structures are more expensive to set up and maintain than others, and more formal steps may be required to establish them. Corporations must comply with strict statutory formalities regarding their creation and continued existence. In Arizona, corporations must file annual reports, whereas LLCs are not required to do any ongoing filing after their formation.  Tax rules also must be observed. For example, failure to continually meet the requirements for S corporation eligibility will result in termination of S corporation status and thus result in potentially serious tax consequences. On the other end of the spectrum, general partnerships require no formalities whatsoever.

The management and control of the business is another big consideration. Corporations are not actually operated by the owners (shareholders) of the business. Instead, the shareholders elect a board of directors and officers to manage and control the business. By contrast, the partners in a general partnership have complete control over business operations, as does the sole proprietor. The general partners manage a limited partnership, and an LLC may be managed either by its members or by managers selected by the members.

Personal liability for the obligations of the business is critical. The protection of the owner's personal assets from the claims of business creditors is generally not available to a general partner in a limited partnership, all partners in a general partnership and the owner of a sole proprietorship.  In these business forms the owners are all subject to unlimited personal liability for the debts of the business.  This means that the owner's personal bank accounts, investment accounts, real and personal property and other assets are at risk.

Because different organizational forms are taxed differently, the tax consequences of the chosen organizational form should be explored. As a separate entity, the C corporation is subject to what is known as "double taxation."  First, the corporation pays income tax on its earnings. Then, if the corporation chooses to distribute its after-tax income to the shareholders in the form of dividends, the shareholders must pay tax on that income as well. The same income is taxed twice at the corporate and at the shareholder level. Money passing through partnerships, limited partnerships, limited liability companies and S corporations are not taxed as separate legal entities. Instead, the profits and losses of the business flow through to the owners themselves. There are many other factors to be considered, such as, how the owners will be compensated, whether benefits will be offered to owners and employees, whether there will be more than one class of stock, and, whether there will be restrictions on the transferability of ownership. 

The decision as to which organizational form to use depends on numerous factors, including the limitation of personal liability of the owners, tax consequences, and the roles of the various owners.  An experienced business attorney can help you decide which business structure is right for you in light of your specific business needs.

As a small business owner and a business attorney, Jeana Morrissey has the experience to help you sort out these factors and form your business entity.  Contact us today by email or by phone at (602) 556-1902. 

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