Failure to choose entity can be costly to owner

by James F. McLeod

for the Business Journal

Every business owner has a large choice of business entities. Even leaving out those business entities that are unique to professional organizations or charitable organizations, the business owner has a choice of a corporation, limited liability company, proprietorship, partnership, limited partnership or a limited liability partnership.

When the entrepreneur begins his business, he selects a business entity. In the absence of any other decision, the entrepreneur selects a proprietorship or partnership by default.

The most common mistake the beginning business owner makes is to default to a proprietorship or partnership where some other type of business entity would be more appropriate.

The use of a proprietorship or a partnership for the business entity may leave the business owner's assets exposed to the creditors of the business. In both the proprietorship and the partnership, the business owner's liability is general, therefore any creditor of the business can seek to satisfy the debt out of the business owner's assets.

Corporations and limited liability companies separate the business assets from the business owner's assets for purposes of satisfying liabilities to creditors. A creditor of a corporation or of a limited liability company can only look to the assets of the corporation or limited liability company for satisfaction of the debt.

The tax structure of the business may also be controlled by the choice of entity. All of the income and expenses of a proprietorship are reported on the business owner's personal income tax return. No other return is required. All other types of business entities require a separate income tax return for the business.

The income from a partnership or a limited partnership is reported on a business owner's tax return. Corporations or limited liability companies can be taxed either at the business level or at the level of the business owner. A limited liability company must make an election whether it is to be taxed as a corporation or as a partnership. This election is made at the time the limited liability company is established.

The shareholders of a corporation may elect to have business income taxed either to the corporation or to the shareholders directly. This election to have income taxed to the shareholders is made by filing an "Election by Small Business Corporation" with the Internal Revenue Service. The election results in the corporation being treated as an S corporation by the Internal Revenue Service.

There is no fundamental structural difference between a regular corporation and an S corporation, the only difference is that the election form has been filed. Not every corporation can elect to be a small business corporation.

One eliminating factor on whether a corporation can be an S corporation is the number of shareholders. An S corporation cannot have more than 75 shareholders. When the shareholders of a corporation are not people but some type of business entity, other elections may have to be made as a part of the election to be taxed as an S corporation.

Each type of business entity has its own advantages and disadvantages. Every new business owner makes an election as to the type of business entity the business will be. Where no other action is taken, the business becomes a proprietorship or partnership.

(James F. McLeod is a practicing attorney with Miller & Sanford in Springfield.)

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