Incorporating is the act of forming a new “corporate” business structure that affords certain business, tax, and legal advantages to its owner(s). By the act of incorporating, a separate legal entity is formed that can own property, pay taxes, sign binding contracts, and protect its owners from business and financial liability. There are several different structure models that a business owner may choose, depending on which legal and tax advantages work best for his or her company’s interests.
- Sole Proprietorship
- General Partnership
- Limited Partnership
- Limited Liability Partnership
- Limited Liability Company
For additional information on both unincorporated and incorporated business structures we have provided detailed information on popular entities in our Business Types section.
A Sole Proprietorship describes a simple business structure that is owned by an individual. Many smaller businesses operate as Sole Proprietorships (for example, your typical “mom and pop” shop, shoe store, etc.); however, one of the major disadvantages of this structure is that the owner is personally responsible for all legal and financial liabilities. A business-related lawsuit or IRS tax audit puts the owners personal assets at risk of seizure. Further, all business income is taxed as personal earned income by the owner . Though a business may choose to use a trade name (or a “DBA,” etc.–any trade name must be registered with the clerk of the town/city where the business is located), there does not exist a legal separation of the owner from the business as can be the case with other types of business structures.
Advantages of Sole Proprietor
- Minimal Paperwork
- Minimal Legal Restrictions
- Ease of dissolution
- Income reported on Owner’s tax returns
Disadvantages of Sole Proprietor
- Unlimited Personal Liability for Debts and Liabilities of the Business
- Owner can lose personal assets in a business lawsuit
- Business terminates upon death of Owner
- Limited Ability to Raise Capital
A General Partnership allows two or more parties to share in the liability and profits of a company. Those parties could be compromised of corporations, individuals, other partnerships, trusts, or any combination thereof.
Advantages of General Partnership
- Easy to Establish
- Financial and Managerial Strengths of all Partners can be Utilized
Disadvantages of General Partnership
- The Partners have are exposed to unlimited liability for the legal and financial liabilities of the business
- Liability caused or incurred by one partner leaves all partners vulnerable to seizure of business and personal assets
- Business ceases to exist in the event of the death of a Partner (in instances where business continuity planning is absent)
- Partners are able to commit business to obligations without approval from the other partners
The Limited Partnership (LP) business structure creates a separate legal entity that involves one or more general partners and one or more limited partners. These limited partners typically invest capital in the business and are limited in their liability proportional to the amount of capital they invest. The general partner(s) controls the operation of the partnership and is personally liable for its obligations and debts. A corporation is often placed in the general partner position in order to absorb the liability. A majority vote of the voting partners, unless specified otherwise by a written agreement, can change who serves as general partner.
When a limited partner is sued personally and a judgment is issued, that limited partner’s interest in the Limited Partnership entity is protected from seizure as are any assets held by the Limited Partnership. Because of this protection, the Limited Partnership is often used effectively to shield assets from creditors.
Advantages of Limited Partnership
- The assets inside of the limited partnership can be protected from seizure when a limited partner loses a lawsuit.
- The profit made by the Limited Partnership are simply reported on the partners’ personal tax returns
- The Limited Partners are protected from the liability in a business lawsuit
- With an appropriately drafted partnership agreement, there is no cap on the amount of money that the general partners may garner from the business
- Limited Partnerships may own property, sue, and be sued due to their status as a separate legal entity
Disadvantages of Limited Partnership
- The Limited Partnership requires more legal documentation than a General Partnership
- The General Partner shoulders liability, so requires another entity, such as a corporation, to serve in this capacity
Limited Liability Partnership
A Limited Liability Partnership (LLP) most often employed in professional practices such as law, accounting and architecture. This type of separate legal entity allows for liability protection for all general partners, as well as management rights. In most cases the Limited Liability Partnership provides for the same limited liability found in a Corporation. For tax purposes, the Limited Liability Partnership is a flow-through entity like a Partnership.
Advantages of LLP
- The Limited Liability Partnership provides legal framework to the beginning of the business
- The Limited Partners are protected from the liability of the company in that their liability depends on the amount of capital they invest
- The dividends paid to the partners are reported on the partners’ personal tax returns
- There is no requirement to set a date of termination of the partnership agreement
- Limited Liability Partnerships may own property, sue, and be sued due to their status as a separate legal entity
Disadvantages of LLP
- The Limited Liability Partnership requires more legal documentation than say a General Partnership due to its’ status as a legal entity
- The business is considered dissolved when the Limited Liability Partnership loses a partner
- In some states only professionals, such as attorneys, architects and accounts may use this type of entity.
Limited Liability Company
The Limited Liability Company (“LLC”) has the lawsuit protection benefits of a Corporation and the asset protection benefits of a Limited Partnership. Limited Liability Companies combine the limited liability found in Corporations and the tax status of a Sole Proprietor or Partnership, at the discretion of the ownership. One can also choose to have the LLC taxed as a C corporation or an S corporation. In a Limited Liability Company, the owners are referred to as “members.”
When the LLC is sued, legal provisions based on its status as a separate legal entity protect the individual members from liability. When the members are sued personally, statutes protect the LLC and assets therein from being seized by creditors. Because of these benefits, a Limited Liability Company is often used to own real estate investments and to protect members of various professionals of larger professional Firms (accounting, legal, etc.).
Advantages of Limited Liability Companies
- Protects company assets if members are sued
- Protects members if company is sued
- A Limited Liability Company may be formed by one or more members
- Members of the LLC can elect another person, or entity to manage the company
- An operating agreement governs the Limited Liability Company
- The Limited Liability Company can typically enjoy Perpetual Duration unless stated otherwise in the articles of organization
Disadvantages of Limited Liability Companies
- As a legal entity, the Limited Liability Company requires more legal documentation than would be found in a Sole Proprietorship or General Partnership
A Corporation is considered by law to be a legal entity or “person” separate from those who own or control it. A Corporation can file taxes either as a C-Corporation, or as an S-Corporation. The S-Corporation is a former C-Corporation that files IRS form 2553 to elect special tax status. The S-Corporation has pass-through taxation, is limited to between 75 and 100 or fewer shareholders (depending on which state it is formed in), and cannot have non-U.S. resident shareholders. C-Corporations can have an unlimited number of shareholders, are allowed to be U.S. and/or non-U.S. residents shareholders, and are taxed on net profits. A C-corporation can deduct employee medical expenses and insurance.
Both C and S corporations may have a pension plan. Money paid into the pension plan is tax-deductible to the corporation and tax-free to the employee. The money inside of the pension plan can grow tax-free until withdrawn for retirement.
Advantages of Corporations
- The shareholders (owners) of the Corporation are protected from liability when the business is sued
- Perpetual Duration of the Company unless specified otherwise in the Certificate of Incorporation
- The owners have their liability limited to the amount they have paid into their share of stock
- The operations of a Corporation are not affected by the transfer of shares, or death of a shareholder
- Corporations may own property, sue, and be sued due to their status as a separate legal entity
Disadvantages of Corporations
- Minimal record keeping
- Registration with government registries
Once incorporated, there are a few helpful steps to take that can help one enjoy the benefits of the corporation. For example, the acquisition of a Federal Tax ID from the IRS is an essential step. If filing as an S-Corporation, the IRS form 2553 must be filed before the 16th day of the third month of the tax year that the election is to take effect, or at any time during the tax year proceeding the tax year the S-Corporation is to take effect. After receiving the Federal Tax ID number, the articles of incorporation, and the certificate that has been file-stamped by the government, a separate bank account should be established for the business, with the understanding that the “co-mingling” of personal and business funds should not occur. Care must be taken that any follow-up documents are filed with the state as required, such as the list of officers and directors, and that a secretary is assigned and held responsible for the Corporate Minutes. If required, make sure to get a business license in the county in which the company operates. It is sound advice to have a tax professional who is experienced in corporate accounting prepare the required tax filings. Below is a summary of important items to remember after your corporation has been delivered:
- Obtain Federal Tax Identification Number
- Make S-Corporation designation if desired
- Open Company bank account
- File necessary follow-up documents such as a list of officers and directors, if required
- Consult with a Tax professional at least annually