There are many ways to carry on a business or to own real estate or other assets. We will review some of them.
This is a work in progress, and I will be adding to it from time to time. If you have a specific question about any matter, let me know.
1. Sole Proprietorship
A sole proprietor is one person operating a business. He may do with the business as he wishes. He is personally liable for any of the debts of the business. He may obtain some protection by placing a homestead declaration on his house and, within the limits of the bankruptcy law, he could move assets into an irrevocable trust.
As with other entitles, if he operates his business under an assumed name most jurisdictions require that he file a certificate showing his true name and the name under which the business is carried on. The purpose of this is to protect those who do business with the sole proprietor.
For tax purposes, the sole proprietorship does not exist, gains and losses are reported directly on the tax return of the sole proprietor.
2. A General Partnership
A partnership consists of two or more persons engaged in a venture for profit. The partners are personally liable for the debts of the partnership, and in addition, are responsible for the acts of each other. The general partners have authority to bind the other partners in contractual matters having to do with the ordinary course of the partnership business.
Generally the death of a partner will cause a partnership to terminate, and if the enterprise continues in existence it will be as a new partnership, not the initial partnership
The partnership files a partnership tax return (Form 1065) and the income and losses appear on the tax returns of the partners.
3. A Limited Partnership
A limited partnership is a partnership consisting of two or more persons engaged in a venture for profit.
At least one partner must be a general partner - that is, fully liable for the debts of the partnership. The general partner or partners have management control of the partnership.
Limited partners are liable only to the extent of their investments in the partnership - they may lose their investment in the partnership but otherwise are not liable. The limited partners do not have management authority and do not have authority to bind the firm by their actions.
The limited partnership files a partnership tax return (Form 1065) and the income and losses appear on the tax returns of the partners.
A form of limited partnership - the societates publicanorum - existed as early as 300 BC in Rome
3. A Limited Liability Partnership
A limited liability partnership is a partnership consisting of two or more persons engaged in a venture for profit. The liability of each partner is limited to his or her investment in the partnership. A partner is not responsible for the acts of another partner.
The partners have management control of the partnership and have authority to bind the firm by their actions.
The limited liability partnership files a partnership tax return (Form 1065) and the income and losses appear on the tax returns of the partners.
4. The Corporation Sole
The corporation sole is a concept which goes back some five hundred years. There is only one member of a corporation sole, and that is a person who holds property by virtue of his office. Upon his death or removal from office the title to the property passes to his successor in that office. This is distinguished from a regular corporation (called, in early English law, a "corporation aggregate") where there were a number of people involved.
Every parson and vicar in the Church of England is a corporation sole. Property of the Roman Catholic Church in Boston is often held by the "Roman Catholic Archbishop of Boston, a corporation sole." The Queen of England is a corporation sole.
You will not encounter the corporation sole unless you are dealing with a religious entity. You may find a website offering you instructions as to how to designate yourself a corporation sole and, in theory, relieve yourself of the duty to file income taxes. If you follow such instructions to the ultimate you might indeed find yourself relieved of the duty to pay rent, since the United States Government has facilities in which you may be safely housed - they give you three meals a day, free medical care, and you are protected from being disturbed by visitors. You might meet a fellow named Bernard Madoff in your new home.
4. A "C" Corporation
A corporation receives a charter (from the Latin "Charta") from the state. One or more shareholders may constitute a corporation.
Shareholders in a corporation are not subject to liability for corporate debts. They may lose the amount of their investment in the corporation, but their own assets are safe.
A corporation is managed by a board of directors, who are elected by the shareholders. The shareholders do not directly manage the corporation.
Shares of stock in the corporation may be freely transferable or, by limitation in the corporation's Articles of Organization, or agreement by the shareholders, the shares may have limited transferability.
A "C" corporation is subject to Subchapter C of Chapter 1 of the Internal Revenue Code. It files its own federal income tax return (Form 1120).
Dividends paid by corporations to shareholders are not deductible by the corporations for income tax purposes and are generally taxed as income to the recipients.
A corporation is almost never a desirable vehicle to hold real estate, except if the shareholder is a nonresident alien. In that case, holding real estate in a corporation may protect the real estate from the federal estate tax.
5. An "S" Corporation
An "S" corporation receives a charter (from the Latin "Charta") from the state. One or more shareholders may constitute a corporation.
Shareholders in an "S" corporation are not subject to liability for corporate debts. They may lose the amount of their investment in the corporation, but their own assets are safe.
An "S" corporation is managed by a board of directors, who are elected by the shareholders. The shareholders do not directly manage the corporation.
Shares of stock in the "S" corporation may be freely transferable or, by limitation in the corporation's Articles of Organization, or agreement by the shareholders, the shares may have limited transferability.
An "S" corporation is subject to Subchapter S of Chapter 1 of the Internal Revenue Code. It files its own federal income tax return (Form 1120S). This is a "pass-through" return - income or losses flow through to the shareholders, in the same fashion as in a partnership.
Any corporation may be a "C" corporation - there are certain limitations on the formation of "S" corporations.
6. A Limited Liability Company
The limited liability company is generally known by its initials - "LLC" or "L.L.C.". It is a hybrid, structured to have the limited liability of corporations and the tax-free status of partnerships.
An LLC consists of one or more "members" who have joined together to carry on business. It is governed in accordance with the provisions of an "Operating Agreement" which can be drafted in a very creative way, so as, for example, to provide different compensation formulas for various members. Such flexibility would not be available in a regular corporation.
Members of an LLC are not liable for debts of the LLC. If the LLC becomes bankrupt, all they will lost is their investments.
The LLC is not subject to federal income tax unless it elects to be so taxed. Absent such an election, the LLC is a "disregarded entity" for tax purposes. Thus it has an identity for state law purposes and protects its members from liability, but for tax purposes it simply does not exist.
Under the "check the box" protocol developed in 1997 the LLC may elect to be taxed as a sole proprietorship, a partnership, an S corporation or a C corporation.
It is possible for an LLC to be a member of another LLC. Sometimes we see situations in which there may be a string of LLC's - an LLC owning an LLC owning an LLC, etc. None of them may be required to file tax returns - the income or loss will ultimately flow through to a member or members, and will show up on their income tax returns.
The earnings or losses of an LLC flow directly to the tax returns of the members.
As in the case of partnerships, the management of the LLC should have access to competent tax advice. There are certain complexities in the LLC which require attention. For example, there will be a basis (the "inside basis") for assets held inside the partnership and another basis (the "outside basis") for a partner's share of a partnership. These bases may be the same initially, but over time they may become substantially different.
When a member of an LLC or a partner in a partnership dies, it is possible to make an election, under Section 754 of the Code, to bring the "inside basis" and the "outside basis" into line with each other. This is of a complexity beyond the scope of this writing, but it is something that requires the attention of an alert accountant.
The filing fee for the LLC in Massachusetts is $500 per year. In many other states the cost is considerably less.
Often when we establish an LLC we incorporate it under the laws of the state of Delaware. The reason for this is that Delaware is more "user-friendly" - the state authorities in Delaware are more cooperative than those in Massachusetts when one is incorporating or otherwise dealing with an LLC (that also applies to other entities, such as corporations). Much filing can be done in Delaware by fax, and filing fees in Delaware are less than in Massachusetts.
The LLC is a marvelous tool for carrying on a variety of businesses.
