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How to choose your business structure

Law Offices of Yu & Associates

Choosing a business structure is the first issue that must be dealt with in setting up a new business. It's the foremost of the many factors that should be considered before registering and setting up your business. Careful planning beforehand can have a great impact on the business's eventual growth and development and avoid unnecessary lawsuits and paying of losses and damages later.

The factors that should be considered in choosing a business structure include: the business's size and development prospects, potential liability, whether you will issue different types of stock, whether you want to avoid double taxation, and whether you plan to eventually go public.

In general, the following business structures are available in most states:

Corporation

The corporation is the classic business structure. The corporation is completely independent of the individual in legal terms. It is owned by shareholders, who may be individuals, partner companies, trustee companies or other companies. Investment risk is limited to the company¡¯s capital and assets; the property of individual shareholders is protected by limited liability, meaning that individual shareholders are not liable for the company¡¯s obligations. There are two types of corporations, C-corporations and S-corporations.

The C-corporation is the most common type of business structure in the US. It is independent of the individual and exists perpetually, meaning that upon the retirement or death of the founder, the company can continue to do business. Raising capital tends to be easier for corporations; they can go public and sell stock in order to raise capital. Compared to other business structures, the most notable characteristic is double taxation. Not only must the company pay taxes on its profits, but shareholders must also pay taxes on their dividends, and the shareholders cannot claim the business's losses on their tax returns. However, the corporation can decide not to distribute its profits, but rather to re-invest them into the company. In addition, shareholders will not have to pay self-employment tax. This is advantageous compared to other business structures, because partners in partnerships and most individuals in LLCs must pay a not insubstantial amount in self-employment taxes, whether the business's profits are distributed or not.

The C-corporation structure has its drawbacks, however. Its operation and management must follow specified procedures and regulations. This adds to the cost of doing business and can be burdensome for smaller companies. If one violates regulations and abuses the principle of limited liability, so that the company and proprietor are not clearly separate, the courts may potentially "pierce the corporate veil," forcing shareholders to take individual liability and lose the protection of limited liability.

S-corporations and C-corporations both have the advantage of limited liability. Their greatest difference lies in that S-corporations are not taxed at the company level. The company's profits are reported by individual shareholders on their income tax returns, as in a partnership, and, particularly during the start-up phase, the company's losses can be claimed by the shareholders. If you want to minimize your payroll taxes and provide maximum profit to shareholders, the S-corporation may be your best choice.

The S-corporation does have limitations, however, on the number of shareholders and the capital stock structure. An S-corporation cannot have more than 75 shareholders, and they must be US citizens or permanent residents. The company can also only issue one type of stock, and cannot issue preferential shares. In addition, an S-corporation cannot be held by another company.

Limited Liability Company (LLC)

A limited liability company (LLC) can be held by an individual, or it can be jointly held by several natural or legal persons. The holders or investors of an LLC are not legally called shareholders, but members. The ownership structure of an LLC is not the same as a corporation; the members do not own stock, but they have legal interest proportional to their investment in the LLC. When they transfer their portion to someone else, what they transfer is interest, not stock. Based on the needs of the company, however, the LLC¡¯s members may hold preferred ownership interest, just as the shareholders of corporations can own preferred stock.

Limited liability companies were first legally recognized in 1977 by the state of Wyoming, and since then they have grown very quickly. This is primarily because they combine the advantages of a corporation and a partnership. Not only does this structure protect the business owners through limited liability, but the business owners can enjoy the same tax treatment as a partnership ¨C that is to say, when the company¡¯s profits are distributed, the members can combine them with their other income and pay taxes on them at their individual rate.

In general, the greatest advantage of the LLC is avoiding double taxation. In addition, an LLC's debts and obligations are entirely the company's debts and obligations; the company's members are not responsible for anything beyond their own investment. Distribution of profits and losses is also rather flexible for LLCs ¨C it doesn't necessarily have to be proportional to the investment amount. Moreover, there is no limit on the number or nationality of investors for an LLC, which makes it more advantageous than an S-corporation.

The drawback of the LLC is that it is not very suitable for going public, should the business owners eventually wish to do so. Investors are accustomed to buying shares rather than interest, and the Securities and Exchange Commission (SEC) is more adapted to issuing shares for stock corporations. Furthermore, the business owner's tax deduction for health insurance is not as good for LLCs as for corporations.

Based on the company's needs, a company can be converted from a C-corporation to an S-corporation or from an LLC to a C-corporation. This process should be undertaken strictly following legal guidelines, and one should keep in mind that there are time limits, as well.

General Partnership

A general partnership is formed by two or more people as partners. The partners must write up a partnership contract. The organization and management of a partnership is very flexible. Each general partner, however, must accept full liability for the partnership, meaning their liability can extend their personal property. The partners undertake joint liability; if one partner assumes full liability for the partnership, he or she has the right to demand payment from the other partner(s). A partnership does not need to pay income tax, but it must file Form 1065 with the Internal Revenue Service (IRS). The partnership's profits and losses are reported by each partner on their individual tax returns. If the partnership is engaged in commercial trade or other business, the partners must also pay self-employment tax on their earnings from the partnership.

Limited Partnership

A limited partnership must consist of at least one general partner and one limited partner, and must be registered with the state. The tax responsibilities of partners in a limited partnership are similar to those of a general partnership. In a limited partnership, the general partner is responsible for the management of the business, and also assumes full liability for the partnership's obligations. The limited partner has no management rights or control over the business, and his or her liability is limited to the investment amount. The limited partner does have the right to look over the partnership's financial accounts, however.

Limited Liability Partnership (LLP)

A limited liability partnership (LLP) is a special form of general partnership. Some states require that LLPs must be registered with the state. LLPs are fairly similar to limited liability companies (LLCs), except that LLPs are more often utilized by professionals such as doctors, attorneys, accountants and architects. An LLP's tax responsibilities are similar to those of a general partnership, but its liability protection is much greater.

Limited Liability Limited Partnership (LLLP)

A limited liability limited partnership (LLLP) is a type of limited partnership. The difference between the two is that in an LLLP, the general partner, like the limited partner, is only liable for the investment amount. Most states do not allow LLLPs, however.

Sole Proprietorship

A sole proprietorship is the simplest business structure, as it is entirely held by one person. A sole proprietor does not need to register the business with the state, provide Articles of Incorporation or any other documents, or even register with the IRS. The sole proprietor has complete authority over the business's day to day operation. The business owner is responsible for any profits or losses, and is fully liable for the business's debts. At the same time, the business will not be taxed and does not need to file anything with the IRS; the business owner reports the profits and losses on his or her individual tax return. The advantage of this structure is that the setup cost is very low and the proprietor has the greatest authority over the business. It is only suitable for low-risk enterprises, however, because the drawback is that the business owner is fully liable and thus his or her personal property is at risk. In addition, financing is limited and raising capital can be difficult, which can have a profound impact on the business's growth.

Non-profit Organization

A non-profit organization is a society or organization founded to advance social causes, education, technology, charity, religion or other causes rather than for commercial gain. Non-profit organizations include churches, public charities, trade unions, professional organizations, museums, research organizations and a few organizations that play government roles. Non-profits may accept donations or funds from the government as well as the public.

Because article 501(c) of the tax code exempts non-profits from Federal and state taxes, therefore non-profits are sometimes referred to as 501(c) organizations. A 501(c) organization's Board of Directors and its employees must pay individual income taxes, however. Also, even though non-profits do not need to pay taxes, they do need to file information returns and annual reports with the IRS and the state tax department. Non-profits cannot issue stock or distribute profits, and their profits also cannot be distributed in employee salaries. If a non-profit breaks up, all its remaining capital must be given to other non-profit organizations.

In general, a non-profit's Board of Directors and management personnel are protected by limited liability, therefore creditors can only go after the organization's assets to pay down debts, but not the personal property of the Board members or management personnel.

In order to set up a non-profit organization, you must properly prepare the organization's Articles of Organization and submit an application in accordance with your state's regulations, and also apply to the IRS for tax exempt status. If the application is accepted, tax exempt status can be retroactively applied back to the date when the Articles of Organization were submitted. The setup process for a non-profit is certainly far more complex and time-consuming than for other business structures, but the advantage of tax exemption is something that other business structures cannot obtain.

Selecting a business structure is an extremely important decision. It is also a decision that may need to be adjusted according to changes in your situation, as your business develops, tax codes are revised and the goals of the people involved in the business change. In making this decision, you should evaluate the advantages and disadvantages of each business structure in order to select the one that's best suited for you.


The above is a general introduction to immigration policies, and should not be construed as individual legal advice. For specific legal questions, please contact the Law Offices of Yu & Associates. Attorney Xiaohui (Sharon) Yu is a graduate of New York University School of Law, one of the top five law schools in the US, and has practiced law at some of the top firms in the US, UK and China.

Tel: 301-838-8986, Fax: 202-595-1918; E-mail: syu@yulegal.com, Address: 110 N. Washington St., Suite 328E, Rockville, MD 20850. (All rights reserved.)

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