In Brief

Factors to Be Considered

From an income tax viewpoint, there are six principal forms of business enterprises: sole proprietorship, partnership, regular corporation, subchapter S corporation, limited liability partnership, and limited liability company. The selection of the form of business enterprise requires consideration of both tax and nontax considerations such as legal, economic, and personal factors.

The article discusses the advantages and disadvantages of the sole proprietorship, partnership, and regular or C corporation. In addition to showing both the advantages and disadvantages, it provides some additional background information on S corporations, limited liability partnerships, and limited liability companies.

An exhibit contains a summary of the tax and nontax factors that should be considered in determining the type of business in which to operate.

One of the first major problems in the establishment of a business organization is choosing the best form under which to operate. Undoubtedly, consultants are often called upon for advice on selecting the best form of operation. From the Federal income tax viewpoint, there are six principal forms of business enterprises: sole proprietorship (SP), partnership (P), regular corporation (C), subchapter S corporation (S), limited liability partnership (LLP), and limited liability company (LLC). The selection of the form of business enterprise most advantageous for a particular business requires consideration of the many tax and nontax aspects of each form. Also, many legal, economic, and personal factors are relevant to the choice and should be weighed carefully. Each form of business has traditional characteristics, which may or may not be advantageous in a particular situation. An intelligent choice among the alternatives usually depends on an understanding of their characteristics.

There is no formula or rule that can be used to decide which form should be utilized. Each business type must be given individual attention, and the decision should be made only after giving much consideration to the circumstances surrounding the particular business and its owners.

Sole Proprietorship

The major advantages of the sole proprietorship include--

* simplicity of organizing and operating the business,

* lack of red tape or attorney fees,

* ability to have sole control of conducting the business, and

* simpler government regulations.

The major disadvantages include--

* exposure of personal assets to risks of the business (unlimited liability),

* lack of flexibility for obtaining financing,

* generally no continuity of existence (limited life), and

* possible complexity in transferring ownership.

The major advantages of the partnership include--

* similar advantages as those of the sole partnership except the availability of capital from more than one source and more alternatives available for financing needs (such as borrowing money, seeking additional contributions from the partners, additional capital by the admission of new partners) and

* the possibility to mix talents and management skills.

The primary disadvantages include--

* unlimited personal liability, similar to a sole proprietorship, but each general partner can be held personally liable for the debts incurred in the firm's name by any other partner (mutual agency) as each general partner has personal joint and several liability for the debts of the partnership;

* limited continuity of existence (at least from a technical standpoint); and

* under the doctrine of delectus personae, a partner's rights are generally not transferable without the consent of all the partners.

Regular or C Corporation

The most significant advantages of the regular corporation are--

* limited liability (limited to each shareholder's investment in the corporation's securities),

* the ability to attract additional investors when capital is needed,

* continuity of existence,

* free transferability of interest (in the absence of a stock transfer restriction), and

* the ability to obtain financing by selling different types of securities (such as stocks or bonds).

Major disadvantages include--

* lack of control of business operations by the shareholders (as control is shifted to the board of directors and officers of the corporation);

* greater governmental regulation and control in its formation, operation, and dissolution;

* significant expenses for incorporating a business;

* the possible necessity of formally qualifying to do business in states other than the one where it is incorporated; and

* double taxation of any corporate earnings distributed to shareholders in the form of dividends.

S Corporation

Subchapter S of the IRC of 1986 allows for unique treatment of certain corporations for income tax purposes (S corporations were actually initiated in 1958; major rule changes were made in 1982). Corporations that elect S treatment are regular corporations in all respects except for Federal income tax purposes. Generally, an S corporation is a tax-reporting rather than a taxpaying entity. In this respect, the entity is taxed much like a partnership. Under the conduit concept, the taxable income of an S corporation flows through to the shareholders whether or not it is distributed in actual dividends. S corporations may be subject to two special taxes--the built-in gains tax and the passive investment income penalty tax. S corporations became very popular after the Tax Reform Act of 1986 established a maximum tax rate on corporations higher than the top individual tax rate. Forty-eight percent of all corporate returns filed for 1993 were from S corporations. From 1994 to 1996, however, there has been a slowdown or reversal of the growth rate of S corporations because the Tax Act of 1993 increased the top individual tax rate to 39.6%, which is 4.6% higher than the maximum corporate rate of 35%. Tax factors relating to S corporations kept bouncing back and forth as Congress passed new liberal provisions in the Small Business Job Protection Act of 1996 (which took effect at the beginning of 1997). Its provisions--increasing the maximum number of shareholders of an S corporation from 35 to 75; permitting elections as small business trusts (ESBTs); and allowing certain exempt organizations, retirement plans, and charitable organizations to be eligible shareholders--have caused an increase in the number of corporations electing "S" status since the beginning of 1997.

The S corporation, because it operates in corporate form, possesses most of the same nontax advantages and disadvantages as the regular corporation. Among the more important nontax advantages are the attributes of continuity of existence (the corporation will normally survive despite the withdrawal or death of any of its shareholders), free transferability of interests (there are some limitations), and, very importantly, the same limited liability as a regular corporation. The most important feature of the S corporation is that it generally pays no income taxes. Instead, the corporation passes the profits and losses to the shareholders, who pay taxes on or apply them against other income when filing their personal tax returns.

On the other hand, there are disadvantages unique to the S election. First, the world of the S corporation is filled with many rules, time limits, regulations, provisos, prohibitions, and pitfalls. In addition, the S election is not available to all corporations. It is strictly for "small business corporations," and several stringent requirements must be met and maintained for qualification.

The code, with the new provisions taking effect in 1997, defines a "small business corporation" as one that--

* is a domestic corporation;

* is not an "ineligible corporation";

* has no more than 75 shareholders;

* has as its shareholders only individuals, estates, certain trusts (including ESBTs), and certain exempt organizations, retirement plans, and charitable organizations; and

* has only one class of stock issued and outstanding.

If these requirements are not maintained, the S election may be terminated. Growth prospects and flexibility for financing are much more limited than a regular corporation since an electing corporation is only allowed 75 shareholders and can only have one class of stock issued and outstanding. Furthermore, the S election only encompasses the Federal income tax consequences of the electing corporations. Some states do not recognize the S election, and, in such cases, these corporations are subject to state corporate income tax and whatever other state corporate taxes are imposed. Also, because the S election is a relief provision, strict compliance with the applicable code provisions generally has been required by the IRS and the courts. Slight deviations from the various governing requirements may lead to undesirable and often unexpected tax results.

Limited Liability Partnership (LLP)

A limited liability partnership is similar to a general partnership. During the past several years many states have added LLPs to their list of legal business forms. The major difference between a general partnership and a limited liability partnership is that, in an LLP, a partner may not be liable for damages resulting from failures or errors in the work of other partners. In other words, a partner may have only limited liability as a result of certain kinds of transactions are concerned, according to the particular state laws. There is a lack of consistency among the states regarding the lines of business which an LLP can enter. Before selecting this business form, owners or their consultants are advised to thoroughly research the applicable state LLP laws. In 1994 all the Big Six accounting firms became LLPs, and many local and regional accounting and law firms did the same.

Regulations finalized in December 1996 permit unincorporated entities to elect whether or not to be taxed as corporations. The regulations establish default classifications, and Form 8831 is used to elect treatment other than the default or to change a previous election.

Limited Liability Company (LLC)

Even though many countries throughout the world, especially in Europe, have permitted limited liability companies for many years, the form is relatively new to the U.S. Presently, all 50 states have adopted LLC laws; such provisions, however, have not yet taken effect in a few of the states.

The limited liability company business form combines the advantage of limited liability for all of the firm's owners with the possibility of being taxed as a partnership. Under newly issued guidelines, nearly all will be treated as partnerships, rather than corporations, by the IRS for tax purposes.

If an LLC is treated as a partnership, it offers greater flexibility than an S corporation because there is no limit on the number of shareholders, classes of stock, types of owners (such as partnerships and corporations), or types of investments in related entities that can be made. Also, each owner's basis in the LLC interest includes that member's share of the firm's debt (not just shareholder debt as in an S corporation), which is advantageous whenever the business has an operating loss.

Summary of Business Organization Comparison

The Exhibit provides a summary of comparisons for the forms of business enterprises relating to tax and nontax factors that should be considered in making an appropriate decision on the type of business form in which to operate. The Revenue Reconciliation Act of 1997, also known as the Tax Relief Act of 1997, had no significant impact on decision-making for the determination of which business form to choose except for the following changes:

* Maximum capital gains tax,

* Holding periods for determination of long-term capital gains,

* Net operating loss (NOL) carryback and carryforward periods,

* General business credit carryback and carryforward periods, and

* Alternative minimum tax provisions (such as the new provision that the AMT has been repealed for certain qualified "small corporations"). *

Jack R. Fay, PhD, CPA, is an associate professor of accounting at Pittsburg State University, Pittsburg, Kan.