Understanding Your Options in Business Entity Selection
A partnership is an association of two or more persons who act together to carry on as co-owners of a "for profit" business. The legal presumption is that each partner shall be repaid his contributions, whether by way of capital or advances to the partnership property, shares equally in the profits and surplus remaining after all liabilities, including those to partners, are satisfied and contributes equally toward losses. This legal presumption can be overcome by agreement between and among the partners.
All partners have equal rights in management and business conduct. No person can become a member of a partnership without the consent of all the partners. Differences arising as to ordinary matters may be decided by a majority of the partners. No contravention of any agreement between the partners may be done without the consent of all the partners. Each and every partner has a duty of loyalty to the other partners, duty to care for partnership property and duty of accountability to each other.
Partnerships are dissolved by any of three ways: death of any partner, bankruptcy of any partner or the partnership or by withdrawal of any partner from the partnership. A partnership is structured and managed by verbal, implied or written agreement. There are no fees or other conditions or requirements and nothing needs to be filed with the state. A partnership is the easiest form of business entity to form and is the most flexible.
Partnerships can take the form of a General Partnership, Limited Partnership and Limited Liability Partnership. The General Partnership is the traditional partnership model as described above. The Limited Partnership and the Limited Liability Partnership operate in much the same fashion as the General Partnership, however, they require registration with the State and provide some personal liability protection. The chief disadvantage to a General Partnership is that it allows for unlimited personal liability of the partners on all partnership debts and obligations. Over the years, variations in partnerships have evolved to add some protections against liability to the partners. These variations include the Limited Partnership and the Limited Liability Partnership.
A Limited Partnership ("LP") is a partnership formed with at least one general partner and at least one limited partner. The advantage of the LP is that the limited partner is not personally liable for the action of the partnership or the actions of any of the partners, agents or employees of the LP. However, the general partner has no such protection and could be held personally liable for the actions of the LP and the other partners, employees and agents of the LP.
Limited Liability Partnership
The Limited Liability Partnership (LLP) is an option that is available to both General Partnerships and Limited Partnerships. The LLP provides a partial shield to all partners. A partner in an LLP is not individually liable for the debts and obligations of the partnership that arise out of the wrongful actions or misconduct of another partner. However, a partner remains liable for his or her own actions and the actions of any person under the partner's direct supervision or control. A partner remains liable for the traditional commercial obligations of the partnership.
Although partnerships are created by agreement or conduct between or among partners, corporations are creatures of statutory law and are created by fulfilling several legal requirements and the filing and receiving of a corporate charter from the state. A corporation comes into existence not by agreement or conduct between or among the principal business-people, but by the filing of the appropriate paperwork with the Pennsylvania Department of State and by paying the appropriate fees, including the initial filing fee.
A corporation is considered a "person" separate and apart from the individuals who formed it. A corporation consists of shareholders, who own the business, members of the board of directors, who are elected by the shareholders and are charged with overseeing the business and managers who are hired by the members of the board of directors and are charged with the day-to-day management of the business. Managers hire employees to help carry out this duty.
A corporation must register with the state, pay the appropriate registration fee and seek a state charter by filing an Articles of Incorporation. It must have shareholders, members of the board of directors and managers. Unless the shareholders elect that the corporation be run by shareholder agreement, it must have an annual shareholders meeting. At the annual shareholders meeting, members of the board of directors are elected. Once elected, board members have duties of good faith, care and loyalty to shareholders.
Members of the board of directors have the duty to acquire available information, disclose material information that a reasonable shareholder would want, use informed business judgment, select officers, set policy and make sure it is followed and deploy capital to achieve profits. The corporate bylaws set the number of directors. A majority of directors is a quorum. The board can take action without meeting as long as there is written consent from all board members. Election of the board is by straight or cumulative voting depending on statute or the articles of incorporation. The board can only act collectively and not individually.
Officers are appointed and removed by the board of directors. Powers of the officers are delegated by the board of directors. The president is the only officer with the implied authority to act in the usual course of business to bind the corporation. The vice president's power is contingent upon what is granted by the board. The treasurer has the narrow implied authority to receive funds, not expend them. The secretary has the narrow implied authority to certify actions adopted at shareholder meetings of the board. Otherwise the express duties of each officer shall be assigned and delineated in the corporation's by-laws.
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"S" Corporation refers to a business that has been duly incorporated and elects to be taxed not as a corporation but as a partnership. The name "S" Corporation is taken from Subchapter S of the Internal Revenue Code. This is the section of the Internal Revenue Code that allows this special tax treatment for certain qualifying corporations. (By the way, "C" Corporations are all corporations that do not elect to be taxed under Subchapter S; these corporations are taxed under Subchapter C of the Internal Revenue Code).
"C" corporations face double taxation on its income. The income is taxed once at the corporate tax rate. Then, when the corporation's profits are distributed to its shareholders, its shareholders are taxed on these "dividends." Partnerships, however, are taxed only once at the individual partners respective tax rates. A partnership is subject to what is called pass-through taxation. A partnership files a tax return that is informational only. It is the partners in the partnership who are taxed, and they are taxed at their individual rate. Thus, the chief benefit of a partnership over a "C" Corporation, from a tax standpoint, is this conduit or "pass through" tax treatment because it escapes double taxation of profits. Certain qualifying corporations can elect to be taxed as partnerships.
In order to take advantage of partnership taxation, owners of a corporation may elect that the corporation be treated as an "S" corporation for the purposes of taxation. Pass-through tax treatment will be achieved if the "S" election is properly made and if the corporation is a small business corporation. This means that all shareholders at the time of the election must sign the "S" election form. Additionally, a separate "S" election must be made for a corporation to have a Pennsylvania "S" status. "S" Corporations, like a partnership, will file information returns and the profits of the corporation will be taxed to the shareholders of the corporation at the shareholders' individual tax rates. There is no taxation at the corporate level. (There is one exception to this rule; corporations that elect to be taxed as "S" Corporations are still required to pay one corporate tax in Pennsylvania, known as the Capital Stock and Franchise Tax).
Limited Liability Company
A Limited Liability Company (LLC) is an entity that allows its members the corporate benefit of limited liability and the partnership benefit of one level of income taxation, i.e. the pass-through to LLC members of the profits and losses of the entity. The term "member" is to an LLC as the term "shareholder" is to a corporation. An LLC can be managed by its members; this is referred to as a member-managed LLC. Or, an LLC can be managed by a designated manager or managers; this is referred to as manager-managed LLC. A manager-managed LLC can have many of the characteristics of a corporation. An LLC is functionally a limited partnership but does not place liability on a single partner.
An organizer of an LLC can choose the form of taxation of the LLC at the time of its formation, i.e. taxation as a "C" corporation or as an "S" corporation. An organizer would simply check the box on the IRS form to choose the method of taxation, the same way one checks the box to choose to be taxed as an "S" corporation. There is no longer the need to plan the features of governance and organization in order to avoid taxation as a "C" corporation. Therefore, there is great flexibility afforded to you in the creation of the LLC's constituent documents.
A member-managed LLC is treated as a form of general partnership. A manager-managed LLC is treated as a form of limited partnership. The managers have the authority of general partners and the members are deemed limited partners. LLCs are organized by the filing of the certificate of organization with the Pennsylvania Department of State and by the adoption of an operating agreement. The certificate of organization delineates whether the LLC is manager-managed or member-managed
In an LLC all of the owners (referred to as members) have the same limited liability as shareholders in a corporation. By forming an LLC one does not escape the common law doctrine "piercing the corporate veil." Although the LLC form is a rather recent development, the issue of applying the piercing the corporate veil doctrine to LLCs has begun to appear in some reported cases in which parties have sued the LLC and attempted to pierce the corporate veil of the LLC to attach the personal assets of the members. When the issue has been presented, courts have generally held that piercing the veil doctrine does apply to LLCs; the courts have, nevertheless, been reluctant to actually pierce the LLC's veil of limited liability.
An LLC will automatically be treated as a partnership when it comes to taxation. Thus, owners will receive the significant benefit of pass-through tax treatment if they elect to form an LLC. LLCs, however, are subject to Pennsylvania Capital Stock and Franchise Taxes (CSFT). However, in calculating this tax, an LLC taxable as a partnership is able to deduct certain distributions to members who are "active." Only an LLC which has elected to be treated as a corporation will be treated as a corporation for Pennsylvania Corporate Net Income (CNI) taxes.
Like a partnership, the death or withdrawal of a member of the LLC will trigger technical termination of the LLC under Pennsylvania law. However, the operating agreement can provide to the contrary.