"Business Entities 101"

Lawyers Company Service, Ltd. cannot select your business entity for you. Your accountant, attorney or other business adviser can and should help you identify and evaluate the numerous factors which go into that decision. This summary will provide general background information and identify and summarize some of these factors.

Following are some of the more basic factors which help determine the appropriate entity for the new business:
     • The type of business
     • Owner's concern over potential business liabilities
     • Tax considerations
     • Expected size of the business and number of employees
     • Expected management style of the business
     • Whether the business will operate in more than one state

If you do not have a tax or legal adviser and would like a recommendation for one, please send us an email at the address shown on the Home Page.

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Sole Proprietorship

The sole proprietorship is the simplest of all forms of business enterprise. It's just you (and perhaps your spouse) going into business for yourself. The sole proprietor is the owner and sole manager of the business. All income and deductible expenses of the business are reported on the owner's tax return. The owner is responsible for all debts, claims and obligations of the business.

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Partnership

The next simplest form of business entity is the partnership. A partnership may exist whenever two or more persons carry on a business as co-owners. Most modern partnerships adopt a written partnership agreement that spells out the rights and duties of the partners. In a general partnership, any partner may legally bind the partnership, and each partner is personally liable for the debts and liabilities of the partnership.

Partners may limit their liability by forming a limited partnership, which is accomplished by filing a certificate of limited partnership with the Secretary of State. A limited partnership must have at least one general partner, who manages the partnership and has unlimited liability for partnership debts and judgments. The limited partners, on the other hand, generally do not take part in the management and have no liability beyond their respective investments in the partnership. Certain partnerships may limit the liability of general partners by registering the partnership as limited liability partnership with the secretary of state or other state official.

Taxation:
Partnerships are treated as "flow-through" entities under federal tax law. This means that the various items of income, gain, loss, deduction and credit are not taxed to the partnership itself, but rather "flow through" to the individual partners' tax returns. Certain partnerships, and expecially limited partnerships, may be subject to very complex tax rules governing tax basis, and allocations of profits and losses among the partners. In most cases, there is no tax liability when a partnership is formed and initial property is contributed to it.  Receiving a partnership interest in return for services performed for the partnership can have unexpected tax consequences.  Persons planning this kind of arrangement should consult a tax adviser to assist in properly documenting this plan.

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Corporation, S Corp

Next to the sole proprietorship, the corporation is probably the most common, best understood and most legally predictable business entity. There is extensive law concerning all major aspects of corporations. Corporations also have the highest degree of formality, although there are some shortcuts which can significantly minimize the formality.

Properly formed and run, the corporation will be treated as a separate legal entity. Thus, only the assets of the corporation -- not the personal assets of the shareholders -- are available to satisfy claims against the corporation. Of course, some creditors such as lending institutions may require shareholders to guarantee payment of loans made to the corporation.

When a corporation is established, the founders contribute money or property to the corporation in exchange for stock. The shares of stock represent the ownership interests of the shareholders in the corporation. The type of stock normally issued by a new corporation is "common stock." The shareholders have one vote at meetings for each share of stock owned. If so authorized, a corporation may issue different types, or "classes," of stock such as non-voting stock or preferred stock. But most small, new corporations engaged in active business operations have little need for different classes of stock.  A corporation is permitted to have a single shareholder.

The articles of incorporation which are filed to form the corporation must state the number of "authorized shares" of stock. This is the total amount of stock which the corporation may legally issue. Out of this "authorized capital," the corporation issues stock to the shareholders. The corporation may change the amount of authorized capital from time to time by amending its articles of incorporation. At the time of incorporation, it is prudent to issue only a fairly small percentage of the authorized shares to the initial shareholder(s), reserving the remaining authorized stock for future issuance.  Stock certificates are usually issued to document the ownership of the shareholder(s). There is no maximum on the number of shares that can be authorized, but some states, including Delaware and Nevada, base their initial filing or annual corporation franchise tax, at least in part, on the number of shares authorized.

The board of directors is responsible for the overall management of the corporation. Day-to-day management of operations is delegated to the officers, for example, the president, vice president, secretary or treasurer. The shareholders, as the owners of the corporation, elect the Directors who, in turn, elect the officers. This management structure is carved out in the New Mexico statutes and is fairly rigid, but again this rigidity has little effect on the corporation's everyday activities. In very small corporations, only one or two persons may perform all of the above roles in the corporation.


Taxation:
A corporation is a taxable entity separate and distinct from the owners (shareholders). Thus, taxable income and gains and deductions and credits of the corporation are reported on the corporation's tax return. Then, if the corporation distributes money or property as dividends to the shareholders, they may have to pay tax on those amounts received. (This is sometimes referred to as the "double taxation" of corporate earnings.) Many if not most small corporations elect to be taxed as "S Corporations " (named for Subchapter S of the Internal Revenue Code). The resulting tax situation is similar to that of a partnership: the S corporation does not file a regular corporate tax return, but income, deductions and credits of the corporation are "passed through" the corporation and are reported directly by the shareholders on their individual tax returns. An S corporation is subject to several limitations, including those limiting the number of shareholders (currently 75), restricting the types of shareholders -- mainly to individuals and certain trusts -- and limiting the corporation to one class of stock. In addition, most tax advisers are not comfortable using a corporation as a real estate investment entity.  As with a partnership, the formation of a corporation and contribution of initial property to it does not usually create any tax liability.

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Limited Liability Company

The limited liability company (LLC) is a relatively new but very popular business entity. It appears to have overtaken the corporation as the new business entity of choice. Like a corporation, an LLC can only be formed by filing the appropriate papers with the agency designated in the governing statute -- in New Mexico, the Public Regulation Commission. Because of its newness, the LLC as a business form has experienced relatively few court decisions. This results in less certainty about how the laws and documents will be interpreted by the courts. Most advisers, however, believe this uncertainty is manageable and is more than offset by the flexibility of the LLC to tailor the management and profit-sharing arrangement to the needs of the particular persons involved. In addition, there generally is less ongoing expense and regulatory compliance involved with an LLC.

An LLC is a separate legal entity in which the owners are called "members." Their ownership interest in the company is called a "membership interest." Just as a corporation issues stock to the initial shareholders, the membership interests of the LLC members are given in exchange for money, property or services contributed to the LLC. Unlike a corporation, there is no distinction between authorized and issued interests–the LLC may create new membership interests at any time if the members so desire.The members may govern the entity themselves or may appoint one or more "managers" to do so. Usually, the managers are also members of the LLC, but this is not legally required. Also like a corporation, the liability of LLC members is generally limited to the assets of the company and does not extend to the personal assets of the members. In contrast to the S corporation, which is limited to one class of stock, an LLC may have more than one class of membership interests (although the average operating LLC typically has little need for this).  An LLC is permitted to have a single member.  Membership certificates may be issued to the LLC members, although this is not required.The rights and duties of the members and, if any, managers, the profit-sharing arrangements, and certain other aspects of the LLC operations are generally contained in a written operating agreement. The operating agreement resembles a cross between corporation bylaws and a partnership agreement.  The New Mexico LLC Act permits considerable flexibility in provisions that may be contained in the operating agreement.

Taxation:
An LLC with two or more members generally is taxed as a partnership. An LLC with only one individual as the member will be disregarded for federal tax purposes; the sole member would then be taxed like a sole proprietor. Either a single-member or a multiple-member company may elect to be taxed as a corporation (including an S corporation). Your tax adviser can discuss the advantages and disadvantages of the different tax forms. An LLC desiring to elect S corporation status would be subject to the restrictions applicable to S corporations (See "Corporation – Taxation" above). In most cases, forming an LLC and contributing initial property to it does not create any tax liability.

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Factors In Choosing the Entity

How does the accountant, attorney or other professional adviser employ the various factors in recommending a business entity to the client? The factors listed at the beginning of this discussion might be applied as follows:

Type of Business
A real estate development or oil and gas drilling venture would rarely be found in the form of a corporation. Such a business would most likely use a limited partnership or LLC. This is primarily because investors in the entity would retain limited liability and would receive tax benefits that flow through the entity.

Potential Liability
A business engaging in a particularly hazardous activity such as building demolition would rarely be found in partnership form. Instead, a corporation or LLC would be used, to limit the potential liability of the equity owners.

Tax Considerations
If investors in a business need (and can use) certain losses or deductions on their individual tax returns, a tax "flow-through" entity such as a partnership, S Corporation or LLC would be used. A regular corporation (or "C corporation") might be used if the business will generate high income and if opportunities exist to shelter that income through corporate expense deductions.  As mentioned above, an S Corporation is generally not considered advisable as a real estate investment vehicle.

Expected Size of Business
If the business founders had special reason to believe that the business has the potential to become a large business, they might select a corporation from the outset because certain types of employee fringe benefits may be easier to implement, especially equity ownership plans such as stock option. Also, firms which provide institutional or venture capital type investment often prefer that the investee company be a corporation.

Expected Management Style
If the business founders favor a centralized, hierarchical management structure, a corporation probably would be the likely choice. On the other hand, if a more diffuse, democratic style is sought, the owners would tend to favor a partnership or LLC.

Operations In Multiple States
If a New Mexico entity conducts business in another state, how will it be treated under the laws of that state? A sole proprietorship will not generally be subject, as such, to any special regulation in other states. A general partnership also may be able to operate multistate without specific regulatory differences. Corporations are recognized in all states; their limited liability aspect is not in doubt. While LLC's are also recognized in all states, their treatment may differ from state to state; these differences seem to be diminishing over time. Both corporations and LLCs must register to do business in that state. Finally, it is always necessary to consider franchise and other business taxes which may be imposed by the foreign jurisdiction; these may differ depending upon the choice of entity.

The following chart may be useful in comparing the various entities discussed above, according to their more salient characteristics.

TYPE OF ENTITY	FILING NEEDED TO FORM?	SEPARATE ENTITY FROM OWNERS?	PERSONAL LIABILITY?	CENTRALIZED / DECENTRALIZED MANAGEMENT?	TAXED AS SEPARATE ENTITY?
Sole Proprietor	No	No	Yes	N/A	No
Corporation	Yes	Yes	No	Centralized	Yes
S Corporation	Yes	Yes	No	Centralized	No
Partnership	No	Yes	Yes	Either	No
Limited Partnership	Yes	Yes	No *1	Centralized	No
Limited Liability Company	Yes	Yes	No	Either	No *2