In any investigation, you need to bring with you a basic understanding of the entities you are likely to encounter. The following is a summary of the common business entities. Trusts have been excluded, and will eventually be covered in a separate article.
A sole proprietorship (also known as a “Schedule C business”) is wholly owned by one individual. The characteristics of a sole proprietorship are:
1. The owner has unlimited liability.
2. The owner (rather than the entity) pays income tax.
3. The sole proprietorship has a limited life.
4. Assets of the sole proprietorship are held in the owner’s name.
A general partnership is an entity created by agreement (oral or written) between two or more parties to combine assets, labor, and/or skills in a business, and to share the profits and losses therefrom. Profits and losses do not have to be shared equally.
The characteristics of a general partnership are:
1. The partners have unlimited personal, joint, and several liability.
2. The partners pay income tax on earnings of the partnership.
3. The partnership has a limited life.
4. The partners have a right to bind the partnership and/or the partners by their individual acts (absent agreement to the contrary).
5. Each partner’s equity is reflected in his partnership capital account.
A limited partnership is an entity created by written agreement, having at least one general partner and one limited partner.
The characteristics of a limited partnership are the same as those of a general partnership; however, there are two significant differences.
1. The limited partner’s liability is limited to the investment in the partnership.
2. Each limited partner’s interest in the partnership is freely transferable.
Corporations – Regular and Subchapter S
A corporation is an entity created by state law; ownership is evidenced by shares of stock.
The characteristics of a corporation are:
1. There is limited shareholder liability.
2. The corporation has an unlimited life.
3. The rights of the shareholders are determined by state law and the corporate bylaws.
4. The corporation has centralized management (which may be held liable for actions taken by the corporation at their direction).
The corporation has free transferability of ownership interest. In some corporations there may be limitations on the transferability of the stock shares; e.g., a co-op.
A corporation is generally taxed at a rate separate from that of individuals. If the shareholders of a company elect to be taxed under subpart S of the Internal Revenue Code (“S Corporation”), the shareholders are taxed directly on their proportionate share of the company’s total profits or losses.
Limited Liability Companies
(Since the limited liability company is a relatively new form of business organization, we have given more space for explanation of the entity.)
Origin of the Entity
Although limited liability companies had existed for more than a decade, it was not until 1988 that they began to attract widespread attention. Wyoming enacted a limited liability company statute in 1977, and Florida passed a limited liability company act in 1982. In Revenue Ruling 88-76, the Internal Revenue Service (“IRS”), after eight years of study, ruled that a limited liability company created pursuant to the Wyoming law would be treated as a partnership for tax purposes.
This ruling marked a significant shift in the IRS’s ruling policy with respect to entities in which the liability of the owners is limited to the owner’s agreed-upon investment.
The owners of an LLC are its “members,” and their economic interests in the LLC are “member’s interests” or “interests in the limited liability company.” An LLC is formed by filing “articles of organization.” At the time of formation, the filed articles must indicate whether management authority will be vested in one or more “managers” (who need not be members) or will be reserved to the members. The operations of an LLC and the internal rights and obligations of its members and managers may be governed by an “operating agreement” among the members, which may be written or oral.
Practitioners who have become involved in drafting LLC legislation frequently use the term “default rule” or “default provision” to describe a rule or provision contained in the LLC act that operates only in the absence of a contrary agreement among the members. The term does not appear anywhere in the statute, but serves as a convenient, shorthand way to refer to the many statutory rules that the members of an LLC may “contract around” if they desire. The term, as used in this outline, is intended in this sense. (The term is not used in the sense of a default or failure to discharge a contractual obligation.)
As there is no uniform or model act, each state has adopted its own unique statute. The statutes generally share the limitations on continuity of life and transferability contained in the Wyoming act, with some variations. All the statutes combine characteristics of partnerships (both general and limited) and corporations. A limited liability company may be operated either by its members (owners) or by managers elected by the members. The acts draw upon the Revised Uniform Limited Partnership Act (“RULPA”) with provisions borrowed from the Revised Model Business Corporation Act (“RMBCA”) added to deal with issues that result from the absence of a general partner.
Purposes and Powers
An LLC may be organized for any lawful purpose, although individual states have imposed restrictions upon the activities in which an LLC may engage. The statutes provide a laundry list of the powers of the LLC.
The inversion of the corporate and individual tax rates and the provisions reinforcing the double taxation of corporations and shareholders under the Tax Reform Act of 1986 have profoundly increased the interest in entities that are not taxed as corporations. The alternatives generally available are partnerships and S corporations. The LLC can be an alternative vehicle in situations where an S corporation cannot be used. Because no member is personally liable for the obligations of the entity, the LLC is an attractive alternative to the limited partnership. These benefits have caused states to consider limited liability company legislation to provide maximum flexibility in forms of ownership.
Management of an LLC
An LLC may be managed either directly by its members, or by a manger or managers who need not be members. The articles of organization must specify this choice. If management is vested in one or more managers, the LLC act permits the members either to designate managers for indefinite periods (similar to general partners in a limited partnership) or to elect managers at regular intervals (similar to directors of a corporation).