Do I Have the Right Business Organization?

by Philip Isaacson

There isn’t one particular business organization that would be perfect for everyone. In fact, there isn’t an absolutely perfect business organization for anyone. They all have advantages and drawbacks, but some will suit one business much better than others. In selecting a form or in changing from one form to another, you’re trying to accomplish a group of things. For example, you’re trying to organize the control of your business and protect yourself from people who make claims against your business. You’re also trying to make the eventual transfer of your business, by sale or within your family, convenient and orderly. Finally, you want to accomplish all of this at the lowest tax cost. Taxes are the tail that wags the dog and it’s a long tail.

The simplest business organization isn’t an organization at all. It’s called a SOLE PROPRIETORSHIP and is a vanishing breed. It’s cheap – simply file your trade name, if you have one, with the City Clerk. There are no legal fees to pay to set it up, but there are no real tax planning opportunities and no protection from your creditors. You have unlimited personal liability and insurance doesn’t provide all the answers.

The next organization up the line is the JOINT VENTURE, but it combines the problems of the Sole Proprietorship with those of the General Partnership and is rarely – knowingly – used.

The GENERAL PARTNERSHIP is the old, classic way for two or more people to do business. There are filings to be made with the City Clerk and unless you want a State law called the Uniform Partnership Act to steer some of the structure of your business, you need a Partnership Agreement. Problems arise when a partner dies, or leaves the business or gets into financial difficulty, and these and other matters such as the division of rights and responsibilities should be ironed out in that Agreement. As far as taxes go, a Partnership is a pass-through. Partners pay taxes as individuals. The Partnership itself is not taxed.

The giant red flag in a Partnership is the fact that each partner is jointly liable with all of the other partners for the debts of the partnership even though they may have been unauthorized. Further, each partner is jointly and severally liable for the wrongful acts of any partner. All of this is called personal liability and often makes a General Partnership unattractive.

We now come to LIMITED PARTNERSHIPS. Until recently they were popular in certain situations. They were used when some of the partners were simply investors. They are called limited partners. They took no part in operating the business and wanted to be shielded from personal liability. The active partner is called a general partner and that person – or organization – ran the business and assumed all of the liability. As long as the limited partners remained inactive, they were free from personal liability. Limited Partnerships are taxed as a General Partnership. Limited Partnerships are cumbersome and have generally been replaced by the Limited Liability Company.

LIMITED LIABILITY COMPANIES are usually called LLC’s and have all of the pass-through tax advantages and none of the personal liability dangers of a General Partnership. Members of LLC’s need not be “silent” as the limited partners had to be in a Limited Partnership. In general, you can have it your way. You can have a Manager who has full authority to run the business and Members who have almost no authority at all. On the other hand, you can eliminate a Manager entirely and have the Members run the business. And you can do almost anything you want in between these extremes. It’s a kind of a business “salad bar.” You can have as many classes of Members and Managers and ways of allocating profit and losses as you may want. There is no personal liability on the part of anyone for regular business activities. While it is extremely flexible as to structure, a Member of an LLC is severely limited when it comes to the ability to pledge or transfer interests in the LLC. All of this and much more is embodied in an extensive document called an Operating Agreement.

An LLC is an excellent choice when you have uninsurable liabilities, when control of the management of a business is a principal concern, when you have property that is apt to increase substantially in value and you are interested in making gifts of it, and when you have a participant whose finances are fragile and might become a candidate for Bankruptcy. It also has probable tax benefits if the business is liquidated. Converting from a corporation to an LLC, in fact converting from any form of business into another requires careful consideration and may have substantial tax consequences.

The most popular sophisticated business organization is still the BUSINESS CORPORATION. For convenience it is often thought of as divided into two types, viz., the C-Corp and the S-Corp. This is only a distinction as far as taxes go and is not an operating distinction. For all purposes other than taxes, C-Corps and S-Corps are the same organization. The Shareholders of Business Corporations are exempt from corporate debt.

An S-Corp has certain easy-to-meet restrictions. It is treated for tax purposes as a Partnership – that is to say, as a pass-through – and is one of its most attractive features. Therefore, if it holds real estate, it can pass any losses on to its Shareholders. If it provides health care coverage to its Shareholders, they are taxed for it and this is sometimes a consideration. In some cases, it allows a certain amount of planning with respect to Social Security obligations and it has no retained earnings. If an S-Corp is dissolved and distributes its assets, gains on those assets are likely to be subject to immediate taxation.

Unlike an S-Corp, a C-Corp is itself subject to income taxes and, therefore, dividends paid to its Shareholders face what is called “double taxation.” This has made S-Corps much more popular than C-Corps. The tax rates range from 15% to 34%. It is a less desirable organization than an S-Corp if it holds real estate and will often present tax problems on retained earnings and the transfer of its assets at the time it is dissolved. It will, however, keep health care coverage provided by the Corporation out of the Shareholder’s taxable income. In all matters regarding the selection of a business organization or a change from one to another, the advice of an Accountant is an essential element.

        Co-founder of Isaacson & Raymond, Phil Isaacson is a veteran practitioner specializing in corporate, business and real estate law.

jeanie Clemmer