Our offices provide a wide range of services including choice of entity and structuring for start-ups, stock and asset purchase agreements for growing businesses, and counseling on termination/dissolution for those closing their doors.
There are various types of entities for a business client to choose from and a number of factors must be considered in making this critically important decision. These factors include formalities in creation and operation, cost, liability protection, tax consequences, compensation, profit and loss allocation and dividends/distributions. Entity types in New York include sole proprietorships, general and limited partnerships, corporations (including S corporations), limited liability companies and corresponding professional entities.
Sole proprietorships are without question the easiest and most informal way to conduct business. A sole proprietor is a business owned and run by a single person. Obvious advantages include ease and expense of formation, and control in decision making. If an individual will conduct business under his or her own name, there are no fees or filings required.
The sole proprietorship is not without its disadvantages. With no required fees and filings comes no liability protection. A sole proprietor is personally liable for all the debts and obligations of the business. This includes tort liability (personal injuries, malpractice, etc.) and complete exposure to creditors.
With respect to taxes, the sole proprietor simply reports any income or loss on the Schedule C of his or her individual returns. A true sole proprietorship cannot apportion between distributions and income/wages, a significant disadvantage with respect to determining self-employment tax liability.
A partnership is an association of association of two or more persons to carry on as co-owners a business for profit. The requirements and formalities associated with a general partnership are similar to those of a sole proprietorship. However, a general partnership is required to file a doing business as ("DBA") certificate in each county where the partnership conducts business.
In a general partnership, the decision making is shared equally amongst each partner. While a partnership agreement is not required, it is apparent why having one is prudent considering the number of partners/'chefs' that can be involved.
Disadvantages of the general partnership include unlimited joint and several liability and lack of flexibility with respect to tax planning.
A limited partnership differs from a general partnership in that there is at least one general partner and at least one limited partner. The limited partner has the comfort of limited liability (up to his or her investment in the partnership), but lacks control and decision making power. A limited partnership is required to file a certificate of limited partnership with the Department of State.
A corporation is an entity separate from it shareholders (owners). A corporation is formed by filing a Certificate of Incorporation with the Department of State pursuant to Business Corporation Law ("BCL") § 402. While the BCL sets forth rules for how a corporation is run, the Certificate of Incorporation can alter these rules. Other rules and regulations for a corporation are set forth in the corporate by-laws. Corporations must follow a significant number of formalities, both in their creation and operation. Operating formalities include minutes for annual shareholder and director meetings, as well as minutes for any special meetings.
C corporations corporations are tax paying entities subject income tax. If there is income to the corporation and dividends are distributed to shareholders, the dividends are not deductible and are taxed to the shareholders. This is the concept of double taxation, often making a C corporation an unattractive choice for business owners.
S corporations or 'small business corporations' differ from C corporations in that they are not tax paying entities. The income 'passes through' to the shareholders and can be considered either wages/income or distributions/dividends. If structured properly, this flexibility allows a business owner to enjoy certain self-employment tax savings. However, S corporations can have disadvantages depending on the type of business: filing fees, franchise taxes, formality of annual meetings and corresponding corporate records, limited number of shareholders (100) and certain restrictions to the type of shareholders (corporations, LLCs, non-resident aliens cannot be shareholders). While in some instances these characteristics are inapplicable, their consideration is always warranted.
Limited Liability Companies
Since 1994, Limited liability companies ("LLCs") have been an alternative to partnerships or corporations in NY. LLCs are a hybrid of sorts providing the tax treatment of a partnership and the limited liability of a corporation.
A LLC is formed by filing Articles of Organization with the Department of State, similar to the Certificate of Incorporation for a corporation. The LLC is also required to publish a summary of the Articles once a week for six consecutive weeks in two newspapers (one being published daily) in the county where the LLC principal place of business is located.
LLCs are typically more informal than corporations in their operation; annual meetings are not required and records do not need to be maintained. Also, LLCs have more flexibility with respect to the number and citizenship of members (shareholders in a corporation).
The LLC must have an operating agreement setting forth how the LLC will be managed and controlled ; otherwise, the LLC will be guided by the default rules of New York, which limits member(s)' flexibility in planning.
LLCs vs. S Corporations
Often times, people will ask which entity type is 'better', the LLC or the S Corporation. In order to answer this question, it is important to examine the business purpose. For instance, if the business will hold real estate investment property, the LLC may be the preferred choice. Essentially, basis for property contributed to a corporation under IRC § 351 equals the contributor's basis. However, if the property has liabilities exceeding basis, the contributor must recognize gain (IRC § 357); this can be avoided if the contribution is for at least 80% of the stock (ownership) of the corporation. Alternatively, the LLC has the ability to make IRC § 704 and IRC § 754 elections, beneficial for special allocations and basis.
Where the business purpose will involve the payment of significant self-employment taxes, the S Corporation can be an attractive choice. S corporations have the ability to characterize income to the business as distributions to shareholders versus wages. These distributions/dividends are not subject to the 15.3% FICA tax, resulting in substantial savings. While an attractive characteristic, compensation for shareholders must be reasonable to survive scrutiny of the IRS.
Whatever the objective, it is extremely important to have experienced and knowledgeable guidance. Business planning is a complex and constantly developing area of law and a small misstep could have severe consequences. Effective business planning will also often include succession planning for closely-held businesses to minimize the impact of estate, gift and income taxes, contract negotiations, non-competition agreements, and selecting appropriate retirement plans.
Business Planning Areas Include:
- Formation and Development: Corporations, Limited Liability Companies, Limited Liability Partnerships, Not-for-Profit Organizations, Professional Entities
- Business Succession Planning/Counseling
- Employment, Non-Disclosure and Non-Competition Agreements
- Shareholder and Buy-Sell Agreements
- Business Acquisitions (Asset and Stock Purchase) and Dissolutions