Steven Weiser is a tax lawyer with a practice focusing on international tax matters. His contact information and information on his practice can be found on his web site at http://www.lw-law.com/.

Very often we field questions from aspiring entrepreneurs who immigrate to the United States seeking new business opportunities.  Establishing a US entity or permanent establishment is not always the best and immediate answer for entrepreneurs; especially where business risk can be minimized through other business arrangements such as distributorship agreements with US-based representatives for foreign manufacturers.  However, where a formal US presence is necessary the decision concerning the type of business entity through which to conduct business can often be complex and confusing.

Generally, the choice of business entity is often dictated by two primary concerns: (1) limitations on the business owner’s personal liability for debts and obligations of this business, and (2) tax considerations.  When working with immigrant entrepreneurs, residency status can also become a significant factor.

The purpose of this article is to provide a brief overview of the most common types of US legal entities used to conduct business.  It is not an exhaustive review of the law or issues for consideration in making the determination of what type of entity is appropriate for you.

Historically the principal forms of business entities consisted of (1) sole proprietorships, (2) partnerships, and (3) corporations.  However, in recent years this list has expanded to include, among other things, limited partnerships, limited liability partnerships, limited liability limited partnerships, limited liability companies, and S-corporations.  The need for professional assistance in selecting the correct type of entity has become more necessary than ever.

Sole Proprietorships

The sole proprietorship is perhaps the most basic form of doing business in the US.  A single individual without the creation of a separate legal entity operates the proprietorship.  A sole proprietorship ordinarily operates under a business name, but for legal and tax purposes is treated as if the individual owner is conducting business herself.  The individual owner is liable for all debts and obligations of the business and no protection is provided for the business owner’s personal assets.

For tax purposes, the business owner is treated as if directly engaged in the business activity since a separate entity has not been formed.  A separate tax return is never needed and instead, the business owner reflects all results of business operations on her own individual tax return.

A sole proprietorship is the simplest business entity to form, operate and dissolve, but is also the riskiest entity to operate due to the owner’s unlimited personal liability for the debts and obligations of the business.  With the availability of S-corporations and limited liability companies (both discussed below) for single person owned businesses, no one should ever assume the risk of unlimited liability by operating as a sole proprietorship.

General Partnerships

A general partnership is like a sole proprietorship in many respects, the main difference being that it has multiple owners.  Some tend to think of a general partnership as a collection of sole proprietors.

A general partnership is often operated in accordance with a written partnership agreement.  A partnership agreement generally outlines the terms for the sharing of profits and losses among partners, each partner’s ownership interest, management and dissolution of the partnership, the ability to incur debt or other liabilities in the name of the partnership, and the transfer of partnership interests.  To the extent these matters are not addressed in a partnership agreement, state laws tend to dictate how these matters are resolved.

Like a sole proprietorship, the general partnership comes with substantial risks.  Most notably among those risks, are a partner’s unlimited liability for debts and obligations of the partnership, including those that arise on account of actions taken by another partner.  Sophisticated business owners may hold their interests in a general partnership through entities that provide some form of liability protection to shield them from risk.

General partnerships are nearly as easy to create and dissolve as sole proprietorships, save for the creation of a partnership agreement, if any.  Generally, there is no need to file a document with a state government to create a general partnership.  For federal income tax purposes a partnership is recognized as a separate entity, and must file an annual information return with the Internal Revenue Service (IRS), though the partnership itself pays no tax.  Profits and losses of the partnership “flow-through” to the partners who pay income taxes on their share of profits or deduct their share of losses in arriving at their individual taxable incomes.  However, where a partner is a non-resident alien the partnership is generally responsible for collecting and remitting to the Internal Revenue Service (IRS) a withholding tax charged against such partner’s allocable share of partnership income.

Limited Partnerships

A limited partnership is a partnership of one or more general partners and one or more limited partners.  Like partners in a general partnership, the general partner in a limited partnership has unlimited liability for the debts and obligations of the partnership.  General partners are in charge of the management and operation of the partnership.  Limited partners, on the other hand, are viewed as passive investors in the enterprise and are generally prohibited from managing the partnership’s business.  In exchange, the limited partner is not liable for the debts and obligations of the partnership and may lose no more than his investment in the enterprise (provided the limited partner does not participate in the management of the enterprise in his capacity as a limited partner).

A limited partnership is a creature of state law.  Unlike the sole proprietorship and general partnership, a limited partnership must file a certificate of limited partnership or similar document with the appropriate state agency (often the Secretary of State).  If the entity fails to file the certificate of limited partnership it will be treated as a general partnership instead.  It is recommended, but never required, that the partners enter into a limited partnership agreement that outlines the terms for the sharing of profits and losses among partners, each partner’s ownership interest, management and dissolution of the partnership, the ability to incur debt or other liabilities in the name of the partnership, and the transfer of partnership interests.

Limited partnerships are extremely flexible in terms of structure.  Often, the general partner is given complete control over almost all operational aspects of the partnership while holding a minimal ownership percentage as a general partner (e.g., a 1% general partner interest).  This structure is ideal for a business owner who wants to control the operational aspects of a business in which he or she may have outside investors, even though the business owner has little capital at risk.  It is also possible for a partner to own a minimal interest as a general partner and a greater interest as a limited partner (e.g., a 1% general partner interest and a 10% limited partner interest).  This is ideal where the partner wishes to control the entity, will provide some capital to the partnership, but has other investors that will provide the bulk of capital.  To limit the general partner’s liability, some form of limited liability entity is often interposed to provide some form of personal liability protection.

A limited partnership is also an ideal entity through which real estate is owned (but be aware of the Foreign Investment in Real Property Tax Act, reviewed in the April 14, 2003 issue of Siskind’s Immigration Bulletin).  Appreciating real property can easily be transferred to, and distributed from, a partnership without creating a taxable event, whereas it is difficult to do the same with a corporation or S corporation.

Limited partnerships are taxed in the same manner as general partnerships.  Items of income, gain, loss and deduction flow through to the partners without the imposition of income taxes at the entity level.  Like the general partnership, the limited partnership must file an annual information return with the IRS, and must withhold and remit taxes with respect to non-resident alien partners.

Limited Liability Partnerships and Limited Liability Limited Partnerships

Several states, like Colorado, have two other forms of partnerships known as limited liability partnerships (LLPs) and limited liability limited partnerships (LLLPs).  Both are creatures of state law.  General partnerships and LLPs are nearly identical.  An LLP is simply a general partnership that has filed a certificate of registration (or similar document) with the appropriate state agency.  LLPs enjoy the advantage of shielding their partners from debts and obligations arising from the acts of other partners in the course of partnership business.

A LLLP is similarly formed when a limited partnership files a certificate or registration with the appropriate state agency.  LLLP status insures that a general partner is protected from debts and obligations arising on account of the actions of any other partner.

When operating in a state that recognizes LLPs and LLLPs, there should be no reason to ever form a general partnership or limited partnership. Business owners wishing to form partnerships in these states should always take advantage of the liability protection afforded by filing a certificate or registration.  However, LLP and LLLP partners should beware when conducting business in states that do not recognize LLPs and LLLPs.  For example, a Colorado LLP doing business in a state that does not recognize LLPs will generally be treated as a general partnership in the other state, exposing all partners to unlimited liability for partnership debts and obligations.

Corporations

A corporation is another creature of state statute.  A corporation must be formed in accordance with state law and the requisite documents (generally the articles of incorporation) must be filed with the appropriate state agency.  A corporation is a separate legal entity.  In general, the owners of a corporation (known as shareholders or stockholders) are not liable for the debts and obligations of the corporation.  Shareholders may lose nothing more than their investment in the corporation.  However, in certain circumstances, US courts have disregarded the corporate form and held shareholders liable for certain acts or losses of the corporation.  This is known as “piercing the corporate veil.”  To prevent this from occurring, the corporation should not intermingle its operations, property and records with its shareholders, should observe corporate formalities, be adequately capitalized, and should not hold itself out as the “alter-ego” of its shareholders.

State corporate laws are generally well developed and provide a framework for forming and operating a corporation.  These laws often require the appointment (by shareholders) of a board of directors and certain officers responsible for the day-to-day operation of the corporation.  Annual shareholder meetings are another example of corporate formalities imposed by state laws.

As stated above, a corporation is a separate legal entity.  This is particularly true with regard to the tax laws where corporations are viewed as taxpaying entities.  A corporate income tax is imposed upon the earnings of a corporation.  Additionally, when corporate earnings are distributed to shareholders in the form of dividends, a separate shareholder level income tax is imposed.  The concept of separate corporate and shareholder level income taxes has come to be known as the “double taxation” of corporate earnings.  The double taxation of corporate earnings is historically a primary reason why business owners often choose to operate through a “flow-through” entity (e.g., sole proprietorships, partnerships, and limited liability companies).  However, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the tax generally imposed on dividends received from a corporation to 15-percent, thus mitigating the harsh tax consequences associated with conducting business through a corporation.

S Corporations

The S corporation is a creature of federal law.  Congress enacted the S corporation provisions in response to the concerns of small business owners who wanted the liability protection formerly available only to ordinary corporations, but were severely hurt by the double taxation or corporate earnings.

An S corporation is a corporation formed under state law, for which the shareholders have made a federal tax election to be taxed as an S corporation.  As a result, an S corporation is taxed in much the same way as a partnership (no double taxation) and is still entitled to liability protection granted to shareholders of a corporation under state law.  An S corporation is operated in the same manner as an ordinary corporation.  Today, very few closely held businesses operate as ordinary corporations because of the double taxation of corporate earnings, and instead choose to operate as S corporations.

In order to be eligible to make an S corporation election, the corporation may have no more than 75 shareholders.  Additionally, S corporations may issue only one class of stock (although flexibility is available with regard to differences in voting rights), and shareholders are limited to US citizens and resident aliens (see the February 14, 2003 edition of Siskind’s Immigration Bulletin for a review of the definition of “resident alien”), certain trusts and other S corporations that own 100% of the subsidiary S corporation.  Changes in ownership structure can result in the loss of S corporation status (for example, when a resident alien shareholder transfers stock to a nonresident alien shareholder).

Limited Liability Companies

Limited liability companies (LLCs) are creatures of state law that have been gaining popularity and familiarity with people in recent years.  LLCs were designed to combine the best of the corporate, partnership and sole proprietorship worlds.  The LLC is a single entity of which all owners (known as “members”) have liability protection from the debts and obligations of the LLC, much like the protection afforded to shareholders in a corporation.  Earnings of an LLC flow through to its members without the imposition of an entity level income tax much like a partnership (two or more members) or sole proprietorship (one member).  However, members of the LLC can elect to have the LLC taxed as a corporation (as can sole proprietors or partners in a partnership). 

To create an LLC, articles of organization (or a similar document) must be filed with the appropriate state agency.  It is recommended, but not necessary, to also execute an operating agreement that governs the operation of the LLC and the rights of its members, much like a partnership agreement does for a partnership.  Members in an LLC may choose to operate the entity themselves, or they may choose to appoint a manager to operate the business for them.

LLCs that have two or more members must file annual partnership information returns with the IRS (unless the members elect to have the LLC taxed as a corporation).  An LLC with a single member is taxed as a sole proprietorship (unless the member elects to have the LLC taxed as a corporation).