Choosing the proper structure for your business, whether you are starting a new business or changing the type of entity for an existing business, is one of the most important business decisions you will make. The two primary considerations in selecting the type of entity are usually liability protection and tax treatment. Here is a summarization of several of the business structures that are available to you in Arizona. We recommend you consult with legal and tax professionals before making a final decision as to which entity is best for you.
Sole Proprietorship (“SP”): This is the simplest structure and most common form of business. A SP is created when an individual commences doing business if s/he has not taken steps to create one of the other business entities described below. Major considerations include that the individual owner is personally liable for any and all liabilities of the business, as well as that it can be difficult to attract financing from banks and other lenders, which can place further strain on personal assets. There is no taxation at the entity level. Profits and losses are reported on a separate schedule within the personal tax return.
General Partnership (“GP”): This is a business entity where two or more partners (individuals, companies, trusts, or any other legal entity) join together to carry out business. Each partner contributes money, property, labor or skill, and expects to share in the profits and losses of the business. It is advisable to have a formal partnership agreement that sets out the rules for how the company will be managed, including what happens in the event of the death, divorce, or other withdrawal of a partner from the general partnership. Partners are personally liable for liabilities incurred by the partnership and it can be challenging to find financing. That said, a general partnership can file a “Combined Certificate of Limited Partnership & Statement of Qualification to be a Limited Liability Partnership” (“LLP”) with the Arizona Secretary of State. Arizona law provides the partners of an LLP protection from a significant amount of business liability to the extent that the debt, obligation, or other liability is solely the debt, obligation, or other liability of the LLP. A GP can be converted to an LLP at any point in time, even if the GP has been in existence for many years. An LLP is required to file annual reports with the Arizona Secretary of State. There is no taxation of the partnership, but the partners share in the profits and losses, which are reported on each partner’s personal tax return.
Limited Partnership (“LP”): This is a type of partnership comprised of one or more general partners and one or more limited partners. A formal partnership agreement is required to form a LP. General partners are held personally liable and, for that reason, it is a good idea for general partners to be an LLC or a corporation instead of an individual. Unlike general partners, a limited partner’s liability is limited to the amount of their investment in the LP. They have very little, if any, involvement in the day-to-day operation of the business, which is helpful in attracting investment partners who may not want to be involved in the day-to-day operations or take risks faced by the business. If limited partners begin to get too involved in the day-to-day operations of the business or become alter egos of the business, they can be held liable for business debts. Like a GP, an LP can file a “Combined Certificate of Limited Partnership & Statement of Qualification to be a Limited Liability Limited Partnership” (“LLLP”) with the Arizona Secretary of State. Arizona law provides both the general and the limited partners of an LLLP protection from all business liability to the extent that the debts, obligation, or other liability is solely the debt, obligation or other liability of the LLLP. An LP can be converted to an LLLP at any point in time, even if the LP has been in existence for many years. An LLLP is required to file annual reports with the Arizona Secretary of State.
Limited Liability Company (“LLC”): This is a flexible business structure that has become the most common structure over the past decade. Owners are called members and there can be one or more members. Members may be individuals, corporations, other LLCs, foreign entities, or trusts, among other types of entities. There is no maximum number of members. An LLC can elect to be taxed as a corporation or, more commonly, a partnership with pass-through taxation that has the limited liability of a corporation. LLCs can be structured to be (i) “member managed,” which means that there is no formal manager and the day-to-business is operated by the members; or (ii) “manager managed,” which means that the members appoint a manager (who can be one of the members or an outside manager) who operates the day-to-day business of the company. It is strongly advisable that LLCs work with counsel to create an operating agreement, especially when they are multi-member or “manager managed.” Among other things, an operating agreement can control which operations are left to a manager’s discretion or voted upon by the members. In comparison to the aforementioned types of entities, LLCs can be more attractive to investors because they have greater structure and protection. LLCs shield members and managers from all business liability to the extent that the debt, obligation, or other liability is solely the debt, obligation, or other liability of the company. Currently, there is no annual report filing requirement for an LLC.
C Corporation: A C corporation provides limited liability to its owners. Its owners are called shareholders, who elect the board of directors, which makes a majority of the decisions regarding the operation of the corporation. The board of directors in turn elects the officers who handle the day-to-management of the corporation. C corporations are subject to double taxation because taxes are paid when the company makes money, and the shareholders have to pay taxes on distribution of profits the corporation makes to them. There are many formalities that need to be followed. The biggest advantage to this corporate structure is that you can go public to increase capital through the sale of stock, although the process is heavily regulated. Shareholders can take almost any form and some investors are very comfortable with this type of entity. A corporation structure is not for everyone because of the double taxation as well as the extensive list of formalities that need to be followed. This structure makes the most sense for those who wish to take the company public at some point in the future. Currently, there is an annual report filing requirement for a Corporation.
S Corporation (sometimes erroneously referred to as a Subchapter S Corporation): This structure allows the protection of a C corporation, but with some of the financial flexibility of a partnership. S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates, which functions to avoid the double taxation issue. Importantly, S corporations can have no more than 100 shareholders and all shareholders must be U.S. citizens or U.S. residents, which is an issue if foreign investors are a possibility. Currently, there is an annual report filing requirement for an S Corporation. The S corporation is very similar to an LLC, but with more restrictions and requirements, so most people find the LLC a better choice.
For all of the business entities described above, except for the sole proprietorship and general partnership, it is important that the business be operated in a manner that will prevent plaintiff’s lawyers from being able to “pierce the corporate veil.” Piercing the corporate veil (also known as the “alter ego theory”) is when plaintiff’s lawyers attempt to prove that the business was not operated as a legitimate business, but is just being used to defraud creditors, and will be the subject of my next report to you.
Article Written By: Jill-Ann
Business and Commercial / Real Estate