There are several types of business entities that a person can choose from when establishing and operating his or her business. These entities offer different combinations of business, legal and tax benefits and protections that should be taken into account in analyzing what works best for a particular type of business. The purpose of this article is to highlight the major differences between the commonly-formed entities, and provide a framework for effective analysis of the choices involved. Before discussing the differences between these entities, it is important to keep in mind the driving forces behind these differences. One major consideration is the process involved in forming the entity. There are entities that can be formed simply by conducting a business, such as sole proprietorships and general partnerships. On the other hand, most business entities can be formed only by filing the applicable formation documents with the Minnesota Secretary of State’s office (“MSSO”) and paying the required fee, which is generally over $100. Limited liability protection is a critical element in analyzing the attributes of a business entity. An entity that offers limited liability protection shelters its owners from the financial obligations and liabilities of the entity. This means that the individual owners do not have to use their personal assets to settle the obligations of the entity. An entity that affords its owners limited liability protection must be formed by filing the applicable document with the MSSO, and pay annual fees to maintain is “active” status. The tax payment and reporting obligations associated with a particular business entity are ordinarily the most significant consideration in selecting a business entity. As a general rule, all entities that have two or more owners must file a separate tax return with both federal and state tax authorities and, depending on the entity involved, may have to pay tax on the income they generate. I.Sole Proprietorships. Sole proprietorships have a single person for an owner. The income and expenses of a sole proprietorship are reported on Federal Form 1040, U.S. Individual Income Tax Return, of the individual owner, and no separate tax is imposed on the entity itself. The income generated by the entity is added to all other income of the individual owner in calculating the tax liability payable by the owner. Nothing needs to be filed with the MSSO to form a sole proprietorship. Thus, sole proprietorships offer the benefit of simplicity from the formation and tax compliance perspective.

However, they have significant drawbacks. The most significant drawback of sole proprietorships is that they offer no limited liability protection to the individual owner. Hence, for instance, if a person slips and falls in a grocery store that is owned by a sole proprietor and the injured person sues, any liability that arises is covered not only by the assets of the grocery store, but also by the assets of the individual owner, including the owner’s house. II. Partnerships.

There are numerous types of partnerships. The most commonly formed partnerships for operating an active business include general partnership, limited partnership (LP), limited liability partnership (LLP), and limited liability company (LLC). A general partnership can be formed merely through a verbal agreement or understanding between the parties. Thus, nothing needs to be filed with the MSSO to create a general partnership. A general partnership does not afford its partners limited liability protection.

LPs, LLPs and LLCs are all created by filing some kind of a form, certificate or document with the MSSO. LPs have two classes of partners: general partners and limited partners. The difference between the two is that the general partners are personally liable for the partnership’s debts and obligations, but the limited partners are not. LLPs and LLCs generally provide protection to all of their partners from the partnership’s debts and obligations.

The tax treatment of the different types of partnerships discussed above is generally the same. A partnership is not an entity subject to tax. Instead, the partners are taxed directly on partnership income whether or not the income is actually distributed to them. If a partnership has a loss for the year, it is passed through to the partners. A partner’s ability to deduct partnership losses is limited to the basis of his/her interest in the partnership. A partner’s basis in his partnership interest is subject to fluctuation because it is increased by the partner’s capital contributions and his share of the partnership’s income, and decreased by his share of the partnership’s losses and distributions made to him.

Partnerships file Form 1065, U.S. Partnership Return of Income, to report their income or losses that are passed through and reported by the partners. The net income of a partnership is calculated in much the same way as an individual, subject to certain exceptions. Certain items, such as charitable contributions, are required to be “separately stated,” which means that the item is not taken into account in arriving at the net income or loss of the partnership. Rather, the item is passed through to the partners without being offset with any other item.

CHOICE OF ENTITY DEMYSTIFIED:WHICH BUSINESS ENTITY WORKS FOR YOUR BUSINESS?

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By Pomy Ketema

The income and losses of a partnership are ordinarily allocated (i.e., divided) among the partners based on their agreement as to how to split such income and losses. Hence, having a clearly defined partnership agreement is paramount to effective allocation and taxation of the income generated. Although there is great flexibility in how partnership items are allocated among the partners, the manner of allocation must reflect the real economic arrangement of the parties. If an allocation is designed to shift the tax consequences of partnership income and losses among the partners, the IRS has the authority to re-allocate those items.

Partnership income retains its character on the tax returns of the partners. This means that the tax treatment that would have applied to a specific item of income at theentity level would apply at the partner level. For example, if capital gain income is generated by the partnership from a sale of land, the income would remain capital gain income when it is passed through to the partners. The effective tax rate on partnership income is a function of the tax brackets of the partners.

A partner’s interest in a partnership could terminate due to a sale or redemption of his or her interest, or a termination of the partnership. Upon the sale of a partnership interest, a partner must recognize gain equal to the difference between the basis in his partnership interest at the time of the transfer and the amount realized on the sale. The basis of the partnership interest is adjusted to the date of sale to reflect any interim partnership items of income, loss and distribution. Although gain or loss recognized on the sale is typically characterized as capital gain or loss, the selling partner may recognize ordinary income or loss if the partnership holds “hot assets,” such as appreciated inventory or unrealized accounts receivables.

The redemption of a partner’s interest is treated similarly as a sale or exchange. A partnership generally does not recognize gain or loss upon liquidation. A partner receiving a liquidating distribution typically recognizes gain or loss only in limited circumstances. Any gain or loss recognized by the partner is capital gain or loss.

III.Corporations.

There are two types of corporations for federal income tax purposes: C corporation and S corporation. Both types of corporations are formed by filing Articles of Incorporation with the MSSO. Both types of corporations offer limited liability protection to their owners. The most significant difference between the two entities is the manner in which they are taxed under federal and Minnesota income tax laws.

A. C Corporations

C corporations are separate taxpaying entities. Taxable income or loss is calculated at the entity level and reported on Form 1120, U.S. Corporation Income Tax Return. For tax year 2005, taxable income would have been taxed to the corporation at a rate as high as 35%. If the corporation incurs a loss, such loss can be either carried back or carried forward as a net operating loss and offset taxable income in prior or future years.

The shareholders of a C corporation are taxed on distributions as “dividends” to the extent of corporate earnings and profits. If the corporation distributes appreciated property to its shareholders, it recognizes a gain on the distribution as if it had sold the property for its fair market value. This results in double taxation of the earnings of a C corporation – once at the entity level and again when distributed to the shareholders. Dividends are ordinarily taxable to the shareholders at ordinary income tax rates, which can be as high as 39.5%. However, the Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the rates applicable to dividends to a flat rate of 15%, which is scheduled to expire on January 1, 2009.

The treatment of the sale of stock in a C corporation is considerably simpler than that of the sale of ownership interest in an S corporation or partnership. This is because the stock basis of a C corporation shareholder is static. It is not adjusted for the income and losses of the corporation. The shareholder recognizes gain or loss based upon the difference between the amount realized on the sale and his adjusted basis in the stock sold. The gain or loss recognized is generally characterized as capital gain or loss.

One of the most restrictive and difficult aspects of a C corporation involves redemptions of shares. A distribution of cash or property by a C corporation in a redemption transaction is treated as a dividend unless the transaction meets certain requirements to be treated as a sale or exchange. The requirements for sale or exchange treatment can be difficult to meet, particularly in the context of closely held businesses where ownership interests of a redeemed shareholder are attributed to family members who are also owners of the subject corporation.

A C corporation generally recognizes gain or loss on the distribution of property to its shareholders in liquidation. When a corporation makes a liquidating distribution of property to a shareholder, the shareholder must recognize gain or loss equal to the difference between the value of the property received and the adjusted basis in his stock. A liquidating distribution by a C corporation results in double taxation.

B. S Corporations

S corporations function much like partnerships when it comes to income taxation. S corporations are pass-through entities, allowing earnings to be taxed and losses to be deducted at the shareholder level. S corporations file Form 1120S, U.S. Income Tax Return for an S Corporation, to report the taxable income or losses of the corporation that are allocable to its shareholders. S corporation shareholders are taxed on the earnings of the entity regardless of whether such earnings are distributed. Items of income and loss, whether ordinary or capital in nature, generally retain their character on the shareholder’s return.

One of the major differences between S corporations and partnerships is allocation. Unlike partnerships, the allocation of S corporation items is not governed by an agreement between the shareholders. Rather, the income and losses of S corporations must be allocated on a pro rata basis for each day of the taxable year and among each share of stock. As is the case with partnerships,

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