Forms of Commercial Legal Entities

Posted by Southwest Beverages on 1/17/2015
Forms of Commercial Legal EntitiesGenerally speaking, there are four (4) broad forms of commercial legal entities, each of which has its advantages and disadvantages with respect to taxes, ownership, legal liability, legal existence, capital infusions, selling of the business and the relationship between owners. When selecting the proper form of legal entity the owner’s vision of the company is of paramount importance and should be taken into consideration. For example, will the company be simple, that is, will all employees report to the owner? Or will the company be complex, which is, will the company be multi divisional? Will it operate in numerous states and/or countries? Will it have numerous products? Will it be managed under a hierarchy form of organization structure?  

Specifically, the four (4) broad forms of legal entities, presented from the simplest form to the most sophisticated, are:

·       Sole Proprietorship

·       Partnership

·       Corporation

·       Limited Liability Corporation

Set forth below are the legal formation steps common to each of the four (4) forms of legal entities. Additional formation steps, unique to each specific form of legal entity, will be discusses in its respective section.

·       Choose a business name and, if applicable, a trademark name; Check their availability with the local state and US Patent and Trademark Office, respectfully; www.uspto.gov

·       Register the business name with the appropriate state government agency; Register the trademark name with the US Patent and Trademark office.

1.     If the entity will be operating under a fictitious or assumed business name the company is required to obtain a, “Doing Business As” certificate (DBA) from its state authority.

·       Obtain, and pay for, all necessary licenses, permits, certificates, etc. from state &/or local municipalities, i.e. business license, liquor license, food handlers license, dumping permit, etc.

·       Apply from the IRS for a Federal Tax Identification Number more commonly known as an Employer Identification Number (EIN)- www.irs.gov 

Steps not legally required but which makes good business sense.

·       Prepare a written Operating Agreement.

·       Open a bank account in the company name.

·       Obtain product liability insurance.

Form of Legal Entities

  1. SOLE PROPRIETORSHIP-According to the Small Business Administration, approximately 73 % of all businesses in the United States operate as sole proprietorships. Generally speaking it is the simplest form of company to form, has the least amount of initial start-up costs associated with it, has virtually no annual maintenance costs and while it must operate in a good faith manner and abide by all laws, it is not subject to the numerous reporting regulations that corporations must ad heard to. The owner of the business is not separated from all financial obligations, legal matter and taxes of the sole proprietorship even though the sole proprietorship is operated as a separate entity and under a different name from that of the owner. The sole proprietorship automatically ceases upon the death of the owner.


    1.   Additional Legal Steps in the Formation of a Sole Proprietorship

    a.      Generally speaking there are no legal requirements necessary for a business to operate as a sole proprietorship other than for it to obtain the necessary licenses and permits required by its state and local multipicalities. 

NOTE 1: The mere filing of a “DBA” does not protect a sole proprietor’s assets because the business and the owner are legally viewed as one.

NOTE 2: A sole proprietor can have only one EIN, regardless of the number or types of businesses they choose to operate.

2.   Advantages and Disadvantages of a Sole Proprietorship

a.      Advantages

1.     Easiest form of entity to create.

2.     Owner is in complete control.

3.     Tax rate (individual rate) is usually lower than that of a corporation.

4.     Tax filing is simpler than those of other legal forms (business income and expenses are passed through to that of owner on IRS tax form 1040 by having owner complete schedule C-“Profit or Loss From Business”.

b.   Disadvantages

1.     Owners liable for all debts of proprietorship.

2.     Owners liable for all legal issues of the proprietorship (which often results in higher insurance premiums for the business).

3.     The owner cannot participate in company funded medical insurance and retirement plans.

4.     Company is not autonomous, that is, the company and owner are viewed as one.

5.     The sole proprietorship does not continue in perpetuity-that is the death of owner dissolves the proprietorship.

6.     There usually are problems between the partners with respect to adding investors or selling a partner’s interest.

7.     Personal financial interests are often co-mingled with that of business interests.

8.     It is often hard to obtain business loans since the business is viewed a being “one and the same” as that of the owner (owner usually required to issue a personal guarantee on all loans).

  1. PARTNERSHIP-There are three (3) forms of partnerships; General, Limited and Limited Liability. Except as noted below all three (3) forms of legal partnerships, in the aggregate, consists of two or more participants, who jointly elect to enter into a business as co-owners. Participants can be individuals, corporations, estates, trusts, partnerships or limited liability corporations. A partnership is in and of itself, an entity unto itself. It is strongly recommended that a formal written partnership agreement be entered into among the partners, regardless of the form of the partnership, which delineates the rights, duties, obligations, and responsibilities of the partners at the inception of the partnership.
                                                                                        

·       General Partnership- All members of a general partnership are called, General Partners. A general partnership is very similar to that of a sole proprietorship in that it retains the same advantages and disadvantages of a sole proprietorship except that:

(a) each of the partners have expanded legal and financial responsibilities-each can be held, personally and severally liable for the actions of the other partners (even if the liability exceeds the partners capital-the partner must satisfy the obligation with his personal assets) and

(b) unlike the sole proprietorship where the income and expenses of the business are passed directly through, and consolidated with, the owner’s personal income and expenses for tax purposes, the income or loss of the partnership is reported on an annual informational tax return (IRS form 1065-U.S. Return of Partnership Income). Partners share of the partnerships income, expenses, deductions, credits, etc. are reported on IRS Schedule K-1, Partner’s Share of Income (Loss) From an Electing Large Partnership. Schedule K-1 is part of IRS form 1065.  NOTE: The partnership entity does not pay any income tax directly, but rather is proportionally passed through to each of its partners, who are personally liable for their respective portion, whether the income from the partnership is distributed or not). In addition, each partner must pay self-employment tax up to the FICA limits.

·       Limited Partnership-The partners in a Limited Partnership are comprised of two types of participants each consisting of one or more partners: General and Limited. General partners actively participate in the management of the partnership and have unlimited personal liability for the partnerships financial and legal obligations. Limited partners do not participate in the management of the partnership but share proportionally in the income and losses of the limited partnership. In addition, each limited partners liabilities for the partnership’s financial and legal obligations are limited to that of their capital contributions. Distribution, tax reporting and payment of self-employment tax of partnership income and expenses is identical to that of a general partnership (i.e. annual information return-IRS Form 1065, partners proportionate share of the partnership income/(loss), credits, deductions, etc. reflected on Schedule K-1).

·       Limited Liability Partnership-The Limited Liability Partnership is very similar in form to that of a General Partnership with one distinctive difference-each of the limited partners has their liability restrictive in certain instances to that of their capital. Each state has certain instances in which limited partner’s liability is restrictive. Some states limited the limited liability partners expose to tort issues, while others expand the exclusion to include the partnership employee and agent’s malpractice issues (acts of errors, omissions and negligence), provided the employee or agents misconduct is not under the “direct supervision and control” of a partner.  All LLP partners remain directly personally liable for their own acts of malpractice or malfeasance.  Distribution, tax reporting and payment of self-employment tax of partnership income and expenses are identical to that of a general partnership.

1.   Additional Legal Steps in the Formation of a Limited Liability Partnership

a.     File the appropriate state statute document: Registration Statement, Application for Registration or a Certificate of Limited Liability Partnership.

b.     Pay filing fee to state; most state require a flat annual fee, however some states base their fees on the number of partners in the LLP.

c.      Use words, Limited Liability Partnership or Registered Limited Liability Partnership in name of company or abbreviation, LLP or RLLP, respectfully.

d.     Some states require the partnership to have adequate proof of liability insurance or sufficient assets to satisfy a potential tort claim.

2.   Advantages and Disadvantages of Partnerships

a.      Advantages

1.     Legal formation is relatively easy and inexpensive.

2.     Combination of resources is prevalent-Capital, manpower, non-duplication of business tasks, etc.; one partner can run the business in the event another partner becomes ill or is temporally disabled.

     Partnerships can hold property and borrow in the partnerships name (lenders/investors might require a personal guarantee from one or more partners if partnership is new or not financially solvent).

4.     Tax rate (individual rate) is usually lower than that of a corporation.

5.     Tax filing is simpler than those of other legal forms.

6.     Partnership entity is relatively easy to dissolve.

b.     Disadvantages

1.     Owners (partners) liable for all debts of partnership; except limited partnerships where their liability is limited to their capital.

2.     Owners (partners) liable for all legal obligations of partnership; except for limited partnerships where their liability is limited to their capital.

3.     Written partnership operating agreement entered into by all partners (can be very burdensome discussion between partners).

4.     Company is not autonomous, that is, the company and owner(s) are viewed as one.

5.     Partnerships do not have perpetual existence, that is, death, disability, or withdrawal of one partner dissolves the partnership, unless substitution is specifically stated in the written partnership operating agreement.

6.     There are usually associated when adding or selling a partners interests.

  1. CORPORATIONS-Corporations are of two (2) forms: “C Corporation” and “S Corporations”, each deriving their name from their respective subchapter of the Internal Revenue code. In many jurisdictions corporations are also commonly known as “Company” (abbreviated “Co.”) or “Incorporated” (abbreviated “Inc.”). Both words have the same legal implications and represent a legal form of entity under that states applicable law. Both “C” and “S” Corporations have a number of attributes, which are common to both. Specifically, these attributes are:

1.     Both require the same legal formation documents (i.e. Articles of Incorporation) to be filed at the state government level.

2.     Both are required to follow the same internal and external statutory requirements.

a.      Internal requirements-Issuing and maintaining stock certificates, books of records, maintaining and filing corporate minutes, adopting by-laws, conducting annual shareholders meetings, etc.

b.     External requirements-Filing SEC documents (Public companies ONLY-8-K’s, 10-K’s, 10-Q’s, registration statements, etc), filing prospectuses, payment of all licenses, permits and certificates, tax filings, etc.

3.     Both are separate legal entities with their own identity separate from that of their shareholders.

4.     Both offer their shareholders the same limited liability protection, that is, shareholders are only personally responsible for the corporation’s debts and liabilities to the extent of their invested capital.

5.     Both corporations have shareholders, directors and officers.

a.     Shareholders are investors who own the companies common stock and who elect the board of directors.

b.     The Board of Directors provides the overall directional strategy of the corporation, but does not manage the day to day affairs of the corporation. The Board of Directors appoints the Officers of the Corporation.

c.      The Officers of the Corporation manage the day to day operations of the company.

·       C CORPORATIONS-Most successful companies in the United States are C Corporations because:

1.     They presents a more formal appearance to outsiders (lenders, investors, the public, etc), and

2.     It is the best form of legal entity, which fulfills its creators financial wishes of raising private capital through:

 a. Private Placement Memorandum’s,

 b.  Private Investment in Public Equity offerings (PIPE’s) and

 c.  Initial Public Offering (IPO).

C Corporations are responsible for paying their own income taxes. Taxes are paid to the IRS by filing Form 1120,     U. S. Corporation Income Tax return. All C Corporations are required to file an income tax return, regardless of if the corporation made a profit or is in bankruptcy.

1.   Additional Legal Steps in the Formation of a C-Corporation

a.      Prepare and execute a pre-organization subscription agreement (Agreement necessary for a corporation to sell stock to potential investors).

b.     Prepare a corporate charter and file with appropriate states secretary.

c.      Prepare by-laws (i.e. how the corporation will operate with respect to the number of officers it has, their duties and responsibilities, the number of directors, their responsibilities and meeting dates, the date of the annual shareholders meeting, headquarters office location, who and where the minutes will be maintained, etc.).

d.     Hold an organizational meeting of the board of directors.

NOTE: The election of corporate officers is not part of the legal business formation process. Once the Board of Directors is appointed, they in turn will elect the company officers.

2.   Advantages and Disadvantages of C-Corporations

a.      Advantages

1.     Shareholders liability is limited to that of their investment (value of shares owned).

2.     Corporation may have an unlimited number of shareholders. New shareholders can be added by the mere issuance of additional stock. Non US residents can be shareholders.

3.     Corporations may have more than one class of stock.

4.     The corporation is a separate legal entity, that is, it exists apart from its owners, directors and officers.

5.     The corporation is taxed separate from its shareholders.

6.     The ownership of the corporation and its assets is easily transferable by investors buying/selling their stock or the corporation purchasing or selling company assets.

7.     Corporations have perpetual lives-that is the existence of the corporations continue indefinitely (the death of a shareholder or the sale of their shares does not end the corporation but is rather a transfer of ownership of the corporations shares of stock from one investor to another). Corporations can be legally dissolved under certain circumstances: voluntary dissolution, bankruptcy, etc.

8.     Outsiders (lenders, investors, public, etc.) view the corporate form of legal entity as more businesslike, more professional than other forms of legal entities (sole proprietorships & partnerships) because it has more structure and regulatory compliance requirements.

9.     The company can deduct as expenses company funded benefit plans: medical insurance, retirement plans, etc.

b.   Disadvantages

1.     The annual maintenance costs of the corporation are the most expensive of all legal entity forms because of numerous regulatory requirements imposed on the corporation to:

(a)   issue prospectuses and file registration statements to raise capital,

(b)  file corporate minutes,

(c)   conduct its annual shareholders meeting,

(d)  register as a “Foreign Corporation” when it operates in a state other than the state in which it is incorporated. In addition, some states require “Foreign Corporations” to have registered agents,

(e)   have a registered stock transfer agent.

2.     Double taxation-Corporate profits are usually taxed twice to shareholders; First, as earned income to the corporation, and second at the personal income tax rate of the shareholders on dividends paid by the corporation.

·       S CORPORATIONS-S Corporations, or more commonly known as “Subchapter S Corporations”, is the form of legal entity generally used by individuals to own small businesses and by families to own family owned businesses. While state laws vary as to the maximum number of investors, the majority of states limited the maximum number to 100. NOTE: Only individuals, and NOT corporations, can be shareholders in an S Corporation. Corporations electing “S” status must file form 2553, Election by a Small Corporation, with the IRS and meet all IRS guidelines. S Corporations file their taxes on IRS form 1120S, U.S. Income Tax Return for an S Corporation.

1.   Advantages and Disadvantages of S-Corporations

a.   Advantages

1.     Shareholders liability is limited to that of their investment (value of shares owned).

2.     No-double taxation as with a C Corporation. Taxes are reported by the S Corporation on an informational return, and the income, expenses, deductions, credits, etc. are passed through to the individual shareholders and reported on their personal income tax return (IRS form 1040).

b.   Disadvantages

1.     Ability to raise capital is limited by the maximum number of shareholders permitted: 100.

2.     No non US residents are permitted as shareholders.

3.     Only one class of stock is permitted.

4.     IRS imposes strict requirements for S-Corporation election.

  1. LIMITED LIABILITY COMPANIES-A Limited Liability Company (abbreviated L.L.C. or LLC) is a legal form of business that draws certain of its characteristics from a corporation (limited liability) and, depending on the number of its owners, either from a partnership or a sole proprietorship (pass through taxation). Owners of the LLC are called, “Members”. A Member can be an individual, corporation or a partnership. Members can manage the affairs and operations of the LLC directly in proportion to their interests, (member-managed) or through a group of managers (manager-managed), in which case the Managing Member is viewed as the Chairman of the Board of a corporation.  The LLC is the ideal form of legal entity when there is only one owner.

1.   Additional Legal Steps in the Formation of a Limited Liability Company

a.      File the appropriate state statute document: Articles of Organization (formalizes legal existence of LLC).

b.     Pay filing fee to state; some states require a flat annual fee, while an increasing number of states have imposed a business privilege tax (tax for the privilege of enjoying the luxury of limited liability)  based on the LLC’s % of sales, % of profit, capital, number of members, etc.

c.      LLC’s must use the name Limited Liability Company in name of the company or either of these abbreviations; L.L.C. or LLC.

2.   Advantages and Disadvantages of Limited Liability Companies

b.     Advantages

1.     Members (owners) liability is limited to that of their investment (value of shares owned).

2.     LLC’s may have an unlimited number of members; Members can be individuals, partnerships or corporations.

a.      Because a corporation can be a member it can offer additional benefits to the LLC in the form of medical, retirement, etc. (Managing member can deduct 100 % of medical premiums up to his contributed capital)

b.     Member’s interests can be assigned.

c.      No citizenship required for members.

3.     The LLC is a separate legal entity, that is, it exists apart from its members (owners).

4.     The LLC does not file a tax return but files an annual informational tax return (IRS form 1065-U.S. Return of Partnership Income). Members share of the LLC’s income, expenses, deductions, credits, etc. are reported on IRS Schedule K-1, Partner’s Share of Income (Loss) From an Electing Large Partnership. The income and expenses of the LLC are pass directly through, and consolidated with, the owner’s personal income and expenses for tax purposes and reported on the individual’s IRS tax form 1040. Each LLC member is personally liable for their respective portion of the LLC profit/(loss), whether the income from the LLC is distributed or not. In addition, each member must pay self-employment tax up to the FICA limits.

5.     The amount of annual legal and administrative fees is significantly less than those of corporations.

6.     LLC’s do not have to conduct annual shareholder meetings or keep company minutes.

b.   Disadvantages

1.     Unless specifically stated in the Operating Agreement, the ownership of the LLC is not easily transferable by its members.

2.     The LLC is viewed not as businesslike and professional by outsiders: (lenders, investors, public, etc.) than other forms of legal entities (corporations).

a.   Outsiders (lenders, investors and public) often view LLC’s as partnerships or sole proprietorships and as such often require personal guarantees to be given by members to support loans, capital, etc.

b.   The LLC management structure is significantly different from that of a corporation-that is, there are no board members, officers, etc., but rather a managing member and members. Principals often use titles of a traditional corporation, i.e. CEO, COO, CFO, etc, which makes it difficult for an outsider to understand where in the LLC the true authority lies.

3.   The majority of state statues do not require LLC’s to have written operating agreements.

4.   LLC’s do not exist in perpetuity, that is, they automatically dissolve upon the death of a member or the filing of bankruptcy.

5.   LLC’s cannot issue stock.

Concluding Comment

While the purpose of this material is to provide the reader with a basis understanding of each of the four (4) broad forms of legal entities it is by no means, nor should it be relied upon exclusively, as an all inclusive document that a potential business owner should rely on in their selection of the proper form of legal entity for their business. As the legalities of setting up a company are numerous with respect to formation, maintenance, tax reporting, regulatory compliance, statutory compliance, etc., it is strongly recommended that the business owner seek professional advice in determining the correct form of legal entity.

dry mix beveragesWritten by Bob Jenkins, Founder & Chief Executive Officer of Southwest Beverages®

Bob has had the privilege of working for some of America’s largest and well run public and private companies, including Philip Morris, Canada Dry, Dr Pepper, Cadbury Schweppes, Snapple Beverage Corporation, Tasker Capital Corp. and The Water Club and River Cafe – two of New York’s finest fine dining restaurants. He has worked in various capacities as Finance Manager, Controller, Director of Finance, Vice President Finance & Administration, Chief Financial Officer, Secretary, and Treasurer.

Bob holds a Masters of Business Administration degree in accounting from the University of Tennessee and a Bachelor of Science degree in accounting from the University of Arizona.

Southwest Beverages® is a manufacturer and marketer of two brands of premium quality dry mix beverages: Sippity® hot cocoa mix and Kemosabe® gourmet flavored coffee. All Southwest Beverages® products are uniquely blended flavors that contain all the ingredients necessary for you to enjoy the ultimate hot beverage experience. Simply add water and stir-then sip, savor and enjoy.

For more information, please visit www.southwestbeverages.com.

Interested in writing a guest blog for Southwest Beverages®? Send your topic idea to [email protected].

All data and information provided on this site is for informational purposes only. Southwest Beverages® makes no representations as to accuracy, completeness, current-ness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information, or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.

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