If you want to form a new business or already have a business, you may be wondering what entity is right for you. Limited Liability Partnership (LLP), Limited Partnership (LP), General Partnership (GP), Limited Liability Company (LLC), S. Corp. and C. Corp. are common business entities in Pennsylvania and are generally used in different circumstances. Which entity is right for you depends on a number of factors such as taxation, liability for owners, control over business decisions and transferability of ownership. This article will briefly describe various business entities and when each entity may be right for a particular business, as well as how to form the entity and certain costs associated with forming and carrying on the business.
General Partnership (GP). Unless another entity is formed, whenever two or more people carry on a business for profit in Pennsylvania they are a general partnership. No document needs to be filed or signed for this type of entity to exist and, if there is no Partnership Agreement, Pennsylvania’s Partnership Act determines the rights of the partners. For example, if no writing is in place, then profits are shared equally between partners and losses are shared in the same manner as profits. This means if one partner has contributed significant money toward the partnership and the other has not, each partner will share equally in the profits, regardless of how unfair this might appear. The good news is that there is a lot of flexibility in creating Partnership Agreements to carry out the intention of the parties.
If you are currently operating as a general partnership, then a Partnership Agreement should be drafted and signed; however, it is rare to think of a situation when this would be the appropriate entity for a business due to the unlimited liability of the partners. This means that the partners’ personal assets are at risk for partnership debts, contracts and actions. Partnership interests are more difficult to transfer than shares and cannot be devised to heirs. In terms of taxation, partnerships are "pass-through" entities, meaning the gains and losses from the partnership pass through to the personal tax returns of the partners.
Bottom line. The cheapest entity to form (usually just the cost of a Partnership Agreement), but GPs should rarely be used in light of other entities that have the same benefits as a general partnership with limited liability.
Limited Partnership (LP). Limited partnerships are similar to general partnerships in that general partners are still subject to unlimited personal liability; however, LPs allow a "limited partner" to invest in the partnership with the benefit of having liability limited to the limited partner’s investment in the partnership. To form a limited partnership, the entity must file a Certificate of Limited Partnership with the state and create a Limited Partnership Agreement to govern the partnership’s internal affairs. This means that if a limited partnership has two general partners and one limited partner who invested $100,000, and the partnership was sued, the limited partner could only be liable up to $100,000, while the general partners would be subject to unlimited liability. In exchange for limited liability, the limited partner is prohibited from actively managing the partnership. The way to get around this limitation is to use another entity, such as an LLC or a corporation, as the general partner and have the limited partners own the other entity.
Bottom line. Although a LP provides limited liability, the emergence of LLCs have made limited partnerships less common. LPs are commonly used for real estate holding companies because they can avoid capital stock tax. The costs associated with formation consist of state filing fees and drafting organizational documents, such as the Limited Partnership Agreement.
Limited Liability Partnership (LLP). Limited liability partnerships were created primarily to protect professional partnerships, such as lawyers, accountants and doctors, from liability for the negligent acts of its partners. Limited liability partnerships function mostly like general partnerships (subject to a Partnership Agreement) except that partners will not be liable for their partners’ negligence and limited liability partners are also not liable for partnership debts unless they agree to liability in writing. The downside to an LLP is that a Statement of Registration must be filed with the state along with an annual fee (currently $310) with an Annual Registration Statement. LLPs are taxed as partnerships.
Bottom line. Limited liability partnerships are viable options for professional service providers because of the flexibility the Partnership Agreement provides and the limited liability of the partners. Cost of formation consists of state filing fees, organizational documents such as the Partnership Agreement and annual registration fees. Although the annual registration fee would exceed $1,200 for four members, it is less than the same annual fee for professional service providers in an LLC ($460 per member).
C. Corp. and S. Corp. Election. The most significant features of a corporation are double taxation and limited liability. The owners of the corporation are shareholders and their liability is limited to their investment in the corporation. Historically, in exchange for this limited liability, shareholders would be subject to double taxation for the corporation’s earnings. This means the earnings of the corporation would be taxed at the corporate level, then again when the earnings were distributed to shareholders as dividends. To avoid this, small corporations would "zero out", that is, pay the earnings to shareholders, who are employees, as salaries or rent if a shareholder owned the land the business was on, and pay no corporate tax. Small corporations and LLCs can also elect S Corporation status, as long as the Internal Revenue Service’s requirements are met, and choose to be taxed as a partnership. A corporation owned by a single shareholder can also choose to be treated as a "disregarded entity" and be taxed as a sole proprietor.
From a planning perspective, forming a corporation and maintaining compliance can be tedious. The costs of creating a corporation are higher than that of other entities because of state requirements such as filing Articles of Incorporation, drafting by-laws, resolutions and corporate minutes and publication costs for the notice of formation. Annual shareholder meetings should be held to elect the Board of Directors and actions by the Board can trigger shareholder dissenter rights.
Bottom line. For large companies, corporations are the way to go because it is still the easiest way to raise capital. For smaller businesses, however, there are greater startup costs and many more state law compliance requirements and provisions that shareholders should be aware of. The benefits, from a tax perspective, of a corporation can still be achieved with an LLC that elects S. Corporation status.
Limited Liability Company (LLC). Lawyers tend to love LLCs. LLC members receive limited liability and there are very few Pennsylvania law requirements. With a few exceptions, the law says that the members can agree to whatever they want in their Operating Agreement. Like a corporation, an LLC can also be owned by one person. An LLC with one member can elect to be taxed as a corporation or a disregarded entity, in which case he or she would be taxed as a sole proprietor. Multiple member LLCs can be taxed as a partnership or a corporation and then elect S Corporation status. Most of the requirements of C Corp.’s, such as annual meetings, minutes and dissenter rights, do not apply. There is also no publication requirements so the startup costs consist of filing fees and drafting the Operating Agreement and other organizational documents.
Bottom line. Forming an LLC is generally a cost efficient option that provides flexibility with taxation, transferability of ownership interests and limited liability. There are many instances, however, when another entity may be appropriate.
What entity is ultimately right for you depends on numerous factors and costs of formation can vary depending on your unique circumstances. This is intended to provide a general framework for planning. If you are ready to form an entity or want to determine if your current entity is the most appropriate, discuss your business with an attorney.
Derek Dissinger is an attorney at Russell, Krafft & Gruber, LLP in Lancaster, Pennsylvania. He received his law degree from Duquesne University School of Law and practices in a variety of areas including Business Law.