The type of legal entity you choose to manage your investment or business can have a significant impact on tax rates, liability risk, privacy, and structure of the business.
Over time, the law has developed different ways of structuring businesses and investments. The most common entities are: LLCs, corporations, partnerships, and trusts.
Let’s explore how the most common legal entities function and affect your business.
Limited Liability Companies (LLCs)
LLCs are a popular way of structuring your business or investment because of the tax and liability benefits.
At the outset, LLCs provide business owners with the standard liability protections enjoyed by corporations. For example, if your business is sued by a customer or supplier, the suing party generally will not be able to go after your personal assets in the event of a judgment. Only the assets of your business will be vulnerable.
One tax advantage of an LLC is known as “pass-through” taxation. This simply means that members of the LLC can treat the LLC’s income as their own on their tax return. So, the business owner may benefit if, for example, the LLC’s income would be charged at a lower personal income tax rate versus the corporate rate.
LLCs may also offer investors a measure of privacy in their investments, which is often popular in real estate ownership. Depending on the state law, LLCs may not need to publicly disclose the entity’s members, thereby concealing ownership.
The primary benefit of organizing your business entity as a corporation is liability protection. As with an LLC, a suing party cannot pursue your personal assets in the event of a judgment.
Another important advantage of corporations is the ability to issue shares of stock—especially for large businesses that foresee significant growth and require large amounts of capital investment.
However, there is a tax disadvantage to the corporation model. Owning your business through a corporation results in “double-taxation.” This means that the corporation’s profits will be taxed and then any dividends you receive will be taxed again.
As a result, the benefits of owning your business through a corporation might be erased by the tax consequences. In that regard, it is important to thoroughly explore all tax implications.
The draw of a partnership is its simplicity. A partnership is the most basic organization structure—although it can become more sophisticated depending on your business’s needs.
All you need to form a partnership are two or more individuals who run a business for profit. Unlike LLCs and corporations, you don’t necessarily need to draw up any legal documents or file forms with the government.
In addition to simplicity, partnerships offer pass-through taxation like LLCs. Unlike LLCs though, partners are personally liable for debts incurred by the partnership. So, if a partnership owes money that it can’t pay back through its business, the individual partner’s assets can be pursued. Moreover, all partners are personally liable for the actions and debts incurred by the partnership, and other partners, in the course of running the business.
There are also variations on the basic partnership that incorporate elements of limited liability. In limited partnerships (LP), the partners are divided into at least one “general partner”—who remains personally liable for business debts—and “limited partners” who are liable only for the capital they invest into the partnership.
LPs can be a popular form of investing in real estate—where limited partners put up capital to purchase properties, while the general partner’s role is primarily restricted to purchasing, developing, financing, and leasing the property. The limited partner functions as a “silent partner” who hopes to earn a return on his investment through the success of the general partner’s running of the business.
A trust is a legal entity where one person (the settlor) transfers assets to another person (the trustee) for benefit of others (the beneficiaries) which may include the settlor. The benefits of a trust are manifold, and combine some of the best aspects of LLCs, corporations, and partnerships.
The transferred assets held by the trustee are generally protected from creditors on the settlor and beneficiary side. So, a mother could transfer a house to a trust and name her son and grandchildren as beneficiaries. If the mother and her son go bankrupt, creditors will not be able to go after the house to satisfy the debt.
Ownership in trusts is also generally confidential and trust beneficiaries can usually take advantage of pass-through taxation.
Understanding how different legal entities affect your business or investment can help you save money, lower liability risk, and plan for the future. Whether you are planning an investment or already have a business, we can help you evaluate the best legal vehicle for your needs. Contact us to learn more at 215-717-2200.