Many, if not most businesses operate as some type of organized entity. The most common are business corporations ( “Inc.”) and limited liability companies (“LLC”).  However, there are others represented by acronyms such as LLP, PLLP, PLLC, and S Corp.  What do they mean and why are there so many different kinds?

FIRST THINGS FIRST:  Most business organizations have at least one goal in mind when organizing as an entity – limiting liability.  The business owners do not want to put their individual assets at risk when operating the business.  The assets of the business are always at risk in the event of a loss, whether due to poor business decisions, economic downturn, injury liability or other loss.  However, by organizing as an entity, the business is treated as a (fictional) separate person from the owners and because the owners are separate from the business, they cannot be held personally liable, except by agreement.  (For example, oftentimes a lender will require a personal guarantee be given by the owners of a business as part of providing a loan to the business.) In addition, operating a business corporation can be complicated with boards of directors, officers, restrictions on shareholder rights, meetings, minutes etc. The simple fact is business corporations can be overkill and over complicated in comparison to the benefit they provide to small businesses.

WHAT ABOUT TAX STRATEGIES?  It is also true that many business organizations form as a particular type of entity in order to avoid paying an unnecessary amount of income tax. Here, a little history lesson may help. Before around 1980, there was no such thing as an LLC, LLP or other “LL…”  The options for business owners were essentially to operate as a sole proprietorship, partnership or business corporation (otherwise known as a C Corp.) the problem with sole proprietorships and partnerships is that they don’t provide any limited liability. The liabilities of the business are also the liabilities of the owner(s). Therefore, if business owners wanted limited liability, they had to incorporate. However, the downside to incorporating was that corporate income is taxed twice, first at the corporate level and then as income to the owners. For example, Amazon.com Inc. sells a lot of stuff and makes a profit doing so. Those profits are taxed and paid to the federal government (and perhaps state governments). Then, each year when Amazon.com Inc. pays dividends to its shareholders, the dividends are taxed as income to the shareholders. Each dollar of income distributed as a dividend is taxed twice. This is not desirable, particularly for small business owners. Essentially, business owners had two choices, submit to double taxation or be subject to risk of personal liability.

IN CASE YOU WERE WONDERING:  You may be wondering, why were business owners limited to two choices? The short answer is the law had not been developed sufficiently yet. Because corporations acted essentially like separate persons, the IRS treated them that way and taxed them separately. On the other hand, state laws which govern limited liability and the way business organizations are allowed to operate had not evolved to allow limited liability to businesses that otherwise operate like sole proprietorships or partnerships.

MONTANA TO THE RESCUE:  Well not quite, but Montana was the first state to recognize limited liability companies in 1977. Modern business practices and the need for flexibility put political pressure on states to recognize simplified ways of organizing a business that allowed limited liability, but preserved sufficient characteristics of a sole proprietorship or partnership to be taxed only at the ownership level (called “pass-through” taxation because income is considered to pass-through the company to the business owners before it is taxed). Today, virtually every state recognizes limited liability companies as well as other variants of the limited liability, pass-through taxation model.

WHAT ARE THE OTHER TYPES OF ENTITIES AND WHY ARE THEY DIFFERENT?  A limited liability company is a new business or a pre-existing sole proprietorship or partnership that reorganizes to operate as a limited liability company. Once organized, the business continues to benefit from taxation only at the owner level, but benefits from limited liability. However, not all businesses are suitable for organization as an LLC. So, other variations have developed over the years. These include:

  • Limited Liability Partnerships or LLPs. LLPs are pre-existing partnerships or newly created businesses that wish to operate as a partnership with limited liability. The operation of an LLP is different from an LLC in several respects. First, in an LLC, the investment of all members[1] is at risk in the event of a liability. In an LLP, like partnerships, each partner may not be held liable for the actions of other partners and therefore a partner’s share in the partnership is not at risk in the event of liability caused by another partner. Oftentimes, state law limits LLPs to be used only by businesses providing professional services (doctors, accountants, lawyers etc.).
  • In some states, including Michigan, businesses providing professional services must organize as either as such either as a PLLC or PLC (“professional limited liability company, i.e.,  Seibold Law Firm, PLC),  PLLP (or PLP) (professional limited liability partnership) or PC (professional Corporation). Typically, all members/partners/shareholders providing services must be licensed in that particular profession.

Limited liability partnerships should not be confused with limited partnerships. Limited partnerships predated limited liability partnerships and provided the unique ability to have one partner (the “general partner”) operate the business and be subject to personal liability and other “limited partners” be passive investors not subject to personal liability.

Lastly, you may have heard of  the ”S. corp.” S corps. still exist and were a precursor to limited liability companies. Most business corporations are considered “C corps.”. The “C” is a reference to 26 U.S. Code Subchapter C which provides for taxes on distributions to shareholders in addition to taxation on income of the corporation at the corporate level. “S Corp.” is a reference to 26 U.S. Code Subchapter S which allows a corporation to elect taxation only at the shareholder level. S Corps. were the solution to obtain limited liability and pass-through taxation before limited liability companies existed. However, the IRS places strict limits on S corps., including stock ownership restrictions, limits on allocating income and loss and  technical filing requirements. These limitations made S corps. An unattractive option for many business owners prior to the advent of limited liability companies.

Limited liability companies and other similar organizations have evolved over the years and become simpler to operate and manage. For example, it used to be that a sole owner could not form an LLC, but that is no longer the case in virtually all states. Further, when there are multiple members, the members can choose to equally share in the management of the business or designate one or more members (or a non-member) to manage the business. However, members are still generally prohibited from being paid as employees of a limited liability company. Whether organizing/incorporating makes sense for your business and which form of organization to choose is a question best answered with the help of a lawyer. At Seibold Law Firm, we stand ready to help.

[1] “Members” of a limited liability are the equivalent of shareholders in a corporation.

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