Legal Forms of Business Entities
The legal form of entity is an important consideration when performing bookkeeping. This article provides a brief description of the more common forms of legal entity (that is; sole proprietorships, partnerships, corporations, and limited liability companies) and discusses the advantages and disadvantages of each.

Sole Proprietorships
Proprietorships are typically the simplest business form. Sole proprietors own 100% of the business and are personally liable for all liabilities. Sole proprietors report profit or loss from the business on their individual income tax returns using Schedule C (Profit or Loss From Business). Accordingly, proprietorship profits are taxed at individual tax rates. The advantages of sole proprietorships include the following:

• Sole proprietorships can be easily formed, and just as easily discontinued. There are few required filings, elections, or registrations.
• Sole proprietorships offer greater independence to their owners than other forms of business. A sole proprietor manages his or her business and reports to no one.
• Because only a single tax paying entity is involved, there are fewer tax returns to file in comparison to other forms of entities.

The disadvantages of sole proprietorships include the following:

• Sole proprietors have unlimited liability not only for debts to creditors but for product liability and personal injuries that may occur on the business premises.
• Selling a business operating as a sole proprietorship is more difficult than selling interests in a partnership or corporation.
• The value of the business may be the intangible value associated with the owner.
• Generally, the availability of credit sources can be more limited for sole proprietors than for entities with multiple owners.
• Because a sole proprietor generally is actively involved in the business, growth beyond a certain point is limited to the proprietor’s capacity to perform.
• A sole proprietorship has no continuity of life.

Proprietorships are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

Partnerships

General Partnerships
General partnerships are formed when two or more entities join together to carry on a trade or business. A partnership may be established by an oral or written agreement, or it can be deemed to exist when there is a perceived intention to be partners, be co-owners of a business, or share profits or losses. The following are some of the advantages of operating a business as a general partnership:

• Partnerships are tax-reporting entities rather than tax-paying entities. That is, partnership income, gains, losses, and deductions are allocated to partners and included in their income tax returns.
• Partnerships generally may distribute property to partners without gain recognition.
• Partnership agreements may provide for special allocations for certain partners.
• Partnerships generally have capital available from more than one source and have more alternatives for obtaining financing. (Partnerships can borrow money, seek additional contributions from the partners, or raise additional capital by admitting new partners.)
• Partnerships generally require less administrative burdens than corporations.
• Partnerships provide the possibility to mix talents and management skills.
• Partnerships can liquidate with little or no tax cost.
• Partnerships conducting a business activity of primarily a service nature are generally eligible to use the cash method of accounting, unless the partnership meets certain conditions such as being a tax shelter.

Some of the disadvantages of operating a business as a general partnership include the following:

• General partners generally are personally liable for 100% of partnership liabilities (not just a share of the liabilities based on their ownership percentage). Partners are also generally liable for torts committed by partners. Furthermore, any partner may be able to bind the partnership in a contract within the scope of the business operations.
• Partnerships have a limited life that may terminate upon the death, retirement, withdrawal, or bankruptcy of a partner.
• Partners enjoy less independence than a sole proprietor when making decisions that affect the business.
• Partnership interests may not be as freely transferable as corporate interests.
• Partnerships cannot provide many of the tax-favored fringe benefits to partners that corporations generally can provide to stockholders.

Partnerships are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

Limited Partnerships
Limited partnerships are similar to general partnerships except that one or more of the partners have limited participation in the risks and rewards of ownership. That form of organization enables limited partners to be passive investors in a partnership. In addition, limited partners’ liability is limited to the extent of their investment.

Limited partnerships must have at least one general partner. Under a limited partnership arrangement, general partners manage and control the day-to-day operations. A general partner’s personal assets can be seized to satisfy debts of the limited partnership.

Limited Partnerships are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

Limited Liability Companies
The limited liability company (LLC) is a form of entity that offers advantages and benefits unavailable to S corporations or partnerships. The LLC combines the corporate characteristic of limited liability for owners with the flexibility and flow-through tax attributes of a partnership.

LLCs are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

Corporations
Corporations are business entities created under state law. As a result, their powers can vary from state to state. The basic characteristics of corporations do not vary significantly, however. Generally, operating a business in the corporate form offers the following advantages:

• Limited Liability. The liability of owners of a corporation for its debt is limited to the assets of the corporation.
• Continuity of Life. The corporation continues indefinitely, even after the death of a stockholder.
• Centralized Management. Stockholders elect a board of directors, which is ultimately responsible for the management of the company. Stockholders need not be involved in the management of the business.
• Ability to Obtain Financing. Corporations can obtain financing by selling different types of securities (such as stocks or bonds).
• Ease in Transferring Ownership. Ownership of a corporation is evidenced by shares of stock, which are generally easier to sell than an interest in a noncorporate entity.
• Benefits. Corporations enjoy favorable tax treatment of certain employee benefits that is not available to noncorporate entities.

There are some disadvantages to operating a business as a corporation. Those disadvantages include the following:

• Administrative Burden of Incorporating. Legal documents must be drafted, and stockholder and board of director meetings must be conducted and documented. In addition, corporations may be subject to state and local franchise tax reporting.
• Cost of Incorporating. There are generally significant expenses related to the incorporation of a business.
• Lack of Control by Stockholders. The board of directors and officers of the corporation, rather than the stockholders, generally control the business operations of a corporation.
• Qualification Requirements. It is sometimes necessary for a corporation to formally qualify to do business in states other than the one where it is incorporated.
• Unreasonable Compensation. The IRS may question the amount of compensation paid to stockholder-employees. If deemed unreasonably high, the excessive amount may be considered a nondeductible dividend.
• Potential Double Taxation on Liquidation. When a corporation liquidates, the corporation is taxed on the gain from the sale or distribution of assets, and stockholders are taxed on the distributions received from the corporation. Note that this disadvantage has been mitigated by the reduction of the tax rates on qualifying dividends and capital gains of individuals to 5% or 15% under the 2003 Tax Act.
• No commingling of assets. Corporate and personal assets must be maintained separately. Unfortunately, small business owners sometimes blur the line, treating the company as an extension of themselves.

Corporations are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

C Corporations
Corporations are characterized as artificial persons created for the purpose of conducting business. Corporations operating in the basic corporate form (that is, as C corporations) are subject to income tax in accordance with corporate income tax rules. C corporation income may be taxed twice; once when the corporation files its income tax return and again when stockholders file their individual returns and report distributions of the corporation’s income as dividends.

C corporations are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

S Corporations
Corporations can avoid the potential double taxation of income discussed above by electing to be treated as an S corporation for income tax purposes. Generally, S corporations are not taxed on their earnings. Instead, income, loss, deductions, and credits are passed through to stockholders to be included in their individual income tax returns.

S corporations are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.

Personal Service Corporations
Loosely defined, a personal service corporation is a C or S corporation whose stockholder-employees perform personal services. Accordingly, they may include businesses that provide services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting. Unfortunately, the IRS defines personal service corporations differently in various parts of the Internal Revenue Code. Thus, no single definition of personal service corporation exists.

Determining whether a corporation is a personal service corporation is important since such corporations are subject to special rules for federal income tax purposes. For example, C corporations that are personal service corporations pay taxes on income at a flat tax rate of 35%; other C corporations pay taxes on income at graduated tax rates of 15% to 35%. In addition, C corporations may select any year-end for tax reporting. Personal service corporations must generally adopt a December 31 year-end, however.

Personal service corporations are discussed in greater detail in NACPB's Accounting for Proprietorships, Partnerships, Corporations, and LLCs.