Options abound for business structures

First there was the corporation, plain and simple.

Then came a division into the S corporation and the C corporation — a distinction easy enough to grasp.

Then there was the formation of limited-liability companies, a somewhat ambiguous entity, a corporation-partnership hybrid.

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And most recently in Colorado, a new law established three new business organizations, the limited-liability partnership, limited-liability limited partnership, and the limited partnership association.

Confused?

Congress was trying to lighten the burden of double taxation on businesses when in 1982 it distinguished organizations as either S corporations or C corporations. The advantage to S corporations was that they retained their limited-liability status as a corporation without being taxed as such; shareholders paid individual income tax on dividends, earned or not, but the corporation was not taxed as a separate entity. In essence, they were a hybrid partnership and corporation.

The sweeping federal legislation opened the door to state laws that helped to ease liability burdens. States passed legislation allowing for mix-and-match taxation and liability status. This time, partnerships already enjoying flow through taxation were granted limited liability simply by registering the partnership with the Secretary of State.

House Bill 1061, signed by Gov. Roy Romer on May 24, 1995, introduced legislation in Colorado granting general partnerships limited liability as a new entity called limited-liability partnerships. Also upon registration, a limited partnership became a limited liability limited partnership. Tax status remained — the new entity is not recognized as a discrete legal entity, so partners pay only individual income taxes.

Prior to the new law, general partners were jointly and severally liable for all the debts of the partnership, regardless of the partners’ interest in the company or involvement with misconduct. Now the law states that a partner’s liability is limited to his or her investment in the company, so they can not be held liable for another partner’s unlawful conduct.

“The trend is more toward limited liability,´ said Mason Mitchell, attorney for Bullard, Larsen, Lunt, Mitchell and Plock P.C., a law firm in Fort Collins. “Legislation is allowing a vehicle to obtain that liability status that previously wasn’t allowed by the law.”

The Colorado law also established a third entity called a limited partnership association. Its definition is less straightforward, but it is essentially a corporation considered a partnership for federal income-tax purposes. Attorneys and businesspeople alike say that this new entity is less well-known and not formed often in Colorado.

To add to the confusion, a fourth entity providing limited liability was formed several years ago as states began following the lead of Wyoming and adopting limited-liability-company statutes. Finally this year, the Internal Revenue Service acknowledged their existence by instituting a “check the box” option for tax purposes, allowing LLCs to determine for themselves if they should be taxed as a partnership or corporation.

“A limited liability company is made up of members who are the owners,” Mitchell said. “But is it not really a partnership, it is more like a corporation. Like shareholders, members are only liable up to their investment in the business.”

The limited liability company seems to be the most popular form of business entity due to the ease of formation, the flexibility of the structure-which can be amended with one form to the Secretary of State – the flow-through tax and the protection from liability. The LLC is a modern form of the S corporation with some improvements.

Owners of an S corporation must be individuals, natural trusts, estates and small business trusts, but they cannot be corporations. Limited-liability companies can have corporations as owners, and can be made up of an unlimited amount of members.

“People went to the S corporation primarily to avoid double taxation,´ said Earl Peterson, a Service Corps of Retired Executives counselor with the Small Business Association at Front Range Community College in Fort Collins. “Any profits or losses passed through to owners. Now since Clinton passed the Small Business Act in 1996, there have been a few changes to S corporations. For instance, nonprofit corporations can form an S corp.”

Peterson points out several differences between LLCs and S corps. In an LLC, there is no restriction on the number of members, and all members enjoy limited liability. S corporations, under new tax law, can have a maximum of 75 shareholders, all owing one class of stock.

In Colorado, an LLC can be formed with one owner, but in order for it to be taxed as a partnership, two are required. So to get around the technicality, LLCs are made up of partnerships in which one owner is active, and one is nonactive.

Come tax time, each member receives a 1065 K1 form attached to the 1040 individual income tax return. If the LLC made a profit, the member adds it to their income, or if a loss, they deduct it. In an LLC, members are responsible for a FICA as well as self employment tax, but for S corporations, half the tax is paid by the corporation, and half is paid by the individual.

“Because LLCs are new, there are certain nuances between states. For instance, the western states patterned LLCs on Wyoming, which first created the LLC in 1977. But the nuances aren’t enough to deter you from doing interstate business,” Peterson said.

In fact, he added, LLCs are becoming very popular.

“They took off like a rocket,” Peterson said.

But because laws allowing such entities are so new, Peterson recommends consulting a SCORE counselor, lawyer or accountant.

“It’s so easy to make a mistake if you form a business on your own, and there could be dire consequences,” Peterson said.