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Business startup and formation are crucial events for a new company. These events can impact the future of a company for as long as it is in operation. It is important to choose the right structure for a company to ensure future success. Descriptions of the most common business structures are listed below.
Sole Proprietorship
This type of business is owned and operated by a single individual. There are very few legal requirements to formation. Financially, the business and the owner are considered one in the same, and are reported on the individual’s income tax returns. The management and power of the company being vested in one person can have both positive and negative aspects. On one hand, there is no power struggle, and all decisions can be made swiftly, without consultation with others; on the other hand, the sole proprietor is personally liable for any debt they create, and will likely have trouble getting business credit when there is no separate legal entity. If the business operates under a different name than that of the owner, it must register a trade name with the Colorado Secretary of State.
General Partnership
This type of business is operated by two or more individuals or businesses for profit. A partnership should have a written partnership agreement outlining the business and each partner’s obligations. This agreement does not have to be filed anywhere, unless the partnership acquires or owns real property, in which case it should file the agreement in the county where the property is located.
Each partner in a general partnership pays their own taxes on their share of the profits/losses of the company. Shares of profits and losses can be divided however the partners wish. The partnership files federal and state partnership returns that report annual earnings, etc.
One of the major disadvantages of the general partnership is that the partners are responsible for all of the debts and obligations of the partnership, meaning that any one partner can be held totally liable for everything. This arrangement exposes the personal assets of all partners to liability with creditors if the partnership encounters financial problems.
Limited Partnership
This type of business is operated by two or more individuals or businesses for profit, with the added element that at least one of the partners has general liability (meaning he or she maintains managing control and power, but is exposed to all liability) and at least one of the partners has limited liability (meaning that his or her liability is limited to his or her financial investment in the company).
This is the major trade off of a limited partnership: In exchange for exposure to liability, the general partner receives managing control over the company; likewise, in exchange for limited liability, the limited partner has no management power. Limited partnerships are effectively used to raise capital. The general partner maintains liability, and investors/limited partners are assured that they can only lose what they have invested in the business.
In Colorado, a Certificate of Limited Partnership must be filed with the Secretary of State to create a limited partnership. A limited partnership should also obtain a Federal Tax ID number (EIN) from the IRS.
Limited Liability Company (LLC)
This type of business is created by filing Articles of Organization with the Colorado Secretary of State, along with a filing fee. The LLC is a hybrid entity that mixes the tax principles of a partnership with the limited liability principles found in a corporation. In an LLC, the owners are called members and they can either run the company, or have managers (which could be themselves) run it.
An LLC should create an operating agreement, which defines itself and its members. This agreement should spell out what happens if members die, how their shares can be transferred, where the company’s offices are located, and other specifics.
An LLC should also obtain a Federal Tax ID number (EIN) from the IRS in order to report a Schedule K1.
In Colorado, an LLC is taxed as a partnership if there are two or more owners, unless it elects to be taxed as an “S” corporation. The main drawback of LLCs is that they are relatively new on the legal scene, so they do not receive uniform treatment across states, and operate without a lot of defined law.
Corporations
This legal entity exists totally separately from the people who create it. A corporation is run by its Board of Directors who are elected by its shareholders, the owners of the corporation. Depending on the situation, the Board can elect officers, if necessary, to handle the day-to-day operations of the company.
A corporation is formed by filing Articles of Incorporation with the Colorado Secretary of State. A corporation must also obtain a Tax ID Number (EIN) from the IRS.
Corporations have many more formalities to operation than any of the entities discussed so far. A corporation must have annual shareholder meetings, elect a Board of Directors, maintain corporate records, adopt bylaws, completely separate personal and business finances, and make proper filings from time to time with the Colorado Secretary of State. These actions help the corporation to maintain its status, and the shareholders, officers, and directors to maintain limited liability.
A drawback of a corporation is that it faces double taxation. It is taxed once as a corporation for its profits and losses, and then distributions to shareholders are taxed to the individuals receiving them.
S Corporation
This entity is still a corporation; the “S” simply refers to its tax election. All of the principles of a regular corporation apply, except that it can elect to be taxed as a partnership or sole proprietorship, rather than as a separate entity. A corporation can elect “S” status by filing IRS Form 2553, Election by a Small Business Corporation. Generally, this election must be made in the first 75 days after incorporation and can be changed at the beginning of each year.
In exchange for generous tax treatment, there are many restrictions on an “S” corporation. To be eligible, the corporation in question must meet the following criteria:
- Domestic
- Have only one class of stock issued and outstanding
- If 25% of gross receipts are from passive income, it cannot have accumulated earnings/profits at the close of each of three consecutive taxable years
- Maximum number of shareholders is 75
- Shareholders must be U.S. citizens, except certain qualifying trusts or exempt organizations
- Tax year must end December 31 of each year
- All shareholders must agree to make the “‘S” election
Limited Liability Partnership (LLP) and Limited Liability Limited Partnership (LLLP)
These entities are used to limit the liability of partners to their investments in the company, except in areas related to their professional conduct. Businesses structured this way are usually taxed as partnerships but can elect to be taxed as a corporation.
LLPs and LLLPs are created by filing a Registration Statement with the Colorado Secretary of State. Typically, the partners are the owners, and no officers or managers are elected. Generally, these entities favor occupations in which all owners belong to a licensed profession, such as CPAs, doctors, and attorneys.
These business structures are even newer than LLCs and are not recognized in all states. Careful planning regarding these entities is very important.
Limited Partnership Association (LPA)
Similar to LLPs and LLLPs, the LPA is a relatively new legal business structure in Colorado. An LPA is formed by filing Articles of Association with the Colorado Secretary of State. LPAs must have at least two members.
A primary feature of this entity is that is lasts for an indefinite time period. It ends when all partners vote to terminate it or as otherwise prescribed by its bylaws, combined with filing Articles of Dissolution with the Colorado Secretary of State. Setting up a business with this structure requires careful consideration, as there is very little legal guidance available for it.
To ensure that your new company is set up properly, and that it continues to serve its purpose and maintain limitation of liability, call the Fort Collins business law attorneys of Bordeaux & Boyes, LLC for a free 30 minute consultation.
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