"Choosing a form of entity for your business is a critical decision involving many legal and tax considerations," says Sam Starr, a Coopers & Lybrand partner who specializes in small business taxation. "While it is necessary to select one when your business is formed, it also is important to reevaluate that decision from time to time as your needs and the tax laws change."

Businesses in most states and the District of Columbia now have a new option to consider when choosing a form of organizational entity: the limited liability company, or LLC. Before adopting the LLC or any other form, however, a business should research its decision carefully. Each form of entity has its own advantages and disadvantages. A new book developed by Coopers & Lybrand ("Choosing a Business Entity in the 1990's") can help companies determine which option matches their particular needs.

Choosing a form of entity for your business depends on many variables.

The standard forms of entity are evaluated and compared in the Coopers & Lybrand book. They include the sole proprietorship, the regular or C corporation and the "pass-through" entities--partnerships, LLCs and S corporations.

C corporations provide limited liability protection, for example, but corporate earnings are also subject to a potential "double tax" that occurs because the corporation pays tax on earnings, and shareholders pay a second tax on earnings distributed in the form of dividends.

The book compares this double tax to the single-tax feature of pass-through entities, which permit income and losses to pass through the business to the owners, who report them directly on their personal tax returns. "It is important to remember, however, that a choice of entity decision should not depend upon on single factor," warns Starr.

The LLC has attracted much attention because it combines the limited-liability benefits of a corporation with the single-level-of-tax attributes of a pass-through entity. Many businesses are considering whether to adopt or convert to the LLC form lately.

PENDING DECISIONS

Starr cautions that Congress is considering several proposals that could affect a choice of entity decision. For one, it is expected to consider liberalizing some of the restrictions currently imposed on S corporations.

"With all of these potential changes, it is imperative to perform a comprehensive analysis of whether your business form is still right for you, to ensure you use the one providing the most benefit," says Starr.

Such an analysis, whether being performed on a new business start-up or one already in operation, should include a number of considerations: tax rates, retained or paid-out earnings, liability protection, allocation of tax items, contributions and distributions of property, existence of losses, tax year, limitations on ownership, financing needs, potential for mergers and acquisitions, likelihood of joint ventures, compensation of owner-employees, employment taxes, estate planning needs and state tax treatment.

Granted, that is a very long list, but start-up entrepreneurs, in particular, may be able to shorten it by weeding out the items that do not apply to their situations. For example, the potential for mergers and acquisitions and the likelihood of joint ventures may not be important considerations in the early years of a new business. Should they become relevant variables later on, you can--and should--consider choosing a new entity for your business.

The sole proprietorship is the simplest form of business entity. Few legal or tax formalities are required to create this most rudimentary of business forms. It is limited to a single owner or a married couple, and business income and expenses are included directly on the owner's federal income tax return. Taxable income is subject to both income and self-employment tax. Business losses may offset income from other sources.

Because the sole proprietorship is a commercial extension of a single business owner, the owner is personally liable for the business's obligations and may be required to pledge personal assets as collateral when borrowing funds. The up side is that sole proprietors have absolute managerial control and unrestricted access to any profits the business generates.

A partnership is a legal entity formed by two or more owners. Unlike corporations, which are taxed on business profits, partnerships do not pay tax. Instead, tax items pass through to the partners, who report them on their personal income tax returns.

TYPES OF PARTNERSHIPS

There are two types of partnerships, general and limited. A general partnership is composed of two or more partners who pursue a venture for joint profit. The partnership may or may not be formalized in a written agreement, but it generally must register its name with the state and obtain any applicable operating licenses.

General partners are personally liable for partnership obligations. In addition to capital contributions and partnership assets, their personal assets are subject to partnership liabilities.

Sole proprietorships are the simplest entity but offer the least protection.

Limited partnerships are composed of at least one general partner and one or more limited partners. Limited partners are liable for partnership obligations only to the extent of cash and property they contribute and recent distributions from the partnership. General partners, on the other hand, are responsible for all limited partnership obligations.

A limited partnership requires the filing of an agreement in the state in which it is formed. Responsibility for management rests with the general partner. Limited partners are investors only and are prohibited from involvement in day-to-day management decisions.

LLCS ARE HYBRIDS

Limited liability companies--LLCs--are hybrid entities combining features of partnerships and corporations. For federal tax purposes, they are generally treated as partnerships as long as they lack two of the four standard corporate characteristics. However, LLCs protect their owners from personal liability for business debts in much the same way a conventional corporation does.

State laws generally treat LLCs as separate legal entities and require that articles of organization be filed with the state. Most states follow the federal characterization of LLCs for income tax purposes, although several impose an annual minimum tax directly on LLCs. This tax usually takes the form of a nominal per-member fee. New York, for example, charges a $50-per-member annual fee with a $325 minimum and a $10,000 maximum.

The popularity of LLCs began to take off following a 1988 Internal Revenue Service ruling that a state LLC could be treated as a partnership for tax purposes. Only a handful of states recognized LLCs at that time, but recognition and use of this entity has skyrocketed since then. Only Hawaii, Massachusetts and Vermont do not recognize LLCs currently, and LLCs appear poised to become the business entity of the future.

Most large businesses and many small ones are organized as regular corporations. These are independent legal entities, separate from their owners. The two most significant features of a regular corporation are limited liability and the double tax on earnings mentioned earlier.

An S corporation is a small business company that elects special tax status. The major difference between an S and a regular corporation is that the former is subject to only a single level of tax. It combines the business and legal characteristics of a corporation with many aspects of partnership taxation, but it does not provide as much flexibility as an LLC.