Business structures 101

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(Fortune Small Business) -- What exactly is an LLP? What's the difference between an LLC and a corporation? What about S-corps and C-corps? Sorting through the legal jargon and tax codes defining these business structures can be daunting for entrepreneurs - but picking the right structure for your company brings vital tax benefits and legal flexibility.

LLC or corporation?

There's virtually no reason why a small business should file as a corporation, unless the owners plan to take the business public in the near future, says Carter Bishop, a professor at Suffolk University Law School who helped draft the uniform LLC and LLP laws for several states.

Instead, filing as an LLC, or limited liability company, is usually the best choice.

The major differences between an LLC and a corporation include decision-making flexibility and the type of taxation the business faces, says Mark Patton, an attorney with Lewis and Roca in Tucson, Ariz.

A corporation has to have a board of directors to make decisions according to a formal process. The "board" could technically be one person, but it still needs to exist. An LLC, on the other hand, can set up an operating agreement at the time the business is created, and make decisions more informally.

Common provisions in operating agreements include:

• Who can make decisions on behalf of the LLC? Will all owners manage the company, or will there be one primary manager?
• What are the owners' responsibilities to contribute money to the company?
• When and how will the company income be shared?
• What procedure is required to transfer membership interests in the company?

The second major difference is that an LLC benefits from "pass-through taxation." Pass-through taxation means the company pays no tax on its profits: It's like the company doesn't even exist for federal tax purposes, Bishop says. In fact, if the LLC is a sole proprietorship, the company does not have to file any tax returns. LLCs with more than one member must file a federal tax return, although the LLC itself is not subject to a tax. Earnings pass through to the owners, who then report the income on their own tax returns and pay the tax on their income.

A corporation, on the other hand, must pay federal taxes as an entity; its shareholders are then taxed on any dividends or distributions they receive from the company, in effect allowing some of the company's profits to be taxed twice.

There is an exception to this rule, however, for companies that file under subchapter S of the Internal Revenue Code. Such companies are commonly referred to as "S-corp" entities.

S-corp or C-corp?

The terms "S-corp" and "C-corp" are merely shorthand references for a company's tax status - they're not distinct business entities.

The major tax difference between the two is that an S-corp receives pass-through tax treatment similar to a partnership or LLC, whereas a C-corp (taxed under subchapter C) is required to pay tax on its income as a business entity.

An S-corp's pass-through tax treatment does not come without some limits, however. An S-corp can have only 100 shareholders, each of whom must be an individual. (Certain types of trusts are also eligible.) Other businesses can't be an S-corp shareholder.

"For tax purposes, a small-business owner will probably want to choose either an LLC or an S-corp to obtain pass through tax treatment and to avoid the double taxation of a C-corp," Patton says.

The shareholders of a corporation can obtain subchapter S treatment by filing Form 2553 with the IRS within 75 days of starting operations. If this form is not filed, the corporation is taxed under subchapter C by default.

So then, what's the difference between an LLC and S-corp?

The members of an LLC can agree to share a company's income and absorb its losses disproportionately, whereas S-corp shareholders must share in the company's income in direct proportion to the number of shares they hold.

Even if an S-corp is small and private, it's still subject to corporate formalities. The company will need to hold an annual meeting and file formal reports to its shareholders documenting its decision-making processes on significant corporate matters. An LLC does not need such documentation.

"Between an LLC and an S-corp," Patton says, "the LLC is again the more flexible of the two and can accommodate most business arrangements."

He recommends, however, that small-business owners consult their advisors to determine whether there are additional tax benefits of an S-corp in their specific situation that might justify incurring the structure's limitations.

Okay, now what about partnerships?

In addition to an LLC or a corporation, there are two types of partnerships a small business may want to consider: a general partnership and a limited partnership.

The first requirement of any partnership is obvious: there must be more than one owner, or "partners" (hence the name). If you're a sole proprietor, opt for an LLC instead.

Partnerships, Bishop says, are typically formed by professionals such as lawyers, architects, accountants and doctors. In some states, such firms are precluded from operating as LLCs; in others, where general partnerships and longstanding law firms predated LLC laws, many organizations opt to retain their existing status.

General partnership and LLPs

In a general partnership, all owners have equal rights to manage the company, regardless of their ownership shares in the company. On the downside, they can also all be equally liable for any mishaps the company runs into, like debt or lawsuits. This is where an LLP, or limited liability partnership, comes into play.

An LLP is merely a certificate a general partnership can obtain to create a liability shield protecting the individual partners, Bishop says. Take, for example, a law firm that has offices in New York and Los Angeles. If a partner in Los Angeles commits malpractice, the partner in New York will not be considered individually liable. Without an LLP certificate, however, the New York partner would not be protected.

Limited partnership and LLLP

A limited partnership structure varies from a general partnership in that not all partners are entitled to participate in managing the business. The general partner or partners actively manage the business, while the limited partners (usually passive investors) do not participate in the day-to-day operations. This type of business structure usually suits real-estate investments.

When it comes to liability in a limited partnership, responsibility follows the management chain: in most actions, the limited partner is not liable, but the general partner is.

In many states, however, a limited partnership can obtain an LLLP certificate, for a limited liability limited partnership. This certificate, Bishop says, works in the same manner as the LLP certificate by protecting the general partners with a liability shield.

An entrepreneur's best choice

In the end, an LLC business structure is the best bet for most small businesses. It's the structure that gives the owners the greatest flexibility. Plus, it automatically includes a liability shield protecting all owners.

For more information on your options, check out the Internal Revenue Service's guide to business structures.