If you own a business you should not overlook it in your estate planning. You will want to give serious consideration to the best entity type for your situation particularly since some forms of business entities are better that others at protecting your assets.

• The major forms of business entities is the United States are as follows:
  
  
• Corporation (C, PSC and S)
  
  
• Partnership (Limited and general)
  
  
• Limited liability company (LLC)
  
  
• Proprietorship

The proprietorship is actutally considered an informal business arrangement; no formalities other than possibly a business license are required. You have a proprietorship just by simply "going into business", with no formality other than a name. The other entities listed above require some additional formalization. Limited partnerships (LP, FLP LLP), limited liability companies (LLC) and corporations are official entitles in each state of the U.S, created by statutes from the state legislature, and they require official registration with the state. These entities are accompanied with formal rules from the state regarding the entity's structure and operation, along with some state supervision and annual taxes or registration fees.

Why Formal Business Entities Are Important. There are four major uses of and reasons for forming a formal business entity:

• Limiting your personal liability from legal problems of the business. This is termed "limited liability" and is granted by state statute (or case law with trusts). This feature usually prevents debts and liabilities of the business from being collected from the owners and officers personally (though there are some exceptions).
  
  
• To provide a simple method of dividing ownership interests among multiple owners.
  
  
• To provide a centralized management system when there are multiple owners.
  
  
• To take advantage of business tax breaks that are only allowed to legal entities. These breaks include various fringe benefits, health insurance, pension plans and profit distributions which may not be subject to self employment taxes.

Sole proprietors and the self employed don't have multiple owner issues, but they do lack limited liability and special business tax breaks. Lack of limited liability is often a major threat to the business owner. There are six entities or groups that businesses deal with, and any one of them is a potential threat to sue the business. These groups are: customers, employees, creditors, sub-contractors or contractors, competitors, and regulatory governmental agencies. If you deal with any combination of these groups as a proprietorship or through self employment, as a licensed professional or as the general partner of a partnership, you are a candidate for a formal business entity. Your status as proprietor, self employed or general partner provides no limited liability at all. You may be in great personal danger from business related lawsuits. Also, you may have mismanaged an existing business entity to the extent that your limited liability is in jeopardy or is non-existent. If so you may be a candidate for a new entity as the best way to distance yourself from the problems that this mismanagement created.

The Meaning of C, Sub S and PSC Corporation Classifications: There are no C, S and PSC distinctions upon formation of a corporation at the state capitol, and the designations have nothing to do with the legal structure of the corporation provided by the state of incorporation. The "letter" designations are federal tax law terms which refer to how the corporation is treated under federal tax laws. Federal tax law does cause a difference in how the three types of corporations may be structured. These letter designations mainly affect tax and stock/shareholder issues. Otherwise C, PSC and S corporations are identical. All corporations are automatically a C type under Federal tax law unless a special S election is filed or PSC treatment is selected with the IRS. The tax and stock/shareholder issues are explained below.

C Corporations: Major advantages are limited liability, the efficiency with which it handles a large number of shareholders, the ease and legality of buying and selling its stock. Owners of the corporation may receive all legal employee benefits, and have the benefits be tax deductible to the corporation. The stock of a C corporation can be owned by other business entities as well as by humans. A serious disadvantage is that all profits are taxed at the corporate level, then dividends or profits are taxed to the shareholders, resulting in double taxation of profits. Other disadvantages are the required annual reporting to the state, and annual formalities such as shareholder and directors' meetings, plus lack of privacy and franchise taxes at the state level. (There are also potential capital gains tax problems with this entity as well.)

PSC Corporations: The letters "PSC" stand for personal service corporations. This corporation type is nearly identical to a C corporation, but with its own special tax rate. It was created for professionals and individuals whose business activity involves the sale of personal services, as opposed to the sale of products or non-personal services. Personal services are those performed in the health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting fields. You "choose" this type corporation by forming a corporation through your state, and then selecting the "Personal Services Corporation" category on the standard IRS form 1120 corporate tax return. This corporate classification is often used by professionals to achieve corporate tax deductible employee benefits for one or more professionals offering personal services. The applicability and usage of the PSC classification is very complicated, and should only be undertaken with the guidance of your professional tax counselor.

Sub S Corporations: The double taxation problem of the C corporation is eliminated, taxes on profits are paid only at the shareholder level. For tax purposes the Sub S corp is referred to as a "pass through" entity, meaning that tax liabilities pass to the shareholders. This is the major reason that Congress created the Sub S corporation status. But there is a limit to the number of shareholders and they generally must be humans. Shares cannot be held by other corporations (either C or Sub S), or by partnerships or LLCs. Trusts may hold Sub S shares but only with special provisions. Major advantages are the pass thru tax status, the ease of buying and selling stock, and the limited liability of the members. Sub S corporations can have deductible employee stock ownership plans (ESOPs) and employee pension plans for both owners and non-owner employees. But many other employee benefits, when given to the owners of the S corporation, are not deductible to the corporation. Some disadvantages are the required annual reporting to the state and annual formalities such as shareholder and directors' meetings, lack of privacy and franchise taxes at the state level. (There are also potential capital gains tax problems with this entity which are discussed below.)

Limited Liability Companies (LLC): This entity first appeared in Wyoming in 1977. LLCs combine the limited liability feature of corporations with most of the characteristics and advantages of partnerships. The LLC is allowed to have partnership tax classification when there are at least two members. This makes it a pass thru entity for tax purposes. Partnership tax classification is a better arrangement than the pass thru tax status of S corporations (due to the LLCs ability to allocate income, deductions and losses to the owners in any proportion). Unlike the S corporation, any person or legal entity can own its shares (called units), there can be any number of shareholders (called members), all members can vote (unlike limited partners) and there is limited liability for everyone connected with the LLC (unlike partnerships). LLCs can have deductible employee pension plans for both owners and non-owner employees. But many other employee benefits, when given to the owners of the LLC, are not deductible to the LLC. LLCs do not have the capital gains tax problem which corporations do (discussed below). LLCs do require annual reporting to the state where they are created. But no annual shareholder or directors' meetings are required, and other formalities of corporations have been eliminated. Many states do not charge a franchise tax but they all charge some annual registration fee. This is an excellent entity choice for a very wide variety of small business situations, and should be given serious consideration.

Nevada Corporations & LLCs:

In earlier decades the state of Delaware was considered to be the best state to form a corporation in. For several reasons the state of Nevada has become the undisputed corporate and LLC haven of the U.S. This does not mean that you can automatically and easily gain the benefits of a Nevada entity when your business operation is in another state. To the contrary, not all non-Nevada based businesses will be able to structure themselves and jump thru the extra hoops that are required to benefit from a Nevada business entity. If you are able to handle the extra requirements, the added benefits of a Nevada entity are:

• Better Limited Liability. An extra level of protection afforded by the Nevada corporate and LLC veil (better limited liability provisions in Nevada). Nevada state law and court precedence make the corporate veil all but impossible to pierce, except for criminal fraud. (See the Nevada case, Roland vs. Lepire, 1983) In most instances your non-Nevada business will have to register its Nevada corporation in your home state, but Nevada's tough laws prevail on matters of limited liability of corporate officers, directors and shareholders.
  
  
• Choice of Governing Law. Choice of governing law means that on most formal and informal contracts and transactions you can specify Nevada as the choice of state law governing the contract or transaction. This places an extra burden of expense on a potential litigant since they will have to travel to Nevada to sue your company. It also forces the lawsuit to be heard under laws that are more pro-business than most states.
  
  
• Additional Privacy. Nevada has no requirement or procedure to register or list stockholders in public records, thus assuring their privacy. Remember that shareholders control the company and receive its profits. Furthermore, the state of Nevada does not share information with the IRS (per state law).
  
  
• Elimination of state income tax for corporations in a few special situations (see the footnote at the end of this article regarding possible corporate tax savings in Nevada.)

If you plan to form either a corporation or an LLC, you may want to consider the added advantages of forming the entity in Nevada. NAFEP provides Nevada entities and all the annual services necessary to keep them legal in Nevada. If you form a Nevada entity, but use it in another state, you must also register the entity in that other state. For non-Nevada businesses, using a Nevada entity does increase your costs by a few hundred dollars each year. The Nevada entity will have annual registration and other costs in two states instead of one.

Partnerships: Partnerships fall into two categories, general and limited. General partnerships have no limited liability for any partner. Limited partnerships have limited liability for the limited partners but not for the general partner (the controlling or operating partner or partners). Lack of limited liability for all partners and owners is a major disadvantage of partnerships. In addition, limited partners have no vote or say in how the business is run. The LLC appears to be a better choice in all cases where a partnership might be considered, and as a result NAFEP does not create partnerships.

Capital Gains Problems with Corporations:

When either C, S or PSC corporations own appreciating capital assets, the appreciation accrues on the books of the corporation only, not to the shareholders. When a C or PSC corporation sells appreciated assets, it must pay capital gains taxes at the corporate level. If the remaining gain is ever passed out to the shareholders they have to pay capital gains taxes again on their distribution. This is the same double taxation problem that exists for profit distributions. If an S corporation sells appreciated assets the gain must be passed out to the shareholders and they must pay the tax. There is no option. If the shareholders of either a C, PSC, or S corporation wish to transfer appreciated assets out of the corporation to themselves, they must pay capital gains taxes on the imputed gain even though the assets are not actually sold. And finally, all three corporate types restrict or at least complicate the chance for capital gains deferral strategies using private annuities or charitable remainder trusts.

Another problem occurs when S corp stock is inherited or purchased. Although an S shareholder receives a step up in basis when the S stock is acquired through inheritance or purchase (changing under the new tax law), that basis applies only to the stock itself (called "outside" basis). There is no adjustment to the basis of the assets in the corporation (called "inside" basis). Upon the sale of appreciated assets in the S corp, the new shareholder is immediately responsible for the capital gains tax even though his stock purchase/inheritance represents the appreciated value of the assets. The new shareholder must wait until liquidation or sale of his stock before receiving an offsetting deduction for the difference between the inside and outside bases. Moreover, the deduction at the time of disposition of the stock is a capital loss, which is subject to limitations on deductibility if the shareholder does not have current offsetting capital gains.

Partnerships, LLCs, and trusts can distribute appreciated property to shareholders, members, or beneficiaries generally without triggering gain at the entity level or income to the recipients. But, a corporation cannot convert to any one of these other entities without negative tax consequences when the corporation has appreciated property.

Which Entity Should You Use?:

This question can only be answered by the specifics of your situation and through the assistance of competent tax help.

If your primary concern is achieving limited liability, and especially if there is more than one owner in the business, you should seriously consider an LLC. Various non-corporate employee benefits programs are available, including pension plans, though ESOPs only apply to S and C corporations. But health and life insurance deductibility for owners of the LLC is limited compared to a C corporation. LLCs often have tax advantages compared to corporations when the entity is taxed as a partnership (the usual arrangement). Partnership tax classification is a better arrangement than the pass thru tax status of S corporations, due to the LLCs ability to allocate income, deductions and losses to the owners in any proportion.