By Stephen J. Dunn
As an entrepreneur, the form of entity you want for your business is not a general partnership, but a corporation or a limited liability company.
State law determines who is liable for an entity’s debts. Under state law, corporations and limited liability companies have limited liability for their owners—there owners are not personally liable for debts of the business. The limitation of liability applies to all debts of the corporation or the limited liability company, including tax debts, with one exception. If a corporation or limited liability company fails to pay its payroll taxes, the “trust fund” portion of those taxes—income tax, Social Security tax, and Medicare tax withheld from employees’ wages—may be assessed against the “responsible persons” of the corporation or limited liability company. But the Internal Revenue Service must afford the target of the proposed assessment due process before making the assessment. The IRS provides the target notice of its intent to make the assessment, and affords the target a hearing on the proposed assessment before the IRS Collection Division. If the target is unable to persuade the IRS Collection Division that the assessment should not be made, the target must be allowed a further hearing before the IRS Appeals Office.
In contrast, partners have unlimited personal liability for debts of their general partnership, including its tax debts. A partner is personally liable for all federal tax obligations of his general partnership—all income tax as well as all employment taxes (not just the trust fund portion of employment taxes). The IRS need not separately assess a general partnership’s taxes against the partners—an assessment against the general partnership is, by operation of law, also an assessment against the partners. United States v. Galletti, 514 U.S. 121-24, 158 L. Ed. 2d 279, 124 S. Ct. 1458 (2004).
A general partnership exists when associates engage in business together, and agree to share profits and losses. The agreement can be a written, oral, or even implicit. A general partnership exists by default when associates engage in business together and agree to share profits and losses, without specifying any other kind of entity.
To avoid general partnership status, associates should specify that they are forming another kind of entity, such as a corporation or a limited liability company. A corporation is formed by preparing articles of incorporation and filing them with the state corporation authority. Minutes of shareholders’ meetings and minutes of directors’ meetings drawn, and stock certificates issued.
A corporation need not have more than one shareholder. If it does have more than one shareholder, they would be well-advised to have a shareholders’ agreement, specifying their rights in the corporation, drawn and signed.
A limited liability company is formed by preparing articles of organization and filing them with the state corporation authority. A limited liability company need not have more than one owner (called a “member’). If a limited liability company does have more than one member, they would be well-advised to have a membership agreement, outlining their rights in the company, drawn and signed.
Associates must not only form their entity as a corporation or a limited liability company, they must also operate it as a corporation or limited liability company. A corporation should have minutes of at least annual shareholders’ and directors’ meetings, or consent resolutions in lieu of meetings. A limited liability company should have minutes of at least annual members’ meetings, or consent resolutions in lieu of meetings.
In contracts and correspondence on behalf of their entity, associates should sign not in their own name, but in the name of their corporation or limited liability company, as follows:
A Michigan Corporation
A Michigan Limited Liability Company
If the associates fail to observe such corporate formalities, a court could hold their entity a de facto general partnership.
Federal law determines how the entity is taxed for income tax purposes. For income tax purposes, an entity with only one owner is disregarded—its income and expenses are reported on a Schedule C, Profit or Loss from Business, to the owner’s individual income tax return.
An entity with more than one owner must chooses its form of entity for income purposes on Form 8832, Entity Classification Election, and Form SS-4, Application for Employer Identification Number, filed with the IRS. An entity may elect to be subjected to income tax as any of the following forms of entity:
C corporation-Entity pays income tax on its taxable income. If the entity makes a distribution to its shareholders, it may not deduct the distribution for income tax purposes, but it is subjected to income tax a second time, to the shareholders who receive it. A C corporation annually files Form 1120, U.S. Corporation Income Tax Return.
S corporation-Taxable income of the entity is subject to income tax not to the corporation, but to its shareholders in proportion of their ownership shares of the corporation’s outstanding capital stock. An S corporation annually files Form 1120S, U.S. Income Tax Return for an S Corporation.
Partnership-Taxable income of the entity is subject to income tax not to the partnership, but tots partners in proportion of their relative shares in profits of the partnership. A partnership annually files Form 1065, U.S. Partnership Return of Income.
If shareholders wish to make an S election for their corporation, they must file Form 2553, Election by a Small Business Corporation, for it with the IRS. Otherwise, the corporation is taxed as a C corporation
One of my recent cases involves IRS action against a man to collect employment taxes accrued by a Massachusetts business trust. A Massachusetts business trust is a corporation in everything but name, and it provides limited liability for its owners. The business trust’s tax advisor had prepared Forms 1065, U.S. Partnership Return of Income, for the business trust, and had the man sign them as “Partner.” We filed amended Forms 1065 for the business trust to reverse the first set. An IRS Revenue (Collection) Officer maintained that these facts made the entity a general partnership and the man a general partner in it. The Revenue Officer did this to try to collect employment taxes of the Massachusetts business trust from the man, statute of limitations on assessment of a trust fund recovery penalty with respect to the business trust having expired. The IRS Appeals Office affirmed the assessment. We are now litigating the matter in Federal court.
Filing of Forms 1065 for the business trust, and having the man sign them as “Partner,” certainly looks like a bad idea—it gave a Revenue Officer a pretext for attempting to collect the business trust’s tax obligations from the man. If the associates wished to avoid the double taxation of entity’s taxable income that obtains under the C corporation form, they would have been better advised to choose the S corporation rather than the partnership form for their entity.