General Information
A business entity is a company that has been formed through a filing with the Secretary of State’s office. A business entity type, sometimes known as a business structure or a business form, provides the legal model under which a business may operate. Kentucky recognizes seven for-profit business entity types:
- Sole Proprietorship
- General Partnership (Partnership)
- Limited Liability Partnership (LLP)
- Limited Partnership (LP)
- Limited Liability Limited Partnership (LLLP)
- Limited Liability Company (LLC)
- Corporation
Each of the seven business entity types differ with respect to three major factors:
- Liability – depending on the entity type, financial and legal liabilities may be shifted from the business owners and participants to the entity itself
- Taxation – depending on the entity type, taxes may be reduced given the nature of the business
- Formalities/Governing Structure – depending on the entity type, the state will require varying levels of action to maintain legal compliance
Because of the interaction of these three factors, the choice of a business entity type is both significant and complicated. The laws applicable to a particular entity type may shift liability for financial obligations or lawsuits from the business owners to the business itself. They may affect how the business tracks revenue, pays its employees, and completes tax filings. They may also mandate or allow various methods of electing those who will perform day-to-day tasks on behalf of the business or voting on the direction the business should take. The entity type decision will have ramifications in all these areas.
Purpose/Necessity
A business must operate as one of the seven entity types. Selecting the best business entity type generally depends on the objectives of the business and the expectations of the owners. It involves legal, economic, and personal considerations. The decision is critical, as the form of doing business can contribute or detract from accomplishing the business objectives and can satisfy or frustrate the owners’ expectations.
A separate but related issue is the selection of the entity’s federal taxation method. Depending on the business entity type, a business may be able to change its federal taxation method to achieve significant tax savings. Both the entity type decision and the tax method decision should be considered in light of specific features of the business in question.
Frequently Asked Questions
- What is a disregarded entity?
- When a business entity is formed, it gains a legal status as distinct from its owner(s). However, its tax status may be treated as if it were the same as its owner and may thereby be “disregarded” as being separate for income tax purposes. Consequently, the IRS and state tax agencies tax its income as if it were the income of the individual alone. Disregarded entities include Sole Proprietorships and LLC’s taxed as Sole Proprietorships (the default classification for a single-member LLC).
- What is a pass-through entity?
- A pass-through entity is very similar to a disregarded entity in that the business entity’s income flows through directly to its owners and is not taxed at the entity level. Owners of disregarded and pass-through entities report business taxes directly on Schedule C of their personal income tax returns at individual rates. However, the income (or loss) of pass-through entities is distributed to the entity’s owners as dividends/profits according to corporate shares, LLC membership interest, or partnership ownership percentages. Also, the entity itself must file an informational return. Pass-through entities include Partnerships (GP, LLP, LP, and LLLP), LLCs taxed as Partnerships or S-Corps, and S-Corps. See KRS 141.010(26).The major distinction between disregarded entities and pass-through entities is that disregarded entities are treated as if the business does not exist at all and the individual owner is receiving income from another source. A pass-through entity still recognizes the entity’s separate tax existence because it allocates tax burden based on ownership percentage (and thereby requires the entity’s informational return). All disregarded entities are pass-through entities but not all pass-through entities are disregarded entities.
- Is an S-Corp a business entity?
- No. While commonly considered a separate business entity type, an S-Corporation is not a business entity, but rather a federal taxation method. An S-Corp election can be made for business operating as a Limited Liability Company or a C-Corporation. Accordingly, the liability protection and formality requirements will be that of an LLC or a C-Corp.
- What non-profit entity types does Kentucky recognize?
- Kentucky recognizes both Non-Profit Corporations and Non-Profit LLCs. See KRS 273.167 and KRS 275.025(6), respectively.Formation as a non-profit entity does not exempt the organization from taxation. A business must file and obtain a federal tax exemption from the IRS to achieve this tax benefit.
- What professional service entity types does Kentucky recognize?
- Kentucky allows General Partnerships, LLPs, LLCs, and Corporations to render professional services. See KRS 362.01-101(15), KRS 275.005, and KRS 274.015(1), respectively.The laws applicable to professional entities are generally the same that apply to their for-profit counterparts. The business governing document for a professional entity will likely contain several provisions applicable to its professional form.
- Is the entity type decision permanent?
- Not necessarily. Though it is important to select the best entity type at the start of one’s business, should the business expand and its needs change, an entity type may be changed through either conversion or merger. This is especially useful for entities that have existed for some time as a form of partnership but would benefit from the liability protection afforded to LLCs. Another scenario in which an entity type change is useful is when an LLC develops the need to issue stock and must take on the corporate form.
- How do I determine which entity type is best for my business?
- This decision is best arrived at by comparing the particular characteristics of the business to the relevant business and tax laws. We find the most efficient way of conducting this analysis is to:
• Have the client answer a series of questions about their intended venture so the attorney understands the business’ particular needs and goals
• Provide the client with a prepared document that summarizes the entity type options and the major ways in which they differ so the client gains a basic knowledge about the issues
• Hold an informed discussion between the attorney and the client to determine the best entity type and discuss other business formation issuesThe document we provide, written by one of our attorneys, is entitled “Choosing the Proper Entity Type for Your Kentucky Business.” It thoroughly describes the extent of Kentucky liability protection, the tax accounting classification options, and the formality requirements to expect. The guide also provides useful information pertaining to running a Kentucky business and may be kept for all time as a reference.
- This decision is best arrived at by comparing the particular characteristics of the business to the relevant business and tax laws. We find the most efficient way of conducting this analysis is to:
Legal Services Offered and Cost
Business Entity Type Selection Advice
Legal fees: $300 flat fee
This includes:
- Review of client’s information to understand the business’ particular attributes and goals
- Up to a 1 hour video, phone, or email discussion concerning how the relevant laws apply to the client’s particular business characteristics
- Attorney recommendation as to best entity type and taxation method
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