One of the first major decisions you will have to make as you start your new business is the form of legal entity it will take. To a large degree this decision may be dictated by the way you have organized your operations and whether you intend to work on your own or in conjunction with others.

The form of entity you choose can have a significant impact on the way you are protected under the law and the way you are affected by income tax rules and regulations. There are four basic forms of business organizations (with some variations) and one hybrid business organization. Each has its own benefits and drawbacks and is treated differently for legal and tax purposes. A chart summarizing their various characteristics follows at the end of this chapter.

Sole Proprietorship

A sole proprietorship is typically a business owned and operated by one individual, or very often by a husband and wife. A sole proprietorship is not considered to be a legal entity under the law, but rather is an extension of the individual who owns it. The owner has possession of the business assets and is directly responsible for the debts and other liabilities incurred by the business. The income or loss of a sole proprietorship is combined with the other earnings of an individual for income tax purposes.

A sole properietor may employ people in the business to whom he pays wages and, at year-end, issues W-2 forms. However, unlike a corporation, the owner does not pay wages to himself. Funds for his personal use are simply withdrawn from the company account and have no tax implications.

A sole proprietorship is perhaps the easiest form of business to own and operate because it does not require any specific legal organization, except of course, the normal requirements such as licenses or permits. A sole proprietorship typically does not have any rules or operating regulations under which it must function. The consequences of the business decisions are solely the result of the owner's abilities.

Partnerships

Partnerships can take two legal forms, general or limited. In a General Partnership, two or more individuals join together to run the business enterprise. A partnership may apply for a trade name certificate from the Secretary of State. Each of the individual partners has ownership of company assets and responsibility for liabilities, as well as authority in running the business. The authority of the partners, and the way in which profits or losses are to be shared, can be modified by the partnership agreement.

The responsibility for liabilities can also be modified by agreement among the partners, but creditors of the partnership typically have recourse to the personal assets of each of the general partners for settlement of partnership debts.

A Limited Partnership is comprised of one or more general partners who are personally liable for partnership debts and one or more limited partners who contribute capital and share in the profits or losses of the business. The limited partners do not take part in running the business and are not liable for the debts of the partnership.

The rights, responsibilities and obligations of both the limited and general partners are typically detailed in a partnership agreement. It is a good idea to have such an agreement for any partnership, whether limited or general.

A partnership is a legal entity recognized under the law and, as such, it has rights and responsibilities in and of itself. A partnership can sign contracts, obtain trade credit and borrow money. When a partnership is small, most creditors require a personal guarantee of the general partners for credit.

In New Mexico, a partnership is also required to file income tax returns. A partnership normally does not pay income tax. The taxable income (or loss) is passed through to the partners, typically in proportion to their share of ownership and is then combined with the other personal income of each partner to determine the overall tax liability of that partner.

There is a variation of a General Partnership called a Limited Liability Partnership (LLP). In some states, partners in an LLP generally remain personally liable for the commercial and general obligations of the partnership and for their own errors and omissions as well as those of persons under their supervision. However, LLP partners generally are not liable for the errors or omissions of other LLP partners nor of persons under their supervision. Recently, however, New Mexico has enacted law that provides LLP partners with the same blanket liability protection as members of a Limited Liability Company (LLC), see below. Competent legal counsel should be consulted before deciding on either of these business formats.

A "joint venture" is technically a Partnership. The only type of joint venture for which the IRS allows the owners to report their shares of income and expenses directly on their individual income tax returns (rather than by filing a Partnership return) is one consisting only of the joint ownership of a passive rental activity which is not regarded as a trade or business. Even for such a rental activity, there are other important issues for considering the establishment of a legal partnership, including such matters as expense reimbursements, deaths, transfers of ownership, financing liability, etc.

Corporation

A regular corporation is frequently referred to as a "C" corporation, as opposed to an "S" corporation (see below). A corporation is a separate legal entity which exists under the authority granted by state law. It has substantially all of the legal rights of an individual and is responsible for its own debts. A "C" corporation must file income tax returns and pay taxes on income it derives from its operations. Typically, the owners or shareholders of a corporation are protected from the liabilities of the business. However, when a corporation is small, creditors often require personal guarantees of the principal owners before extending credit. The legal protection afforded the owners of a corporation can far outweigh the additional expense of starting and administering a corporation.

In New Mexico the organizers of a corporation (whether a "C" or "S" corporation) must file articles of incorporation to commence business. The articles are filed with the State Public Regulation Commission. A corporation must also adopt by-laws which govern its rights and obligations to its shareholders, directors and officers.

Both types of corporations must file annual income tax returns with the IRS and the New Mexico Taxation & Revenue Department and possibly other states in which it does business. New Mexico also requires a Biennial Corporate Report to be filed with the New Mexico Public Regulation Commission. The elections made (or not made) in a corporation's initial tax returns can have a significant impact on how the business is taxed in the future.

Incorporating a business provides a number of other advantages such as the ease of bringing in additional capital through the sale of equity, or allowing an individual to sell or transfer their interest in the business. It also provides for business continuity when the original owners choose to retire, sell their interest or transfer ownership in case of death.

S-Corporations

The fourth business organization is a Subchapter S corporation (most often referred to as an "S" corporation). An "S" corporation is no different from any other corporation under state law in terms of corporate law requirements, limited liability of shareholders, or any other aspect except tax treatment. Simply stated, an "S" corporation is a regular corporation that meets specific requirements and is treated very much like a partnership for federal tax purposes. Generally, an "S" corporation does not pay income taxes. Rather, the income and losses flow through to the shareholders' individual tax returns. This can prove beneficial in the early years of a new business as losses can be passed on to benefit shareholders.

The qualifying corporation must make an election for "S" status with the Internal Revenue Service by filing Form 2553. The election must be signed by all of the corporation's shareholders, including any spouse who has a community property interest in the stock. An example of Form 2553 follows this section. This election must be filed during the first seventy-five days of the corporation's tax year for which the election is to go into effect or at any time during the preceding tax year.

"S" corporations must file annual income tax returns with the IRS and the New Mexico Taxation and Revenue department and possibly other states in which it does business. Here again, as with "C" corporations, elections made (or not made) in an "S" corporation's initial tax return can have significant impact on how the businesses (and ultimately its shareholders) are taxed in the future.

Limited Liability Company

A Limited Liability Company is a separate legal entity created at the state level. If it is organized properly, the LLC is a hybrid entity that combines the pass-through attributes of a partnership with the corporate characteristics of limited liability. The LLC may be taxed as a partnership if it is structured properly. If not structured properly, the LLC is treated as a corporation.

None of the LLC owners (who are known as "members") needs to be exposed to personal liability and the members can participate in management without becoming personally liable. Members may benefit under the passive activity loss rules if they do not actively participate in the operations of the business. There is no double tax; LLCs are easily formed and operated; they have special allocation and flexibility; basis step-up after certain transactions; and no penalty taxes for accumulations or investment income.

An LLC must file a partnership return of income which allocates income or loss to its members in a manner similar to a regular partnership or an "S" corporation. To form an LLC in New Mexico, the organizers must file articles of organization with the New Mexico Public Regulation Commission. An LLC must also adopt an operating agreement which governs its rights and obligations to its members.

Regardless of whether you decide to incorporate your business, elect Subchapter S status or form a partnership or Limited Liability Company, you should seek the advice of competent legal counsel and business oriented certified public accountants.