In deciding what type of entity to choose for your business, there are a number of different factors one must consider. The most important factors that affect the decision of what entity to choose are (a) how will the entity be taxed, (b) the management of the entity, and, perhaps most importantly, (c) to what extent are the owners of the entity protected from personal liability. What follows is a brief description of entity formation in the Commonwealth of Pennsylvania, focusing on the above considerations.

“C” and “S” Corporations
Perhaps the most well known form of business entity is the corporation or “C” Corporation. Companies such as Pepsi, Bank of America, Ford and General Electric are all “C” Corporations. A “C” Corporation is an entity that is separate and apart from its owners. What this means is that the earnings that are distributed to the owners are taxed twice, once at the corporate level and once at the personal level. The “S” Corporation, which is created by electing “S” status with the Internal Revenue Service, is given more favorable tax treatment. The profits and losses of an “S” Corporation pass through to the owners of the corporation, and therefore, the owners of the corporation are taxed only once. An “S” Corporation is not without its drawbacks. The current tax laws limit the number of investors in an “S” Corporation (100), an “S” Corporation can only have one class of stock, and shareholders must be United States citizens or residents, therefore limiting the ability of other corporations or partnerships to be owners. Often, business owners who are looking to “take their company public” will find that the “C” Corporation is the best form of business entity to do so because of the above limitations of the “S” Corporation.
 

Pennsylvania’s corporate management structure is similar to that found in most states. Unless specified in the by-laws of the corporation, Pennsylvania corporations are managed under the authority of the board of directors, who are elected by the shareholders of the corporation. The directors of the corporation stand in a fiduciary relationship to the corporation and must perform their duties in good faith, in a manner reasonably believed to be in the best interest of the corporation. The board of directors of the corporation elect officers of the corporation that handle the day-to-day affairs of the corporation.

In a corporation, shareholder liability is limited to the investment of the shareholder used to purchase the stock of the corporation. When a business is incorporated in Pennsylvania, it is treated as an entity that is separate and apart from its owners. Therefore, if a lawsuit is brought against the corporation, absent extreme circumstances, the shareholders of the corporation are protected from personal liability. In order to protect against personal liability as an owner of a corporation, corporate formalities must be maintained. When a shareholder is also a member of management of the corporation, said shareholder should always hold himself/herself out as acting on behalf of the corporation and not individually.
 

Partnerships
General partnerships and limited partnerships enjoy “flow-through” tax treatment for tax purposes; the entity is not taxed at the entity level and the partners of the partnership report their profits and losses in the partnership directly on their own personal income tax return to the extent that the partner is an owner of the business. Unless an agreement between the partners provides otherwise, each partner in a general partnership is entitled to share equally in the management of the partnership. Additionally, each partner in a general partnership has the authority to bind the partnership. The drawback to the general partnership model is, that in a general partnership, the owners do not have the advantage of limited liability protection.

In contrast to a general partnership, as a general rule, limited partners in a limited partnership do not participate in the management of the partnership’s business. A limited partnership must have at least one general partner and at least one limited partner. The general partner assumes the personal liability for the debts and obligations of the partnership. The limited partners do not have any personal liability beyond the capital contributions they contribute to the partnership. However, when a limited partner participates in the management of the business, that partner is liable to persons who believe, based on the conduct of the limited partner, that the limited partner is a general partner of the partnership.

Limited liability partnerships enjoy the same “flow-through” tax treatment for tax purposes as general partnerships and limited partnerships, but offer a degree of liability protection to general partners. The general partners of a limited liability partnership are not personally responsible for the negligent misconduct committed by another partner, however, they do remain liable for all other debts and obligations of the partnership. Limited partners in a limited liability partnership are treated the same as in a limited partnership.
 

Limited Liability Companies
Like general partnerships and limited partnerships, limited liability companies in Pennsylvania enjoy “flow-through” tax treatment for tax purposes, that is, the profits and losses of the business pass through the business and are reflected and taxed on the individual tax returns of the owners, rather than being reported and taxed to the business. Limited liability companies can be managed by the members or one or more elected managers. The default rule in Pennsylvania is that if the limited liability company operating agreement is silent, the members manage the limited liability company. In this scenario, each member has the authority to bind the limited liability company. If the members of the limited liability company opt to have the company managed by a board of managers, the members may appoint one or more managers to operate and control the business of the limited liability company. In this instance, each manager is vested with the authority to bind the limited liability company. In order to elect to have the company manager managed, the members must so explicitly state in the Certificate of Organization.

Unlike a limited partnership where there must be at least one general partner that will be responsible for all of the liabilities of the partnership, there is no requirement that at least one of the members of the limited liability company be responsible for all of the liabilities of the company. Furthermore, members are not liable for the debts of the company solely because they are members. Because of the ease of formation of the limited liability company and its favorable liability treatment, it has become increasingly popular in Pennsylvania.

It is important, before deciding on a type of entity for your business, to consider the benefits and drawback to each type of entity. Careful planning, and the help of a trusted attorney and accountant can go a long way towards choosing the right type of entity for your business.
 

Disclosure
This article is not meant to constitute a discussion about all tax related issues involving entity formation in Pennsylvania. For a better understanding of the tax issues affecting you or your small business, a qualified attorney or accountant should be contacted.