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                           James H. Bownas, Esq.
                         Zaino & Humphrey, LPA
                   5775 Perimeter Drive, Suite 275
                         Dublin, Ohio 43017-3223
                           (614) 799-2800 (Voice)
                       (614) 799-1500 (Facsimile)

       A.       Limited Liability Considerations

       Clients who are organizing a new business usually want to insulate their personal

assets from the claims of their business creditors. In many cases, unless the client will be

truly a passive investor, the goal is not realistic under any format, because business creditors

(at least the ones with potentially substantial claims) will not deal with the new entity absent

the personal guarantees of the entrepreneurs, and frequently of their spouses, as well.

Besides liabilities to which the owners may have to subject themselves contractually, they

may be statutorily liable for certain obligations of their business, irrespective of the form it

takes. Those obligations may include, but are not limited to:

       ·        federal, state and local payroll taxes withheld from the wages of employees

                but not paid over to the taxing authority;

       ·        Ohio sales tax, and most other taxes for which the vendor is the state's

                statutory collection agent, to the extent not paid over to the state;

       ·        in some circumstances, "Superfund" liability under CERCLA.

Even in the absence of specific contractual or statutory liability, the entrepreneurs may

become personally liable for their business entity's obligations if their participation warrants

"piercing the veil" of the entity. Nevertheless, most clients will expect you to give serious

consideration to their exposure to tort and contract liabilities arising in the business.

       The corporation (governed by Chapter 1701, ORC) has been the traditional vehicle

for insulating personal assets, and there is no distinction between a C Corporation and an S

Corporation in this respect. On the other hand, Ohio law requires certain formalities of
corporations, including annual meetings of their shareholders and directors, and codes of

regulations and bylaws typically adopted by Ohio corporations may require additional

formalities. Failure of the clients to observe those formalities could increase the risk of the

corporation being disregarded for liability purposes. Sometimes, for convenience in

exercising management, the shareholders of an Ohio corporation will enter into a close

corporation agreement, dispensing with some of the corporate formalities. Such an

agreement merely dispenses with, and does not constitute a failure to observe, the statutory

formalities, but it also creates one more set of procedural obligations which, if ignored, can

be pointed to by business creditors as evidence that the owners, themselves, failed to treat the

corporation as an independent entity.

        Limited partnerships (governed by Chapter 1782, ORC) have also been widely used

to limit their owners' liability to the amount of capital invested in the business. Only the

limited partners are protected, however; at least one individual or entity has to agree to be the

general partner, and to bear unlimited liability for the partnership's debts. While the general

partner can, itself, be an entity with liability insulation features, former law required the

general partner to have more than a nominal amount of assets at risk in the partnership's

business in order for the partnership to avoid being taxed as a corporation. With the adoption

of the "check the box" regulations, that issue is no longer relevant, and it is possible, today,

to structure a limited partnership in which no partner has any material exposure for business

debts. A limited partner will, however, lose liability protection as to certain creditors if the

partner's name is part of the limited partnership's name, or if the partner participates in the

control of the partnership's business. While certain basic organizational decisions may be
exercised without participating in control, it is clear that the limited partnership is not ideally

suited for individuals who insist on both strict protection from business debts and a voice in

managing operations. By statute, the mere fact that a limited partner is also a shareholder,

officer or director of a corporate general partner (or holds comparable positions in a general

partner that is a partnership, LLC, estate or trust) does not constitute participating in control,

but it is by no means clear that this protection extends to a limited partner who, in addition to

merely holding such a position, also engages in that capacity in the management of the

limited partnership (and, of course, in the case of a limited partner who is also a partner in a

general partnership that serves as a general partner of the limited partnership, the fact that he

or she does not "participate in control" does absolutely nothing to mitigate her or his

vicarious liability as a partner). Ironically, while corporate shareholders frequently have to

contract away their liability protection in order to borrow working capital, real estate limited

partnerships typically are able to contract for "exculpatory" or "non-recourse" mortgage

financing for tax reasons, even though it may be unnecessary from the standpoint of

limitation of liability.

        The limited liability company (governed by Chapter 1705, ORC) is the newest

addition to the pantheon of entities to shield owners from business debts. As in the case of a

corporation, the owners of an LLC are not personally liable for entity debts, except where

there immunity has been contracted or legislated away. Although there appears to be no case

authorizing the piercing of an LLC's veil under the limited liability company statute of any of

the states, it is reasonable to anticipate that the Supreme Court of Ohio will eventually apply

the same tests for LLC's that it does for corporations.
        Sole proprietors and general partners (Chapter 1775) are personally liable, with few

exceptions, for all of the business debts of their enterprises.

        Some of the more esoteric entities, including limited partnership associations

(Chapter 1783), professional associations (Chapter 1785), business trusts (Chapter 1746) and

real estate investment trusts (Chapter 1747) all provide for limited liability comparable to

corporations and limited liability companies in one form or another. Registered limited

liability partnerships (authorization is sprinkled throughout Chapter 1775) do not limit a

partner's liability for business debts, but do protect a partner against vicarious liability for the

professional malpractice of other partners, employees or agents.

        B.      Management Considerations

        The ease and flexibility with which an entity's business may be operated is a

significant factor to take into account in deciding on the form in which to do business. In

some cases, a lawyer's prior experience with the ability of a particular client to attend to

details may rule out some of the more complex options.

        A sole proprietorship is the simplest form of business. No special formalities are

prescribed by law, although it may be necessary to remind the new sole proprietor of the

need to obtain occupational licenses, to establish various employment-related accounts if the

enterprise will employ others, to obtain a vendor's license if it will make taxable sales and to

register any trade or fictitious name used in the business.

        Single-member limited liability companies, permitted in Ohio for the past year, are

not far behind sole proprietorships. A simple registration, typically one page, and the
appointment of a statutory agent, are required to form the entity. Under the "check the box"

regulations, a single-member LLC does not even obtain a separate tax identification number,

but uses that of its sole member. No operating agreement is required, if the member is

willing to adopt the default features of Chapter 1705. On the other hand, if a single-member

LLC does want to deviate from the statute, it must do so in writing. Multiple-member LLC's

are similarly easy to organize, but are required to obtain a tax identification number from the

Internal Revenue Service. Not only may it dispense with an operating agreement altogether,

if it wants to depart from the statutory default provisions a multiple-member LLC may have

an oral operating agreement (whether is wise to do so is a different issue than whether it is

permissible to do so). Multiple-member LLC's may be more complex to operate simply by

virtue of the fact that there will be more cooks sticking their fingers into the broth than in a

single-member LLC. In order to regulate their procedural wishes and to limit the exercise

of authority by members, a multiple-member LLC may be more likely to require or desire an

operating agreement. Depending on the number of members, and on their personal

management styles, it may be appropriate to appoint one or more managers to operate an

LLC, rather than leaving it to the members. Many LLC's even choose to create offices,

similar to those in traditional corporations, and to fill them with individuals who are charged

with running the day to day operations of the business like in a manner comparable to their

corporate counterparts. Since there is no substantial body of common law or tradition

surrounding LLC's, however, the details of any such structure should be spelled out in an

operating agreement. The management of an LLC does not, for example, automatically

benefit from the Business Judgment Rule, the Corporate Opportunity Doctrine, or any of the
other judicial gloss applicable to corporations. Unlike corporations, Ohio law has no

requirement that either the members or the managers of LLC's have periodic meetings, keep

minutes or otherwise deliberate as a body. Notwithstanding this freedom from detail,

lawyers frequently draft operating agreements for their LLC clients that require meetings,

votes, minutes, quora, proxies, agendae and worse, apparently in an attempt to emulate the

orderliness to which a corporate minute book may aspire (but rarely attain). Sometimes, the

relationship of the members is such that strict procedural rules are appropriate in an LLC, but

when you see a single-member LLC with a requirement for quarterly meetings of its

members, it's pretty obvious that the attorney who formed that entity pulled a form off the

printer without giving any individual attention to the circumstances. The leisure time of LLC

members is invaded not only by the actions of their own attorneys, but of those representing

financial institutions, as well. It is literally impossible for even a single-member LLC to

borrow money from an Ohio bank without adopting and certifying resolutions in which the

member attests that she duly met with herself and authorized herself to enter into the


       General partnerships are easy to form in Ohio, requiring no filing at all except a

fictitious name certificate filed with the Recorder of the county in which the partnership has

its principal place of business and of each county in which the partnership owns real estate.

A partnership must obtain a federal tax identification number. Similar to the situation with

multiple-member LLC's, the management complexity for partnerships stems from the fact

that each partner, when acting in the apparent scope of the partnership's business, is the legal

agent of the partnership and of each other partner, authorized to bind each of them,
personally, to contractual obligations. Accordingly, a fair amount of attention may be

devoted to an agreement among the partners restricting their authority. Many partnerships

operate for years, however, with no written partnership agreement at all.

        Registered limited liability partnerships are, by definition, required to register,

although compliance is relatively simple. Otherwise, their operations are no different from

those of other partnerships.

        A limited partnership is formed only upon filing a qualifying certificate, the

preparation of which is certainly not oppressive, but the importance of which cannot be

overstated. An entity that tries, but fails, to become a limited partnership, is probably a

general partnership, with the consequent personal liability of each owner. Either "substantial

compliance" with the formation requirements or an erroneous but "good faith" belief that one

is a limited partner will protect limited liability, but a complete failure to file the certificate

places the owners in jeopardy. A limited partnership is managed by its general partner(s),

which may make its management very simple or very complex, depending on whether the

general partner is an individual, a group of unrelated corporations, or something in between.

From the view of one who wishes to be a limited partner, management is not complicated at

all, because he or she cannot participate in it. The statute requires the consent of limited

partners for certain material organizational decisions, and limited partnership agreements

typically provide additional democracy rights contractually.

        Corporations are the most cumbersome of the mainline business entities to form and

operate. Their articles of incorporation are a matter of public record which must be amended

upon the occurrence of basic organizational changes, and they typically adopt written codes
of regulations and bylaws which further regulate the conduct of their business. Extensive

statutory provisions regarding the respective rights and obligations of shareholders, officers

and directors are supplemented with common law doctrines. A corporation whose shares are

not registered with the United States Securities and Exchange Commission or on a stock

exchange may adopt a close corporation agreement, by which the operations of the

corporation may be streamlined. A close corporation agreement may not, however, dispense

with any filings required to be made with the Ohio Secretary of State nor with the provisions

of specified statutory provisions. An S Corporation does not differ significantly from a C

Corporation with respect to management issues, except that, by definition, it must elect S

Corporation status by filing its election with the Internal Revenue Service, and that its

reporting to shareholders is complicated by its passthrough nature for federal income tax


        While Ohio professionals may now associate in any business form, professional

associations are essentially special corporations formed for the exclusive purpose of

performing professional services pursuant to a license, certificate or other legal authorization

and regulated by Title 47, ORC. Its formation and operation procedures are the same as for

corporations, with the addition of an annual filing requirement with the Secretary of State,

listing the names and addresses of each of its shareholders, and certifying that each of them is

appropriately licensed.

        Limited partnership associations and REIT's are special purpose entities with some

elaborate operational requirements. REIT's must also satisfy extensive federal income tax

qualifications in order to obtain and retain their status.
       C.      Capital Contribution Considerations

       A client can make capital contributions to any form of business entity with equal

facility. The treatment of capital contributions and the ability to withdraw them, however,

can vary dramatically.

       Except for purposes of internal bookkeeping, the concept of capital contributions in a

sole proprietorship is irrelevant. Cash from any source may be injected into the business and

withdrawn from the business as often as desired, all without tax consequences, other than

those attributable to the source of the cash in the first place. Since sole proprietors are

personally liable for all their business debts, in effect unlimited capital contributions are

mandatory at all times. Loans are indistinguishable from capital contributions when made by

sole proprietors to their business. By definition, capital contributions cannot be made

effectively by non-owners, but loans can be structured to simulate most forms of equity

investment in other types of organizations.

       In the absence of a contrary provision in an operating agreement, capital contributions

to an LLC automatically determine the allocation of profits among members. To a single-

member LLC, this feature is not relevant, because the sole member is entitled to all the

profits in any event. For a multiple-member LLC, however, except in the relatively rare case

of a capital-intensive business with unlimited capacity to absorb additional funds, this is

probably not a feature that the members would favor, and an operating agreement with

different provisions for the effect of capital contributions is probably called for. In other

respects, LLC's exhibit essentially the same characteristics as other entities with respect to
capital contributions:

                ·        single member LLC's (unless they have "checked the box" to be taxed

                         as corporations) are identical to sole proprietorships, except that the

                         member has limited liability, and so future capital contributions are


                ·        Multiple-member LLC's (unless they have "checked the box" to be

                         taxed as corporations) are identical to partnerships, except that the

                         members have limited liability, and so future capital contributions are

                         optional (except to the extent the members have agreed otherwise in

                         an operating agreement)

                ·        Single-member and multiple-member LLC's that have elected to be

                         taxed as corporations are identical to corporations

        In the absence of a contrary provision in a partnership agreement, partnership profits

are allocated equally (i.e., per capita) among the partners, irrespective of capital

contributions. While partners have unlimited liability for partnership business debts, and,

therefore, are required to make unlimited future capital contributions, they are also entitled to

interest on unscheduled advances until they are repaid. Additional capital contributions may

be obtained from existing partners or in consideration for admitting new partners, but an

amendment to the partnership agreement will probably become necessary in either event,

unless these events were specifically anticipated at the time the original agreement was

drafted. For partnership accounting purposes, capital contributions may be withdrawn by a

partner only after payment of all partnership obligations. For tax purposes, distributions to
partners are not characterized as distributions of profits or return of capital. Distributions

may be made either in cash or in other property, with tax consequences as follows:

               ·       distributions of property are generally not a taxable event, but the

                       property will take a carryover tax basis equal to the lesser of the

                       partnership's tax basis in the property and the partner's tax basis in his

                       or her partnership interest (neither basis can ever be less than zero),

                       and any subsequent disposition of the property will generate gain or

                       loss by relation to that carryover basis

               ·       distributions of "hot assets" (unrealized receivables and substantially

                       appreciated inventory items), unless made proportionately to all

                       partners, do constitute taxable events

               ·       distributions of cash are not taxable events, but reduce partners' tax

                       basis in their partnership interests, until basis has been reduced to

                       zero; thereafter, any further distributions are taxed as if they

                       represented gain upon sale of the partnership interest

               ·       partnership debts are treated for tax purposes as if they were capital

                       contributions made proportionately by each of the partners (i.e., they

                       increase each partner's basis in her or his partnership interest) and

                       reductions to partnership debts are treated as if they were distributions

                       made in cash proportionately to each of the partners (i.e., they reduce

                       each partner's basis in his or her partnership interest until it reaches

                       zero, and then generate gain)
Partners may make loans, as opposed to capital contributions, to their partnerships, and the

repayment of such loans, with or without interest, will not be treated as distributions.

        Limited partnerships have the same characteristics as general partnerships, except


               ·       since limited partners are not personally liable for partnership debts,

                       unlimited future capital contributions are required only from the

                       general partner(s), unless there is a contractual requirement to the

                       contrary in the limited partnership agreement

               ·       since limited partners are not personally liable for partnership debts,

                       such debts are not treated as capital contributions by limited partners

                       (i.e., they affect the basis of only the general partner(s)) except in the

                       case of debts for which no partner is personally liable (i.e.,

                       exculpatory or non-recourse indebtedness)

        Shareholders in a C Corporation are not personally liable for corporate debts, and so

future capital contributions are optional for the shareholders, in the absence of an agreement

otherwise among shareholders.        Shareholders may make loans, in lieu of capital

contributions, to their corporations, and repayments of principal will be received by the

shareholders free from tax consequences. Since returns of capital contribution do not receive

tax-free treatment, the Internal Revenue Service has adopted regulations pursuant to which it

attempts to distinguish between bona fide debt and disguised equity. Subsequent capital

contributions can be made readily, either by contribution from existing shareholders, by the

issuance of additional shares to existing shareholders or by the issuance of additional shares
to new shareholders. Corporations are not required to designate a "stated capital" for their

issued and outstanding shares, except in the case of preferred classes. To the extent they do

designate a stated capital, however, corporations may not make distributions that would

impair the stated capital. Distributions to shareholders other than in complete liquidation of

their shares are dividends, taxed as ordinary income to the shareholder. Distributions which

are in complete liquidation result in gain or less relative to the shareholder's tax basis in the


          S Corporations have the same characteristics as C Corporations with respect to

obligations for future capital contributions, the ability to make loans and additional capital

contributions (except that S Corporations may have a maximum of 75 shareholders, the

nature of which is limited, which restricts, to some extent, the ability to raise additional

capital from new shareholders) and statutory restrictions upon distributions to shareholders.

The tax consequences of returns on, and returns of, capital, are dramatically different for S

Corporations, however. Distributions in complete liquidation of a shareholder's stock will

give rise to gain on the sale of the stock. Other distributions to shareholders are not taxable

as dividends unless they are deemed to be made out of "accumulated earnings and profits".

The amount of a distribution is the sum of the cash distributed and the fair market value of

other property distributed. To the extent of each shareholder's basis in her or his S

Corporation stock, distributions are received tax-free, but reduce such basis. After a

shareholder's basis is reduced to zero, additional distributions will give rise to gain. If

distributions are deemed to be made out of accumulated earnings profits (primarily earnings

and profits from prior years in which the corporation was a C Corporation), then they will be
treated as if made in the following order:

               ·       first, tax free distributions, to the extent of undistributed S

                       Corporation earnings and profits (subject to miscellaneous


               ·       then, taxed as a dividend, to the extent of accumulated C Corporation

                       earnings and profits (subject to miscellaneous adjustments)

               ·       then, tax free to the extent of the shareholder's remaining tax basis in

                       S Corporation stock

               ·       and finally taxable as gain with respect to the stock

       D.      Ownership Considerations

       A sole proprietorship is singularly devoid of complicating factors with regard to

operations, but also restricted with regard to flexibility in making dispositions and succession

transfers. While a sole proprietor may contract to sell his or her business assets, or provide

for their disposition testamentarily, there is no way to involve other owners, whether key

employees, family members or prospective purchasers, without converting to another form of

business organization. Sale or testamentary disposition of the business can only be made on

an asset-by-asset basis. Vehicles and other titled assets will have to be retitled. Real estate

owned by a sole proprietor is subject to the dower rights of her or his spouse. Charitable and

other donative dispositions are practically impossible, except to the extent of gifts of cash

after it has been earned in the business. There is no provision under Ohio law that would

permit a sole proprietor to merge or consolidate with any other type of entity in a tax-free

exchange. A sole proprietor could, however, make a contribution of his or her business
assets to a partnership, limited partnership or LLC in a tax-free transaction. The sole

proprietor could also make a tax-free contribution to the capital of a C Corporation or an S

Corporation under §351 of the Internal Revenue Code, provided that she or he remained in

control of the corporation long enough thereafter to satisfy the continuity of ownership

requirements of that section.

        Partnerships are slightly more complicated and slightly more flexible from an

ownership standpoint. They provide at least the prospect that a disabled, retiring or deceased

partner may have a market for his or her interest, in the person of the remaining partner(s).

Partnerships are also vehicles for spreading mortality risks, for example, by the purchase of

insurance on the lives of partners in order to liquidate the interest of a deceased partner.

Partnership interests can be conveyed -- by sale, by gift, by testamentary disposition --

without unbundling all of the underlying assets, but, in light of the mutual agency

relationship among partners, it is seldom desirable for interests to be freely transferable.

Absent a specific provision in a partnership agreement, a partner may not withdraw and

substitute an assignee as a partner without the unanimous consent of the remaining

partner(s). As several of the international accounting firms have demonstrated, there is

practically no limit on the ability of a partnership to add members, provided contractual

provisions are in place to make operating control manageable. Assets held by a partnership

are not subject to the claims of its partners' creditors or spouses. While a creditor can obtain

a charging order against a partner's interest in the partnership, the creditor cannot attach

partnership assets, directly. Any type of entity -- C Corporations, S Corporations, LLC's or

other partnerships -- in addition to individuals, may be a partner in an Ohio partnership.
Ohio partnerships are not permitted by law to merge with any other type of entity, however

the same effect may be obtained in certain transactions. If all the interests in a partnership

are transferred to the same individual, corporation, LLC or separate partnership, for example,

the partnership will cease to exist by operation of state law, and the assignee of the

partnership interests will succeed to the ownership of partnership assets. Technically,

however, this causes a termination of the partnership, and not a merger into another entity,

with consequent loss of continuity that could affect the status of contractual or regulatory


          Limited partnerships are nearly identical to general partnerships, except that there is

no mutual agency relationship among limited partners. Accordingly, restrictions upon

transfers of limited partnership interest may be less of a concern than in the case of general

partnership interests. In fact, since the elimination in 1997 of the "transferability of interests"

test formerly used by the Internal Revenue Service to classify organizations as partnerships or

corporations for federal income tax purposes, restrictions contained in existing limited

partnership agreements may be unnecessarily extensive. Limited partnerships are frequently

used in estate plans to begin the transfer of family assets to younger generations during the

lifetime of the older generations, because limited partner interests can be gifted to family

members without surrendering management control. Under Ohio law, limited partnerships

are permitted to merge with or into domestic and foreign corporations, LLC's and limited

partnerships, as well as with or into other foreign entities which are permitted by the laws of

their domiciliary state to participate in such a merger.

          Limited liability companies exhibit many of the characteristics of partnerships or of
corporations, depending upon the extent to which their operating agreements (if any) move

them from membership-managed to manager-managed models.

       C Corporations are very flexible vehicles primarily due to their commercial

acceptance, and not because of any legal requirements.

       E.      Taxation Considerations

       Typically, the tax consequences of selecting one form of business entity over another

are second in importance only to the ability to limit personal liability.

       Sole proprietors are taxed directly on the income and gains of their businesses, and

may deduct personally the deductions and losses of their businesses. Depending on the size

and nature of their business, they may be on either the cash or the accrual method of

accounting for tax purposes, but they are taxed on net income irrespective of the receipt of

any cash or other property. If the sole proprietorship must make principal payments on loans

or other nondeductible payments, the sole proprietor may be subjected to tax on "phantom

income". The sole proprietor reports business income and expenses on Schedule C to her or

his Form 1040, and pays self-employment taxes on the net income. Sole proprietors may

have draws, but they do not pay themselves wages or salaries. They are not required to

withhold taxes from the sole proprietor and do not issue a Form W-2 or Form 1099 to him or

her. The sole proprietor is, however, required to make quarterly estimates and deposits of

income tax liability and must issue W-2's and/or 1099's to other parties who receive

compensation. An individual who forms a single-member LLC is taxed in exactly the same

way as a sole proprietor. The existence of the LLC is disregarded for federal income tax

purposes and the sole proprietor reports the LLC's income and expenses directly on his or her
Schedule C. A sole proprietor or a single-member LLC may adopt a Keogh Plan or, if there

are employees other than the sole owner, a Simplified Employee Pension plan (SEP).

        With extremely limited exceptions (including for purposes of the Columbus

municipal income tax) partnerships are not taxpayers. The partnership and its partners are

taxed in essentially the same fashion as a sole proprietorship and its sole proprietor, with

some modifications to reflect the need for allocation among the several partners. All of a

partnership's items of income, gain, loss, deduction and credit for federal income tax

purposes are allocated pro rata to its partners, retaining the same character in the partners'

hands as they had in the partnership's hands. Thus, the partnership is a "passthrough" entity

for tax purposes. A partnership agreement that provides for allocations other than on a per

capita basis will be honored for federal income tax purposes, but if the agreement allocates

economic items (i.e., distributions of cash and other assets) in different proportions than it

allocates tax items, a complex series of adjustments must be made pursuant to the

Regulations under Internal Revenue Code §704(b), and the allocations in the partnership

agreement will be disregarded in favor of the "true" proportionate interest of each partner in

the partnership if the tax allocations do not ultimately embody "economic substance".

Partners are taxed on their respective shares of partnership income regardless of whether

distributions are made to partners, and so the prospect of phantom income is present. The

partnership files a Form 1065 with the Internal Revenue Service, attaching a Schedule K-1

for each of its partners, reporting the partners' respective shares of each partnership tax item.

Partners who are individuals report their K-1 items on Schedule E to their Form 1040. A

partnership may pay draws, or even "guaranteed payments" in the nature of salary to its
partners, but it cannot, technically, pay them wages or salaries. It does not issue W-2's or

1099's to its partners with respect to distributions of profits, but it does issue them to non-

partner employees and vendors and it could, for example, issue a 1099 to a partner who

provides a product or service outside the scope of the partners participation in the partnership

business. A partnership may adopt a Keogh Plan or SEP for all its partners and employees.

A partnership may form a single-member LLC, and if it does, the LLC will be disregarded

and its income and expenses will be reported directly on the face of the partnership's Form


        A limited partnership is taxed in exactly the same manner as a general partnership.

The only distinguishing characteristic is that, in light of the limited liability of limited

partners, there is a greater likelihood that net losses of a limited partnership will not be

deductible by the limited partners on their individual tax returns, because they may lack

sufficient tax basis or "amount at risk" with respect to the limited partnership. A limited

partnership may be the sole member of an LLC.

        A multiple-member LLC is taxed exactly as if it were a partnership, unless it "checks

the box" to be taxed as a corporation.

        A C Corporation, unlike the passthrough entities under comparison, is a taxpayer in

its own right. The corporation files a Form 1120 with the Internal Revenue Service, on

which it reports its income and deductible expenses and calculates its tax liability on its net

income. To the extent it pays dividends to its shareholders, it gets no deduction for them,

while the shareholders must include them in their own taxable income. Accordingly, C

Corporations are "double taxation" entities. Shareholders who are individuals report their
dividend income on Schedule B to their Form 1040. A C Corporation may employ

shareholders, in which case it may pay them wages or a salary. It will withhold payroll taxes

from the compensation of shareholder-employees, issue W-2's, and otherwise treat them in

all respects as common law employees. Because a C Corporation is able to deduct

compensation it pays to shareholders, whereas dividends are non-deductible, the Internal

Revenue Service has adopted regulations pursuant to which it attempts to distinguish

between bona fide compensation and disguised dividends. A C Corporation is permitted to

deduct compensation only to the extent it is "reasonable" in amount under all the

circumstances. A corporation issues Form 1099-DIV with respect to dividends paid to its

shareholders. A C Corporation may adopt any of the ERISA-qualified employee retirement

plans, including pension and profit sharing plans, 401(k) plans and ESOP's. Corporations

may also adopt a variety of employee plans providing health and other benefits to employees

(including to shareholder-employees) with the expense of the plan deductible to the

corporation and the value of the benefits excluded from the income of the employees. A

corporation may form a single-member LLC, in which event the LLC will be disregarded as

an entity separate from the corporation. The LLC's income and expenses will be reported

directly on the corporation's Form 1120.

       Under the "check the box" regulations, any partnership, limited partnership or LLC

(including, but not limited to a single-member LLC) may elect to be taxed as if it were a

corporation, while retaining all the non-tax characteristics assigned to it by state law.

       S Corporations are frequently described as being "corporations that are taxed just like
partnerships", but that description is appropriate only with a number of exceptions and

caveats. An S Corporation is a passthrough entity, and (except in certain extremely limited

circumstances) not a taxpayer, itself. It reports all of its income and expenses to the Internal

Revenue Service on Form 1120-S, along with individual Schedules K-1 for each of its

shareholders, allocating their individual shares of its tax items in proportion to their

respective ownership of stock. S Corporation shareholders do not, however, get tax basis in

their stock for debts of the corporation, as general partners do in a partnership. Accordingly,

S Corporation shareholders may benefit far less from tax losses sustained by their

corporation than would general partners in a partnership with the same loss scenario. S

Corporation shareholders do, however, acquire tax basis for loans they make to the

corporation. While this feature may permit shareholders to deduct additional tax losses

personally, it is not triggered by the shareholder's guarantee of a loan made directly to the

corporation; to get the benefit of the additional basis, the shareholder must be the lender

(although the shareholder could, for example, borrow funds from a bank and re-lend them to

the corporation, perhaps with a corporate guarantee, instead of having the loan come directly

from the bank to the S Corporation with a shareholder guarantee). Distributions to a

shareholder who has made a loan to an S Corporation, whether intended as distributions of

profits or as repayments of principal, will first reduce the basis in the shareholder's loan to

zero, and then reduce the shareholder's basis in S Corporation stock. S Corporation's may

employee shareholders and pay them W-2 or even 1099 compensation. In contrast to the

incentive for C Corporations to pay excessive compensation to shareholder-employees in

order, in effect, to "deduct dividends", S Corporations are motivated to minimize the
compensation they pay to shareholders. This is so because if, for example, no compensation

is paid to shareholder-employees, a shareholder will be taxed on the corporation's earnings,

but not on distributions of profits, whereas if she or he receives compensation for

employment by the corporation, his or her taxable income will be the same amount but

employment taxes will have been incurred, in addition. Accordingly, the Internal Revenue

Service has adopted regulations pursuant to which it attempts to identify "inadequate"

compensation to S Corporation shareholder-employees. S Corporations may adopt the same

ERISA-qualified retirement plans and benefit plans as C Corporations, but employees who

are 2% or more shareholders in an S Corporation are limited in their ability to benefit from

the resulting income exclusion. Since 1997, ESOP's have been permitted to own S

Corporation stock without incurring "unrelated business taxable income". An S Corporation

may be the sole member of an LLC, in which case the LLC existence as an entity separate

from the corporation will be disregarded. Since 1977, S Corporations have also been

permitted to be the sole shareholder in a "Qualified Subchapter S Subsidiary", as well as to

own stock in C Corporation subsidiaries.

       F.      "Check the Box"

       After years of wrangling with taxpayers over whether a particular entity had more

"corporate characteristics" than "non-corporate characteristics", the Internal Revenue Service

bagged the whole issue in 1997, and adopted Regulations §301.7701, the so-called "check

the box" regulations. Under these regulations, certain business entities are classified

automatically as corporations. Other business entities ("eligible entities") may choose how

they are classified for federal tax purposes. An eligible entity with at least two members can
choose to be classified as either a corporation or a partnership. Likewise, an eligible entity

with only one member can choose to be classified as a corporation or to be disregarded as an

entity separate from its owner (e.g., treated as a sole proprietorship, as a corporate division or

as a d/b/a). Eligible entities who wish to elect corporate-type taxation must complete and file

Form 8832. Eligible entities who wish to elect partnership-type taxation are not required to

take any action. Note that an eligible entity could elect corporate-type taxation, and then

make an S election, effectively ending up as a passthrough entity.

        The following types of business entities can never be eligible entities, and are always

required to be classified as corporations:

               a "statutory corporation", as defined

               an insurance company

               a state bank insured under the Federal Deposit Insurance Act

               an entity wholly owned by a state or its political subdivision

               a business entity that is taxable as a corporation under a provision of the

Internal Revenue Code other than §7701(a)(3)

               with certain exceptions, any foreign business entity listed in Regulations


        The foregoing "automatic corporations" are not eligible to file Form 8832. All other

entities are eligible entities. If a domestic eligible entity does nothing, it will automatically

be classified as a partnership, if it has two or more members, and will automatically be

disregarded as an entity separate from its owner, if it has only one owner.

        If a foreign eligible entity does nothing, it will automatically be classified as a
partnership if it has two or more members and at least one member does not have limited

liability, will automatically be classified as a corporation if all its members have limited

liability, and will automatically be disregarded as an entity separate from its owner if it has

only one owner, without limited liability.

       G.      Formation Issues

       1.      Sole proprietorship:

               ·       No formation requirements; normal compliance with licensing and

                       employment account (if applicable) requirements

       2.      General partnership:

               ·       No formation requirements beyond the statutory definition; normal

                       compliance with licensing and employment account (if applicable)


               ·       Unless partnership name contains the names of all partners, files

                       certificate of partnership with Recorder of county in which it has its

                       principal place of business and of each county in which it owns real

                       estate, listing name and residence address of all partners [Note -

                       although certificate is a statutory requirement, the only consequence

                       of noncompliance is that certificate must be filed before partnership

                       can take title to real estate and, theoretically, before it can commence

                       a legal action]

               ·       Written partnership agreement is not required, but extremely

3.   Limited partnership:

     ·      Files a certificate of limited partnership with Secretary of State,

            setting forth partnership's name, address of its principal place of

            business, name and address of agent for service of process, name and

            address of each general partner and any other matters general partners

            determine [Note - As of July 1, 1994 this certificate replaces the

            fictitious name certificate required under prior law].

     ·      Name must include one of the following: "Limited Partnership,"

            "L.P.," "Limited" or "Ltd." and must not include the name of a

            limited partner unless it is also the name of a general partner or the

            business of the limited partnership had been carried on under that

            name before the admission of that limited partner

     ·      Written limited partnership agreement is not required, but extremely


4.   Limited liability company:

     ·      Files articles of organization with Secretary of State, setting forth its

            name, duration (perpetual, if not specified), address for requesting

            information, and any other provisions the members elect

     ·      Name must include on e of the following: "limited liability

            company," "LLC," "L.L.C.," "limited," "ltd." or "ltd"

     ·      Files appointment of a statutory agent for service of process, with

            acceptance of appointment by the agent
     ·      Written operating agreement is not required, however single-member

            LLC's may not deviate from statutory default provisions without a

            written agreement and it is extremely desirable for multiple-member


5.   C Corporation:

     ·      Files articles of incorporation with Secretary of State, setting forth its

            name, principal office in Ohio, purpose for which formed (which may

            include "to engage in any lawful act or activity for which corporations

            may be formed under this chapter"), authorized number of shares and

            (if applicable) par value per share, express terms (if any) of shares,

            classes (if any) of shares, initial stated capital (if any) and any

            additional provision permitted

     ·      Files appointment of a statutory agent for service of process, with

            acceptance of appointment by the agent

     ·      Close corporation agreement, buy-sell agreement and other

            documentation are not required, but extremely desirable in multiple-

            shareholder corporations

6.   S Corporation:

     ·      Same as for a C Corporation, to begin its legal existence

     ·      Files Form 2553, Election by a Small Business Corporation, with its

            Internal Revenue Service Center before the 16th day of the third

            month of the taxable year for which the election is to be effective.

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