Choice of Entity (outline)

By Roger Royse

There are four major considerations for every owner when starting a business: control of ownership, flexibility, personal risk, and tax liability. Each entity type discussed in this handout offers different advantages and disadvantages, and each client / business may have different priorities or considerations that will be best addressed by one entity type versus another. Choosing the wrong entity can handicap a business, give rise to personal income tax filing obligations, and in some circumstances, can even result in a violation of state law. This handout only outlines the basic features of each entity type; prospective business owners should consult an attorney before making a final decision.

Owners of businesses will ordinarily organize their business as any one of the following four  types of entities: Limited Liability Companies (“LLCs”), C-corporations, S-corporations, and Partnerships.  Business entities are generally governed by state law, and the laws could be, and often are, different from state to state.  Without addressing the laws of any specific state, this handout outlines the basic features of each entity type that will apply in most states.

LLCs

Ownership Interests; Management

The owners of an LLC are normally referred to as “members” and their ownership of the LLC is often referred to as an “ownership interest” or “unit” (corollary to corporate stock). There can be different classes of ownership interests, or a single class. An LLC is typically managed by its members (i.e. owners) or by a “manager”, managing member, or Board-like group. More typically the day-to-day management is the responsibility of the manager, while more significant decisions are determined by a vote or consent of the members. The terms for management and the rights and obligations of the members are dictated by a written Operating Agreement in effect for the company. LLCs are often considered an extremely flexible type of entity, as the provisions of the Operating Agreement, however drafted, will ordinarily govern the rights and obligations of the parties involved.

Equity Compensation

Business owners are commonly concerned with the ability to compensate the officers, directors and other service providers with equity of the business in a tax efficient manner. LLCs are very flexible in this regard, permitting grants of capital interests, “profits interests”, restricted units, options, and other equity-like compensatory bonuses. Incentive Stock Options (“ISO”) are, however, not available.

Personal Risk and Transfer

LLCs provide members with limited liability when properly capitalized and operated. Members are generally not required to contribute additional capital to the company beyond their initial contribution, but such an obligation may be included in the Operating Agreement. Transfers of membership interests and determination of the eligibility of owners are often both controlled, at least in part, by securities laws and the Operating Agreement. Economic interests and voting / member rights can often be divided for purposes of effectuating a transfer.

Tax Liability

An LLC with one owner is generally disregarded for federal tax purposes, while an LLC with multiple owners is by default a partnership for federal tax purposes. In either case, the taxation of the business is borne by the members and not by the LLC itself. An LLC may elect to be taxed as a corporation, however, which would create a tax at the LLC level. Absent such an election, members are subject to tax on their allocable share income of the LLC. LLCs may be incorporated tax free in most circumstances. Upon sale or liquidation, there is one level of tax, generally capital gain, except for the amount allocable to certain ordinary or “hot” assets. Preparation of LLC partnership tax returns (i.e. when an LLC has more than one member and has not elected to be taxed as a corporation) can be complicated and costly.

Location, Operating, and Maintenance

Nevada does not have a state income tax and Delaware does not tax out-of-state business activities. Nevada and Delaware are regarded as having business-friendly laws and courts. Whatever state chosen for incorporation, the LLC will be subject to the laws of that state (and possibly the laws of other states, depending on activities and the Operating Agreement). Frequently, the state in which the LLC “does business” will also impose taxes on the business activities performed in that state, so it often makes sense to organize in the same state in which the LLC will conduct business.

All LLC finances and transactions must be kept separate from personal finances; a separate bank account for the LLC should pay all expenses and payouts.

Most state governments require filing of an annual report with basic information.

C-Corporations

Ownership Interests; Management

The owners of a C-corporation are referred to as “shareholders” or “stockholders”, and their ownership of the C-corporation is referred to as “shares” or “stock”. Directors and officers have management duties; shareholders are not entitled to participate in management. However, the shareholders do typically vote to elect the directors of the C-corporation. The rights of the parties (shareholders, directors and officers) are normally determined under state law, the organizing documents (including certificate of incorporation and bylaws) and any other shareholder agreements entered into with respect to the C-corporation.

Equity Compensation

Business owners are commonly concerned with the ability to compensate the officers, directors and other service providers with equity of the business in a tax efficient manner. C-corporations are flexible in this regard, permitting grants of stock, restricted stock, options, other equity-like compensatory bonuses, participation in employee stock purchase plans (ESPPs) and employee stock ownership plans (ESOPs). ISOs are commonly granted to employees and Non-Qualified Stock Options (“NSO”) may be granted to consultants and advisors.

Personal Risk and Transfer

C-Corporations provide shareholders with limited liability. Directors and officers are protected from liability when not in violation of their duties to the C-corporation and its shareholders and so long as the C-corporation is properly capitalized and operated. A shareholders agreement, if any, and securities law regulations can often limit both who may become a shareholder and whether a shareholder can transfer his or her ownership in the C-corporation. Unlike other entities, there are no restrictions on the type of person or entity that may hold shares of a C-corporation (assuming all applicable securities laws are satisfied).

Tax Liability

C-corporations are taxed on earnings at a corporate level. Further distributions to shareholders are again taxed on a personal income tax level. For distributions of appreciated property, there is taxable gain to the C-corporation and a taxable dividend to the shareholders. C-corporations may convert to an S-corporation by making an election, but such an election would involve a variety of tax and other considerations (“built-in gains” tax, eligible owners, etc). However, the conversion of a C-corporation to an LLC or partnership is generally fully taxable. Upon sale or liquidation of a C-corporation, there is also potential for double taxation. At the same time, special tax code provisions provide for opportunities to engage in mergers and other reorganizations tax-free. If not eligible for tax-free treatment, there is corporate tax on the sale of assets and shareholder level tax on the sale of stock or liquidation. C-corporations must file a separate federal corporate tax return on Form 1120.

Location, Operating, and Maintenance

Nevada does not have a state income tax and Delaware does not tax out-of-state business activities. Nevada and Delaware are regarded as having business-friendly laws and courts. Whatever state chosen for incorporation, the C-corporation will be subject to the laws of that state (and possibly the laws of other states, depending on activities). Frequently, the state in which the company “does business” will also impose taxes on the business activities performed in that state, so it often makes sense to organize in the same state in which the company will conduct business.

A C-corporation is a separate legal entity and its finances must be kept separate from the personal finances of its owners. The C-corporation should create a separate bank account and acquire a separate federal tax ID number.

Shareholders generally must meet annually to elect corporate directors, who must meet at least annually to elect corporate officers. Special meetings may be required to approve certain actions like amending charter documents.

S-Corporations

Ownership Interests; Management

The owners of an S-corporation are referred to as “shareholders” or “stockholders”, and their ownership of the S-corporation is referred to as “shares” or “stock”. Directors and officers have management duties; shareholders are not entitled to participate in management. However, the shareholders do typically vote to elect the directors of the S-corporation. The rights of the parties (shareholders, directors and officers) are normally determined under state law, the organizing documents (including certificate of incorporation and bylaws) and any other shareholder agreements entered into with respect to the S-corporation. Tax laws restrict an S-corporation from having foreign owners, certain entity owners, more than 100 shareholders, and more than 1 class of stock. Violations of these statutory restrictions can cause loss of S-corporation status.

Equity Compensation

Business owners are commonly concerned with the ability to compensate the officers, directors and other service providers with equity of the business in a tax efficient manner. S-corporations are flexible in this regard, permitting grants of stock, restricted stock, options, other equity-like compensatory bonuses, participation in ESPPs and ESOPs. ISOs are commonly granted to employees and NSOs may be granted to consultants and advisors. As stated above, the S-corporation must be careful not to establish a second class of stock through its grants of equity compensation.

Personal Risk and Transfer

S-corporations provide shareholders with limited liability. Directors and officers are protected from liability when not in violation of their duties to the S-corporation and its shareholders and so long as the S-corporation is properly capitalized and operated. A shareholders agreement, if any, and securities law regulations can often limit both who may become a shareholder and whether a shareholder can transfer his or her ownership in the S-corporation. As stated above, the S-corporation must be careful not to take owners that could cause it to lose its S-corporation status, and will generally place restrictions on the shareholders so that the stock will not be transferred to an ineligible shareholder.

Tax Liability

S-corporations are generally not taxed on earnings at the corporate level; however, some excise taxes and built in gains taxes may apply. S-Corporations may convert to a C-corporation by revoking elections but conversions to an LLC may be taxable. Upon sale or liquidation of the S-corporation, there is normally one level of tax on the sale of stock or assets, generally capital gain on stock sale. At the same time, special tax code provisions provide for opportunities to engage in mergers and other reorganizations tax-free or with tax benefits (including Section 338(h)(10) transactions). Generally the S-corporation and its shareholders both file tax returns annually.

Location, Operating, and Maintenance

Nevada does not have a state income tax and Delaware does not tax out-of-state business activities. Nevada and Delaware are regarded as having business-friendly laws and courts. Whatever state chosen for incorporation, the S-corporation will be subject to the laws of that state (and possibly the laws of other states, depending on activities). Frequently, the state in which the company “does business” will also impose taxes on the business activities performed in that state, so it often makes sense to organize in the same state in which the company will conduct business.

An S-corporation is a separate legal entity and its finances must be kept separate from the personal finances of its owners. The S-corporation should create a separate bank account and acquire a separate federal tax ID number.

Partnerships

Ownership Interests; Management

The owners of a Partnership are normally referred to as “partners” and their ownership of the Partnership is often referred to as a “partnership interest”. There can be different classes of partnership interests, or a single class. A Partnership is typically managed by one or more general partners, while the limited partners take a backseat. The terms for management and the rights and obligations of the partners are dictated by a written Partnership Agreement in effect for the company. Partnerships are often considered an extremely flexible type of entity, as the provisions of the Partnership Agreement, however drafted, will ordinarily govern the rights and obligations of the parties involved. A Partnership must have at least two (2) owners.

Equity Compensation

Business owners are commonly concerned with the ability to compensate the officers, directors and other service providers with equity of the business in a tax efficient manner. Partnerships are very flexible in this regard, permitting grants of capital interests, “profits interests”, restricted partnership interests, options, and other equity-like compensatory bonuses. ISOs are, however, not available.

Personal Risk and Transfer

Partnerships provide limited partners with limited liability while leaving general partners open to unlimited liability. The limited partners, to remain free from exposure, should be cautious not to engage in the activities reserved for the general partner. In addition, the limited partners should be careful not attract liability by improperly capitalizing the Partnership or engaging in improper transactions. Partners are generally not required to contribute additional capital to the Partnership beyond their initial contribution, but such an obligation may be included in the Partnership Agreement. Transfers of Partnership interests and determination of the eligibility of owners are often both controlled, at least in part, by securities laws and the Partnership Agreement. Economic interests and voting / partnership rights can often be divided for purposes of effectuating a transfer.

Tax Liability

There is no federal tax at the Partnership level, but instead, the income flows through to the partners to be taxed at the personal income tax level. Partnerships can be easily converted to an LLC or incorporated tax free. Upon sale or liquidation, there is one level of tax, generally capital gain, except for the amount allocable to certain ordinary or “hot” assets. Partners are subject to tax on their allocable share of the income of the Partnership. Partnerships may be organized tax free in most circumstances. Preparation of partnership tax returns can be complicated and costly.

Location, Operating, and Maintaining

Nevada does not have a state income tax and Delaware does not tax out-of-state business activities. Nevada and Delaware are regarded as having business-friendly laws and courts. Whatever state chosen for organization of the Partnership, the Partnership will be subject to the laws of that state (and possibly the laws of other states, depending on activities and the Partnership Agreement). Frequently, the state in which the Partnership “does business” will also impose taxes on the business activities performed in that state, so it often makes sense to organize in the same state in which the Partnership will conduct business.

All Partnership finances and transactions must be kept separate from personal finances; a separate bank account for the Partnership should pay all expenses and payouts.

Most state governments require filing of an annual report with basic information.

In accordance with Code section 6694, we hereby advise you that the positions set forth herein may lack substantial authority and, therefore, may be subject to penalty under Code section 6662(d) unless adequately disclosed on a IRS Form 8275.

CIRCULAR 230 DISCLOSURE

THE DISCUSSION OF TAX CONSIDERATIONS WAS NOT INTENDED OR WRITTEN TO BE USED, AND CANNOT BE USED BY ANY TAXPAYER, FOR THE PURPOSE OF AVOIDING TAX PENALTIES THAT MAY BE IMPOSED BY THE INTERNAL REVENUE SERVICE. ANY TAX ADVICE CONTAINED HEREIN WAS WRITTEN TO SUPPORT THE PROMOTION OR MARKETING OF THE TRANSACTIONS OR MATTERS ADDRESSED BY THE WRITTEN ADVICE. EACH PARTY SHOULD SEEK ADVICE BASED ON THE PARTY’S PARTICULAR CIRCUMSTANCES FROM AN INDEPENDENT TAX ADVISOR.

Please see www.RroyseLaw.com or contact Royse Law Firm, PC at rroyse@rroyselaw.com for additional information.

Follow us on Twitter

Like our Facebook Page

Visit our YouTube Channel

See us on Pinterest