Choosing the Correct Business Entity: The Basics

by Cooley LLP
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This article briefly introduces each of the principal business forms, namely corporations, partnerships, LLCs and sole proprietorships.

You can also check out the chart in our Comparison of C corp, S corp and LLC Entity Types for quick reference.

Special forms, including benefit corporations and other “hybrid” entity types will be the subject of future articles.

Your chosen entity will guide business decisions, tax efficiencies and ability to scale

By carefully considering the forms of business entity that are available and then intelligently choosing an appropriate one, you can reduce exposure to liabilities, save taxes and launch the business in a form capable of being financed and conducted efficiently.  In addition, formalizing the business helps prevent misunderstandings among the participants by defining their ownership, roles and duties in the business.

Protect your personal assets and minimize your tax liabilities

The primary considerations in the choice of business entity will be how to protect your personal assets from liabilities of the business; tax strategies such as maximizing the tax benefits of startup losses, avoiding double (or even triple) layers of taxation, and converting ordinary income into long term capital gain, which is taxed at lower rates; selecting an entity that will be attractive to potential investors and lenders; availability of attractive equity incentives for employees and other service providers; and cost (startup and ongoing).

The principal forms of business entities: C-Corps, S-Corps, Partnerships, LLCs

A business may be conducted as:

  1. a corporation (including the S Corporation which has special flow-through tax attributes);
  2. a  general or limited partnership;
  3. a limited liability company (“LLC”); or
  4. a sole proprietorship.

Each state has its own laws under which businesses may organize and operate.  A corporation is a distinct legal entity owned by its stockholders and managed by a board of directors.  A partnership is a separate entity for some purposes but for other purposes is treated as a group of individual partners; it does not pay taxes upon its activities; instead, taxes upon its activities are paid by its partners based upon their respective interests in its profits.  The LLC attempts to combine the best attributes of the corporation and the partnership.  If properly structured, the LLC is taxed the same as a partnership.  A sole proprietorship is a business owned by one person and has little legal significance separate from its owner.  Nevertheless, the sole proprietorship is probably the most prevalent form of business because of the large number of family businesses in the United States.

Most large business organizations operate as corporations, despite the tax incentives to utilize the partnership or LLC form of doing business.  The principal attractions to the corporate form are the limited liability it provides to its stockholders, its familiarity and well-understood governance laws and the ability to transfer corporate stock more easily than partnership or LLC interests (particularly in the public securities markets).  Many venture capital and other investment funds are unable to invest in partnerships and LLCs because their major investors are pension and profit sharing trusts and other tax-exempt entities that are subject to certain tax restrictions.  The corporation is also the most familiar business entity and is governed by the most highly developed laws.  However, partnerships, proprietorships and, increasingly, LLCs are also widely used for smaller businesses and where tax and other considerations warrant.

Making the Selection Among the C Corporation, S Corporation, Partnership and Limited Liability Company.

The two most critical factors in selecting the form of business entity are (i) who the owners of the business will be and (ii) and how the earnings of the business will be returned to its owners.

Who Will Be the Owners

If a business is owned by a few individuals, any of the above entities may be the appropriate business form and factors other than who the owners are will be determinative.  The C Corporation is usually the entity of choice if the business is going to be widely held for the following reasons:

  • A corporation has unlimited life and free transferability of ownership.  Although changes in its ownership resulting from transfers of stock (by a living stockholder or upon a stockholder’s death) or the issuance of new shares (i.e. additional shares issued directly by the corporation) will affect the election of directors and therefore corporate management, the corporation’s existence is not affected.  On the other hand, free transferability of interests and unlimited life are more difficult to achieve in a partnership or LLC, and if provided for in a partnership or LLC, can adversely affect flow-through tax treatment.
  • An S Corporation is not suitable for a widely-held corporation because it can only have up to 100 stockholders all of whom must generally be individuals or eligible trusts for the benefit of individuals, and U.S. citizens or resident aliens.  In addition, certain tax exempt organizations may be eligible stockholders but will generally have to pay tax on their income from an S Corporation.
  • If the business is so widely-held that its ownership interests become publicly traded, the corporation is the entity of choice because the public markets are more receptive to offerings of corporate stock than partnership or LLC interests and because a publicly traded partnership or LLC will be taxed as a corporation (i.e. no flow-through tax treatment).
  • If ownership interests in the business are going to be provided to employees, the C Corporation will generally be the preferred entity for several reasons.  First, stock ownership is easier to explain to employees than equity interests in partnerships and LLCs.  Second, creating favorably priced equity incentives is easiest to accomplish in a C Corporation because ownership can be held through various classes of stock.  It is quite common for a corporation to issue preferred stock to investors and common stock to management and other employees.  If properly structured, the common stock can be sold at a substantial discount from the preferred stock because of the special rights and preferences of the preferred stock.  For example, the preferred stock would usually have a liquidation preference equal to the price paid for the preferred stock.  This preference amount must be paid if the corporation is sold or liquidated, before any funds can be paid to the holders of the common stock.  The preferred stock would be convertible into common stock at the option of the holder and conversion would ordinarily occur in an upside situation where the company is successful and goes public or is sold.  Finally, the tax law provides for special “incentive” stock options where the option holder generally incurs no tax until the shares purchased on exercise of the options are sold.  The gain that is ultimately recognized is taxed at the more favorable long term capital gain rates rather than as ordinary income.  Incentive stock options are only available for corporations, not partnerships or LLCs.  In the case of options that do not qualify as incentive stock options, the option holder recognizes ordinary income when the option is exercised in the amount of the difference between the exercise price of the option and the fair market value of the underlying stock as of the time the option is exercised.
  • If the business raises capital from a venture capital fund, the business will usually be formed as a corporation because most venture capital funds raise money from tax exempt entities such as pension and profit sharing trusts, universities and other charitable organizations and these entities would incur taxable unrelated business taxable income if the venture fund invested in a flow-through entity such as a partnership or LLC.

How Does the Business Expect to Return Its Profits to Its Owners?

A business can either distribute earnings currently to its owners or accumulate and reinvest the earnings with the goal of increasing the value of the business so that the business can either be taken public (so that the owners’ equity can be sold in a stock market) or sold to another business for cash or marketable stock of the acquiring business.  Current earnings are taxed as ordinary income whereas the gain on the sale of stock is taxed at the more favorable long term capital gain rates.

A tax flow-through entity such as a partnership, LLC or S Corporation is the entity of choice for a business that intends to distribute earnings currently so that the earnings can be distributed without incurring a second level of tax.  If a C Corporation is used, earnings can be paid out without a second level of tax only if paid as salary or other reasonable compensation to stockholders who work for the business (because such compensation would be deductible by the corporation against its taxable income) thereby eliminating the corporate level tax on the earnings so distributed).  On the other hand, distributions of earnings by a corporation to its stockholders other than as compensation for services will not be deductible by the corporation and will be taxed as ordinary dividend income to its stockholders.  Most small businesses which are not expected to grow into public companies and which have owners who do not work for the business (and therefore cannot receive tax deductible compensation) but who desire the distribution of the earnings of the business currently, have a strong incentive to use a tax flow-through entity such as an S Corporation, partnership or LLC.

The income tax taw provides an additional incentive to organize as a C Corporation for the business that seeks to build long term value rather than the current distribution of earnings.  Stock of a C Corporation (but no other business entity including an S Corporation) that qualifies as a Small Business Corporation (“SBC”) and which is held for at least five years, is generally eligible for a 50% capital gain deduction which reduces the effective tax rate to approximately 14% (taxpayers subject to the alternative minimum tax may incur a rate as high as 14.98%).  More importantly, if proceeds from the sale of stock of an SBC are reinvested in stock of another SBC within 60 days, tax on the gain is generally deferred.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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