From Foraging to Farming: An Overview For Starting A Small Business — Part 2

One of the first legal issues that an entrepreneur faces when starting a new business is the type of entity that should be formed to conduct the business’ operations. There are a myriad of choices available to the entrepreneur — sole proprietorships, general partnerships, limited partnerships, C Corporations, S Corporations, limited liability companies and limited liability partnerships. While the limited liability company is a relatively new type of entity and subject to some uncertainties, it is almost always the best vehicle for a new venture.

Sole Proprietorship/General Partnership

The sole proprietorship and the general partnership are the most basic business forms, and will apply unless the entrepreneur affirmatively chooses otherwise. The default vehicle for a business owned by one person is the sole proprietorship. If two or more persons go into business for profit, the default vehicle will be a general partnership. No affirmative act is required to create these vehicles, other than conducting the business. Neither of these vehicles are considered a separate legal entity, and therefore, the owner(s) remain personally liable for all of the debts and obligations of the business.

Corporation

A corporation is a separate entity, with legal existence apart from its owners, the stockholders. Corporations are a creature of state law, and are generally formed by filing an application with the state government and paying a filing fee. Corporations are managed by a group nominated by the stockholders, called the board of directors. The board of directors, in turn, delegates its operational functions to a set of corporate officers, who carry out the day-to-day affairs of the corporation.

As a general rule, an ordinary corporation, called a C Corporation, is a taxable entity that pays tax on its income. A C Corporation pays dividends out of its after-tax earnings and profits, which are then generally taxed again in the hands of stockholders when those dividends are distributed. This taxation on both the corporate and stockholder levels is referred to as “double taxation.” By contrast, a partnership benefits from “pass-through” tax treatment – it is not taxed at the entity level; rather the income “passes through” the entity, for tax purposes, and is allocated to each partner based on his or her interest in the business or some other agreed-upon basis.

The “S Corporation,” so named because it derives from Subchapter S of the Internal Revenue Code, is an exception to the general rule. Small business corporations that meet specific requirements, can qualify for and elect S Corporation status. An S Corporation files a separate tax return, but, somewhat like a partnership, does not, in general, pay tax on its income. Instead, an S Corporation’s income is allocated to its stockholders based on their respective ownership interests, who will pay personal income tax on their allocated portion of that income.

Limited Liability Company

The limited liability company, or LLC, is a more recent statutory development. Before the advent of the LLC, it was impossible to have both the “pass-through” tax status of a partnership and the full liability shield of a corporation.¹ Entrepreneurs who wanted the complete corporate shield had to pay a form of tax cost for this protection. While the S Corporation comes close to achieving the “pass-through” tax treatment of a partnership, it has never been fully satisfactory (see the discussion of tax and non-tax considerations below).

Beginning in the late 1980s, state legislatures began enacting enabling statutes permitting the creation of a new type of business entity, the LLC, designed to retain tax treatment as a partnership but obtain the complete liability shield afforded by a corporation. All fifty states and the District of Columbia have adopted LLC enabling statutes. Not surprisingly, in the last ten years, the use of the LLC as a vehicle for conducting business has exploded. It is fast becoming, if it is not already, the most common business entity in the U.S.

Analyzing the Choice of Entity

Because most entrepreneurs seek an entity that will generally shield them from personal liability for the debts of the business, the choice is almost always between a C Corporation, S Corporation or limited liability company.² There are basically two categories of considerations — tax and non-tax, and while the determination is largely tax driven, there are significant non-tax factors as well.

The reader must keep in mind that the enabling statutes governing C Corporations, S Corporations and LLCs vary from state to state, sometimes significantly. Accordingly, this article explores these considerations generally. We caution the reader that any determination will depend on, and vary with, the specific circumstances. A brief, summary comparison of the principal vehicles are set out in Figure 1.

Tax Considerations

From a tax perspective, the C Corporation is rarely the best choice for an entrepreneur starting a new business. As mentioned above, the C Corporation has the inherent, substantial tax disadvantage, as compared with an S Corporation and LLC, of having to pay an entity-level tax on its income. Since, unlike the other two, the C Corporation does not receive “pass-through” tax treatment, its owners are subject to “double taxation” on the income derived from the operations of the business. Therefore, with a C Corporation, the Owner pays a substantially larger percentage on each dollar of earnings of the business than he or she would with an S Corporation or an LLC. Figure 2 illustrates the substantial impact that double taxation will have on the net income the owner(s) of a business derive from its operations.

The greatest disadvantage of an S Corporation, relative to an LLC, is that the federal tax laws place significant pre-conditions on the ability to qualify for Subchapter S status. Failure to satisfy these pre-conditions at the time of a formation will destroy the corporation’s Subchapter S election, and result in the entity’s treatment as a C Corporation, double taxation and all. Moreover, even if the pre-conditions are initially met, there is a substantial risk that the ongoing conduct of the business could cause the inadvertent disqualification of the company for S Corporation status.

The S Corporation pre-conditions, which have been liberalized recently, are as follows:

1. Only domestic corporations actually incorporated in the United States may file a Sub-chapter S election — thus, an S Corporation is not an option for a foreign individual or entity. Moreover, the owners of an S Corporation must be cautious about accepting new shareholders, as the sale of shares to a non-U.S. citizen could inadvertently destroy the S Corporation’s status;
2. All shareholders must be individuals (with some exceptions) and either U.S. citizens or resident aliens — effectively, existing entities cannot form new ventures through S Corporations, nor can non-U.S. citizens or non-resident aliens again, Owners must pay particular vigilance to the type of new investors that come into the venture, as any corporation, partnership, LLC or other entity other than an individual will destroy the corporation’s “pass-through” tax status;
3. An S Corporation may not have more than one class of stock outstanding (again, with some exceptions) — this is one of the most difficult pre-conditions to interpret and one that is most often the cause of an inadvertent loss of “pass-through” — even if the corporation does not create an official second class of stock, differences in the distribution rights of the shareholders can create a de facto second class of stock, and debt that resembles equity too closely, such as convertible debt, will be treated as a second class as well;
4. The corporation may not have more than seventy-five shareholders — while this does not pose a problem for the vast majority of S Corporations, a business that accepts new investors could face the possibility of inadvertently losing its S Corporation status, particularly if it begins distributing shares to its employees or consultants as part of their compensation;
5. An S Corporation may not engage in the business of a specified financial institution, insurance company, a company making a Puerto Rico tax credit election, or DISC (?); and
6. An S Corporation’s status may be terminated and a special tax imposed when a corporation has both accumulated earnings and profits and passive income — S Corporations lose their tax status if the S Corporation’s passive income exceeds 25% of gross receipts for three consecutive years and the S Corporation has earnings and profits during that time.

S Corporations are also required to file a formal election to achieve their desired tax status (“pass through”). To make this election, all persons who are shareholders on the date the election is made must consent to the election.

By contrast, an LLC faces none of the above pre-conditions under the tax laws, nor does it have to make an affirmative election in order to obtain “pass-through” tax status. Accordingly, the LLC is most often the best choice for a new business, unless the owner(s) are foreign persons.³

Non-Tax Considerations

Liability. The C Corporation, S Corporation and LLC all afford its owners with a full liability shield that the sole proprietorship, general partnership and other business forms do not offer. It is important to note that, for a start-up entrepreneur, this liability shield can be illusory, as most large or sophisticated creditors, such as banks or financial institutions, will insist upon personal guarantees from the owners before extending credit, thus dismantling by agreement the liability shield for a large piece of the business’ debts. Nevertheless, the liability shield is a tremendous advantage, because it will still shield the owner from liability for debts not secured by personal guarantees, including most of its trade debts, as well as liability from litigation arising from most contracts, negligence, personal injury, etc. Moreover, as the business establishes a track record, the entrepreneur may be able to eliminate some or all personal guarantees. Further, if the entrepreneur is looking to bring in other investors, particularly passive investors, the liability shield will be essential to them, as they might not be made subject to personal guarantees.

Management. The enabling statutes for the different entities provide for different amounts of management structure. Corporate enabling statutes have detailed rules for management of the entity. Decision making powers allocated between owners and managers, and have detailed rules for resolving disputes, and governing the company. LLC enabling statutes vary from state to state, but generally provide substantially less detail on management structure as do the corporate enabling statutes. In addition, LLCs are far more flexible in terms of management structure than the corporate enabling statutes.

Corporate enabling statutes provide for centralized, hierarchical management structure, and create a dichotomy between managerial responsibilities and operational responsibilities, giving each of those functions to the board of directors and officers, respectively. There is also an inherent separation of ownership and management. On the other end of the spectrum, LLCs provide for decentralized management, and eliminate, as a default rule, the dichotomy between ownership and management and between management and operations.

Except for a few major decisions that require shareholder approval, the ultimate right and power to bind a corporation rests with the Board of Directors, functioning collectively as a whole. The Board delegates, through resolutions, much of its right and power to corporate officers. Some states afford the top executive officers some inherent rights and powers to bind the corporation, but these can be negated or limited by express Board action. A shareholder, alone, has neither the right nor power to bind the corporation. The LLC enabling statutes are much more flexible in this regard.

Ownership Interests — Corporations can have different classes of ownership interests, as can partnerships and LLCs. Within each of those classes, however, corporations cannot discriminate in the allocation of profits and losses or in governance rights — within each class, all shareholders must be treated the same. By contrast, LLCs, like partnerships, can allocate profits and losses in a variety of ways, and can bifurcate profit interests and governance interests. As a matter of state law, partnerships and LLCs can flexibly allocate profits and losses among their owners, that is, under an agreement of partners or members, the entity can allocate profits and losses in a way that deviates from normal or past profit or loss percentages or that is out of proportion to the owners’ respective capital interests. This flexibility has an advantage in allowing the entity to vary profits according to individual productivity, and it can also have considerable tax advantages.⁴ Corporations do not have this flexibility.

Exit Mechanisms — Corporations generally do not have the right to “put” their shares to the corporation (to require the corporation to purchase those shares). LLC members, like partners, almost always have the power to withdraw. In most states, the withdrawing members are entitled to receive the fair value of the membership interest within a reasonable time after withdrawal (always absent an express agreement to the contrary). Some states provide for smaller pay-outs.

Regardless of the vehicle, whenever there is more than one owner, they should have a written stockholder or member agreement, as applicable, that outlines the rights and obligations of each owner and provides for an orderly exit should the owners so fundamentally disagree that they can no longer carry on the business together. This topic exceeds the scope of this article, but it is one of the most neglected legal issue facing a new business and often leads to costly litigation that could have been avoided by facing potentially thorny issues at the outset of the relationship, rather than at the time of dispute.

Overall Conclusions

The tax treatment of a limited liability company is always as good as, and frequently better than, the tax treatment of an S Corporation. Moreover, the S Corporation, unlike the LLC, has a number of limitations on the type of business that may be conducted, the amount of passive income that may be earned, the capital structure of the corporation, and the flexibility in allocating profits and losses. Moreover, an S Corporation faces the risk of inadvertent loss of its “pass-through” tax status during the course of its operations. Perhaps the S Corporation’s only advantage is that it generally will not go out of existence unexpectedly, whereas an LLC must pay special attention to the possibility of an involuntary termination of the entity’s existence. Because of certain exceptions to the S Corporation’s “pass-through” tax status, LLCs have a slight but clear advantage over S Corporations.