Selecting a type of business entity is often the first step in the business establishment process. The choice is often dictated by the short and long term goals of the owners and the eventual operation plan for the business. The primary types of entities include:
A sole proprietorship is a legal form of a business that is owned by a single individual. This form requires no charter documents and provides great flexibility because there is no formal governance structure with which to comply. Sole Proprietorships, however, do have significant shortcomings. The biggest drawback is this legal structure does not provide the owner with any insulation from liability. The owner’s personal assets are not distinguished from the business’s assets. Accordingly, if the business incurs a liability (a debt or an adverse judgment), the owner’s personal assets (house, savings, etc.) may be in jeopardy.
A general partnership is typically formed (by default) when two or more persons enter into business together to share profits. No state filing is required. One of the benefits of this business structure is that it provides great flexibility to the owners. Partners are permitted to determine in their partnership agreement how they want to allocate profits and losses among the partners. Profits and losses can be allocated differently among partners who contribute capital, property, or services. It is important to note, however, that this flexibility is not absolute. There are limits in connection with the ability of certain partners (limited or passive) to deduct some losses. For tax purposes, partnerships are treated as “pass-through” entities—i.e. profits and losses of the partnership are passed through to the individual partners who then deduct the losses (to the extent they are permitted) and pay taxes on the income. Please also bear in mind that in a general partnership, each partner has the authority to contractually bind the partnership with third parties. Also (and perhaps most importantly), each partner is personally liable for the debts of the partnership.
A limited partnership is a form of partnership often used to raise investment capital. It requires at least one general partner, who operates the business (and is personally liable for the debts of the limited partnership) and “limited partners” who contribute capital, have no (or little) ability to manage the business’s affairs or operations, and have no personal liability beyond their investment in the partnership. Unlike a general partnership, in order to create a limited partnership, a filing must be made with the state of domicile. Like a general partnership, limited partnerships are transparent for tax purposes—the income and losses of a limited partnership are passed through to the partners. Prior to the advent of the limited liability company (discussed below), limited partnerships were the entity of choice for many (if not most) privately held financing transactions.
A C-corporation is a standard corporation. The “C” simply distinguishes it from an S-corporation (discussed below). A corporation is formed by filing articles of incorporation with the state in which it intends to be incorporated. Ownership in a corporation is evidenced by shares of stock and the owners are shareholders. It is important to note that unlike partnerships, no shareholders have any personal liability for the debts of the corporation. Taxation is significantly different for C-corporations than it is for partnerships, S-corporations or limited liability companies. First the corporation is taxed on its profits, and then the shareholders are taxed individually on any dividends they receive from the corporation—the so-called “double taxation.” Also, shareholders of a C-corporation are not permitted to deduct losses of the corporation on their personal tax returns. C-corporations are sometimes useful with (i) foreign investors looking to avoid United States taxes, (ii) structuring “loan-out” companies (primarily used by actors or other celebrities), and (iii) when the entity is seeking private equity (or sometimes venture) financing or may undertake an initial public offering. Many venture and private equity funds are precluded from investing in LLCs because their major investors are pension funds, profit sharing trusts and other tax-exempt entities that are subject to certain tax restrictions. Most large businesses operate C-corporations despite certain tax incentives available through the use of an LLC (as discussed below) because a C-corporation structure provides familiarity and well-understood and established governance laws, as well as the ability to transfer shares of stock more easily than LLC membership interests (especially public stock).
An S-corporation is identical to a C-corporation for state corporate law/governance purposes. The major difference is in the tax treatment. If the shareholders affirmatively elect to be treated as an S-corporation for tax purposes (by completing and filing Form 2553 with the IRS), then the corporation will be treated as transparent and the income and losses will flow through to the shareholders. It is important to note, however, that S-corporations have numerous drawbacks, including but not limited to the following:
An S-corporation can only have one class of stock. It is not permitted to have preferred shares, which precludes many standard equity financing structures.
S-corporations are limited to 100 shareholders.
With certain limited exceptions, all shareholders of an S-corporation must be individuals who are U.S. citizens or residents. This precludes ownership by any type of entity which limits financing options.
Limited Liability Company
Limited liability companies (“LLCs”) are a hybrid of partnerships and corporations. LLCs are formed by filing articles of organization (or a certificate of formation in Delaware) with the state in which it intends to be organized and operate under a written operating agreement (or limited liability company agreement in Delaware). An LLC is an entity owned by “members” which are legally separate from the company. In other words, the owners are not liable for the company’s debts. From both a governance structure and tax standpoint, the LLC is the most flexible entity choice (the flexibility of an LLC is discussed in more detail here). One of the few negatives aspects of LLCs is that some states (e.g. California, not Michigan) impose significant fees on them. LLCs are by far the most common type of entity for non-public companies.
Each entity structure has unique features, which should be carefully considered when deciding how to organize the business. Three important features to keep in mind are: (1) insulation from personal liability; (2) tax treatment; and (3) flexibility vis-a-vis investors. The entity selection decision is one that entrepreneurs should not make alone. It is important to consult with tax and legal advisors to weigh the various pros and cons associated with each entity type in light of each unique business situation.
Steven J. Enwright is an attorney and partner at Lippitt O’Keefe, PLLC in Birmingham, MI. Steve advises clients in a wide variety of industries on business matters including general corporate counseling, mergers and acquisitions, start-up counseling, venture capital, corporate finance, technology licensing, and a variety of contract law matters.
Contact Steve at [email protected]