BEYOND THE BAR

Reprinted from “Business Transactions Solutions” ©Thomson Reuters 2012, “Business Business
Counselor's Law & Compliance Practice Manual” ©Thomson Reuters 2012 and “Organizational
Management and Administration: A Guide for Managers and Professionals” ©Thomson Reuters
2011. To purchase any of these products please visit http://store.westlaw.com
or call 1-800-328-9352
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This form is intended to provide a proper organizational form for the new or recently created business. It is intended to encourage business principals to consider the goals and objectives of the business as well as the legal characteristics of each type of business entity. Counsel must be able to look beyond the immediate needs of the principals to the changing requirements of the business as it grows and matures. Tax and non-tax factors are to be considered in the decision.
I . Preliminary Considerations
A . General Client Information
Has the following information been collected regarding each of the principals who are to be involved in the proposed venture:

Name and address;

Present business occupation;

Business background and experience;

Marital status and related agreements;

Estate planning arrangements;

Financial information.
B . General Information Regarding Proposed Business
Has the following information been collected regarding the proposed business:

Description of the proposed product(s) or service(s);

Inventions involved in the proposed business;

Present or proposed management structure for the business;

Production and distribution plans;

Market conditions;

Potential liabilities associated with the proposed business.
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C . Client's Business and Personal Objectives
What are the client's business and personal objectives with respect to the proposed business activities?
D . Capitalization
How will the capital necessary for formation and operation of the business be obtained? Consider the personal assets of the proposed owners and outside sources of capital, including passive investors and commercial lenders.
E . Compensation and Profit Distribution
How will the revenues from the business be distributed among the owners and employees?
F . Non-Tax Business Organizations
Has the client been advised of the various non-tax forms of business organization?
□ Yes
□ No
G . Organizational Forms for Tax Purposes
Has the client been advised of the various forms of business organization which are recognized under the tax laws?
□ Yes
□ No
II . Legal Considerations
Are there any legal limitations on the choice of business form?
□ Yes
□ No
III . Non-Tax Considerations
A . Advantages of Non-Corporate Entities
Has the client been advised of the non-tax advantages of conducting business in one of the noncorporate forms of business organization?
□ Yes
□ No
B . Disadvantages of Non-Corporate Entities
Has the client been advised of the possible non-tax disadvantages of conducting business in one of the non-corporate forms of business organization?
□ Yes
□ No
C . Advantages and Disadvantages of Corporate Entities
Has the client been advised of the possible non-tax advantages and disadvantages of conducting business in the corporate form?
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□ Yes
□ No
D . Liabilities Associated with Business Activities
Are there concerns regarding the possibility that the activities of the business will result in personal liability to the owners in excess of the amounts actually contributed to the business?
□ Yes
□ No
E . Capital Requirements
Is it likely that the venture will require outside financing in the near future?
□ Yes
□ No
F . Centralized Management
Is centralized management of the business desired?
□ Yes
□ No
G . Utility of Ownership Interests
How effective are ownership interests in the entity in recruiting key employees and achieving liquidity for the holder?
H . Continuity of Life
Is continuity of life desirable?
□ Yes
□ No
I . Administrative Complexity and Expense
Has the client considered the administrative complexity and expense associated with each of the organizational forms?
□ Yes
□ No
J . Hybrid Forms of Organization
Would a hybrid form of organization satisfy the needs of the client?
□ Yes
□ No
K . State of Organization
Assuming selection of an appropriate form of business organization, should the clients organize the entity in a state other than the state in which they reside and/or the principal activities of the business are to be conducted?
□ Yes
□ No
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IV . Tax Considerations
A . Advantages and Disadvantages of Non-Corporate Entities
Has the client been advised of the various tax advantages and disadvantages of conducting business in one of the non-corporate forms of business organization?
□ Yes
□ No
B . Advantages of Using the Corporate Form
Has the client been advised of the various tax advantages of conducting business in the corporate form?
□ Yes
□ No
C . Losses
Will the venture generate tax losses in early years?
□ Yes
□ No
D . Taxation of Income
Should income be taxed to the participants or should it be taxed to a separate entity? If the latter, how is the double taxation problem to be minimized?
E . Compensation Arrangements
What effect will the choice of entity for tax purposes have on the ability of the business to select and structure appropriate compensation arrangements for its owners and employees?
NOTES :
Selecting the proper organizational form for the business requires a keen understanding of the goals and objectives of the principals, as well as a thorough knowledge of all of the legal characteristics of each type of business entity. Counsel must be able to look beyond the immediate needs of the principals to the changing requirements of the business as it grows and matures.
While there is no established strategy or process for selecting the proper business form, it may be useful to consider the following matters in this order:
1. Are there any non-tax factors which would require utilizing the corporate form?

The need or desire for limited liability may dictate the use of a corporation, as may the restrictions imposed by law on the use of partnerships, limited liability companies, or other non-corporate entities to conduct certain business activities.
2. Will the business generate losses during the early years of operation which makes it desirable that one of the forms of “passthrough” entities be used?

If the business will have losses during the early years, consideration must be given as to whether it will be more beneficial to the owners to recognize those losses on their personal tax returns, in which case it may be preferable to use the proprietorship, partnership, limited liability company, or
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S form of corporation, or to allow the losses to accumulate in a C corporation to offset anticipated income in later years.
 If “passthrough” is preferred, the desire for special allocations must be considered in choosing between a partnership or limited liability company on the one hand and a S corporation on the other hand.
3. Are there any special tax-planning considerations which must be taken into account?

If one or more of the owners may be looking to transfer their interests in the business for estate planning purposes during the course of the business, this may dictate the choice of business entity.
The desire to offer employees certain benefits may be an important factor in selecting the business form.
4. Are there any special non-tax considerations which must be considered when no clear choice has emerged from the balance of the above-referenced factors?

In cases where the preferred entity from a non-tax perspective is different than the choice for tax purposes, it may useful to refer to some of the minor non-tax factors, such as administrative convenience and complexity.
I. Preliminary Considerations
The process of selecting the appropriate form of business entity begins with the collection of certain information about the client(s) and the proposed business activities. Thereafter, counsel should take the time to carefully explain to the client the various organization alternatives which may be available.
A. General Client Information
The general information should, among other things, provide counsel with some sense of the business successes and experiences of each of the principles. In addition, counsel should be aware of any antenuptial or property settlement agreements, as well as existing trusts (inter vivos and/or testamentary).
Finally, if the client contemplates specific testamentary dispositions of his/her assets, this may be a material factor in structuring the various agreements among the owners.
Financial information may take the form of a balance sheet and/or income statement, as well as tax returns for the several years leading up to the formation of the new business. Counsel will need to be aware of the following:

Assets/business related;


Assets/personal/retirement provisions;
Assets/anticipated;
Income/sources;

Liabilities/business/long and short term;

Liabilities/personal/long and short term;

Insurance coverage/business;

Insurance coverage/personal;

Lawsuits pending and contemplated; and

Credit/outstanding/available.
With the increasing popularity of the limited liability company, one of the main non-tax distinctions (i.e., limits on personal liability of owners) between the use of a corporation and a non-corporate entity is becoming less important. As a result, the choice of entity question often comes down a choice between recognizing losses and other tax items on individual returns, as will occur if a partnership or limited liability
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company is selected, and accumulating the losses in the entity, as will occur if a C corporation is selected.
The choice will depend upon a variety of factors, not the least of which is the individual tax situations of each of the owners. The preferences of “high” and “low” tax bracket owners may be quite different and it may be necessary to run projections of the after-tax return on investment based on different types of scenarios in order to make the proper choice. The utility of such projections largely depends on the type of information collected at the outset of the selection process (see also Item 3 below regarding projections for the proposed business).
B. General Information Regarding Proposed Business
In some cases, much of this information can be gathered from the client's own business plan, which may have been prepared for use in attracting investors and/or commercial lenders. Specific questions may include:

If there are most than one product or service, or more than one functional activity (e.g., development and manufacturing) can they be segregated for purposes of multiple entities?

Who will be the ultimate decision makers in the business and, if there are to be more than one, how will decisions be reached?

How and where will the product be manufactured?

How and where will the product be distributed?

What regulations and/or liability theories apply to the proposed business activities?
C. Client's Business and Personal Objectives
Among the matters to be considered are the following:

Sales projections;

Growth in product lines;

Continuation of the business (i.e., succession);

Termination of the business;

Tax and estate planning considerations (e.g., testamentary disposition);

Marital control; and

Liquidity of investment.
D. Capitalization
Obviously, it is important to consider how the client(s) intend(s) to finance business operations. Counsel must determine if there are present assets earmarked for use in the business, and whether those assets will come from the owners or from other sources. Beyond that, sources for future capital infusions must be considered, including:

Additional personal assets;

Assets from family members and associates;

Commercial lenders;

Professional investors (e.g. venture capitalists); and

Public offerings.
It is also important to consider the contemplated effects that capital raising strategies might have on management control and return on investment.
E. Compensation and Profit Distribution
The client should have some sense of the timing and amount of profits from the proposed business, as well as the amounts that will be needed in order to recruit and properly compensate the employees necessary for the success of the business. Counsel should discuss with the client the types of fringe benefits that might be offered to employees, including bonus and pension plans and equity interests in the entity itself. Another important problem is balancing the compensation requirements for employees with the desire of the owners to take profits out of the business as return on their investment.
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F. Non-Tax Business Organizations
For many years, the basic business organizational forms from the non-tax perspective were the sole proprietorship, the partnership, which can be further classified into general or limited partnerships, and the corporation, including the regular corporation, statutory close corporations, and professional corporations.
Recently, however, the limited liability company has received a good deal of attention as an alternative form of business entity which offers both limited liability and many of the tax advantages associated with partnerships. In some cases, counsel may consider other organizational forms, such as the business trust or joint venture. Moreover, two or more of the forms may be combined to operate a business, such as a limited partnership with a corporation serving as the general partner.
G. Organizational Forms for Tax Purposes
The basic business organizational forms from the federal income tax perspective include:

The sole proprietorship, which is taxed in the same manner as the individual who actually owns and operates the proprietorship business;

The partnership, which is generally taxed in the same manner whether it is a general or a limited partnership for non-tax purposes;

The corporation which has not elected to be treated as a so-called S corporation for tax purposes; and

The corporation which has made an election to be treated as a S corporation, thereby gaining some of the advantages of being treated as a partnership for tax purposes.
In most cases, a limited liability company will be treated as a partnership for tax purposes, provided that it meets the tax law definition of a “partnership.”
While, in most cases, counsel will have a fairly free hand in selecting among the various “tax forms” when the business has not yet been formed, there may be situations where one of the possible choices is precluded due to certain factors outside of his/her control. For example, an S corporation may not have more than 75 stockholders (35 stockholders for tax years beginning prior to 1/1/97), all of whom must be individuals, estates, or certain types of trusts, and must be US citizens or resident aliens, and it cannot be used for banking.
II. Legal Considerations
The first step in selecting the business entity is to consider whether there are any laws and regulation which, in effect, restrict or mandate the use of a particular type of organization. For example, most states require that banks be operated as corporations organized as banks under applicable state or federal law.
Similarly, many states require certain types of insurance companies to be incorporated. Also, as a general matter, professions such as medicine, law and dentistry may not be practiced through regular corporations.
III. Non-Tax Considerations
From a non-tax perspective, each of the various business organizational forms are generally distinguished by reference to the following non-tax characteristics:

Centralized management and control, which refers to the ability of the principals to limit management participation to a small group of owners and agents;

Limitation of owners' liability to the assets contributed to the enterprise;

Free transferability of ownership interests; and

Continuity of life with respect to the enterprise following specified events, including the death, withdrawal or retirement of any of the business owners.
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Particularly with the growing popularity of the limited liability company, many of the historic non-tax distinctions among the various organizational forms have become much less important. Moreover, special statutory provisions often will allow the owners of one form of entity to avail themselves of many of the non-tax advantages of another form of entity. For example, shareholders of a closely-held corporation may, if permitted under applicable state corporations law, elect to be governed as a “statutory close corporation” and manage their affairs under a shareholders' agreement without delegating any authority to a board of directors.
A. Advantages of Non-Corporate Entities
Many clients are familiar with the “corporation,” even if they have never actually participated actively in the operation and management of a corporation. It is, therefore, important for counsel to spend a few moments familiarizing the clients with some of the various non-corporate entities in order to see if there are characteristics and advantages associated with any of those entities which the client wishes to have integrated into its organizational and operational documents.
The main advantage to a sole proprietorship is its simplicity. A sole proprietorship can be organized informally and is subject to minimal regulation. The proprietor, who is an individual, owns or leases all of the assets that are used in the business, and has absolute control over the management of the business and retains all of the profits which may be generated out of the activities of the business. Partnerships offer a good deal of flexibility, since partnership statutes generally allow the partners to enter into separate partnership agreements which permit them to fashion their relationship in a manner which suits their specific needs, including allocating responsibilities for the management of the partnership business and dividing profits from the business in a manner which differs from the proportional contributions of the owners to the partnership capital. Limited liability companies may well provide even greater flexibility, since they permit the owners to choose between member-management, like a general partnership, or manager-management, like a corporation, without sacrificing limited liability for each of the ownermembers.
B. Disadvantages of Non-Corporate Entities
The advantages of operating outside the corporate form always must be considered in light of some of the drawbacks with each of the non-corporate entities. For example, one of the main disadvantages associated with the sole proprietorship and general partnership forms is that they each afford no limitation on the liability of the owners. Thus, the owners are personally liable for all the debts, obligations and liabilities of the business. General partners have additional concerns regarding liability, since they are exposed to liability for the actions of the other partners under the agency principles underlying partnership law. The limited partnership form does solve the liability problem for certain investors; however, the price that they must pay includes a substantial reduction in the role they can play with respect to management of the business in comparison to shareholders in a corporation. Limited liability companies have, as the name of the entity implies, solved these liability problems; however, the law in this area is still evolving, and there are still issues to be settled regarding the types of businesses limited liability companies will be permitted to conduct (e.g., professions).
C. Advantages and Disadvantages of Corporate Entities
As noted above, corporations are, perhaps, the most well-known form of business organization, and principals conducting a business as a corporation will benefit from the extensive amount of statutory and case law relating to the formation and operation of corporations and the relationships among shareholderowners.

A corporation has centralized management in that the decision-making authority is vested in a board of directors, whose members are elected by the shareholders.

The directors select officers and other agents to assume responsibility for the day-to-day operations of the business.

Shareholders may also be directors and officers of the corporation, although shareholders are free to recruit independent managers.
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
Assuming compliance with statutory formalities, shareholders enjoy limited liability with respect to the debts and obligations of the corporation, even if they participate in the management of the corporation as directors and officers (although, as discussed below, in practice this may not be significant).

Ownership interests are freely transferable, although the shareholders of a closely held corporation may place reasonable restrictions on share transfers.

Corporations have perpetual lives and, therefore, the death or withdrawal of one or more shareholders will not cause the termination of the corporation.
The main disadvantages associated with operating the business in the corporate form are the formalities that must be attended to in order to form and operate a corporation, as well as the relative inflexibility of the capital structure.

In order to form a corporation, the principals must prepare and file a number of documents, and often must pay substantial fees as a condition to receipt of the corporate charter.

The profits from the corporation's business generally must be shared pro-rata based on the number of shares owned by each shareholder, with shares being issued in relation to the capital that is actually contributed by each shareholder.
In contrast, partners and members of a limited liability company have greater freedom in allocating profits and distributions among the owners. This “problem” may, however, be overcome through the use of two or more classes of shares and the clever use of bonus and incentive plans in the case where shareholders are also active in the conduct of the business.
D. Liabilities Associated With Business Activities
As noted above, sole proprietors and general partners may be liable for obligations and debts of the business. In contrast, limited partners, members of a limited liability company and corporate shareholders generally will not be liable for business obligations, although the limited liability of limited partners is conditioned upon their refraining from participating in the management of the business. However, in cases where corporate shareholders are required to deliver personal guarantees in order to secure financing for the business, the limited liability offered by the corporate form is of little true value. It should also be remembered that some business risks may be covered by insurance regardless of the form of entity that is used.
E. Capital Requirements
While corporations are generally considered to be the preferred vehicle for raising capital from the general public, partnerships can be structured in a manner that allows for a good deal of flexibility in allocating the interests of participants in the profits of the underlying business. Also, the partnership form may allow for distributions which could not be made under corporate statutes relating to dividends and similar payments. The creditworthiness of a sole proprietorship or a general partnership generally depends upon the net worth of the owners. In contrast, lenders to corporations tend to look to the assets of the entity, although personal guarantees from shareholders are often required in the small business context. It is not yet clear how effective a limited liability company structure will be as a capital raising vehicle, since investors are still awaiting the development of case law relating to operation of a limited liability company and the duties of managers to investors in a limited liability company; however, limited liability companies are quickly challenging limited partnerships as the preferred form of entity for certain investment-oriented activities, such as real estate.
F. Centralized Management
Both limited partnerships and corporations generally evidence centralization of management and control.
Limited partnerships are managed by the general partners and the limited partner investors may not participate in management and control. The corporation is managed by the directors chosen by the shareholders; however, in the close corporation setting, shareholder agreements may be used to permit
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shareholders to participate directly in management. A general partnership usually evidences decentralized management, due to the ability of each of the partners to bind the partnership on agency theories. However, the partnership agreement may attempt to create a centralized management structure by appointing a managing partner or management committee, although such an agreement does not necessarily eliminate the authority of the other partners to bind the partnership. Limited liability companies may, depending on the applicable statute, be organized in a manner which affords centralized management.
G. Utility of Ownership Interests
There are material differences associated with the utility of the ownership interests of each entities with respect to such things as providing incentives to key employees and allowing the owner to realize all or a portion of the value associated with his/her ownership interest. It is important to remember that the transfer of a sole proprietorship requires a transfer of all the individual assets of the business. General partnership interests generally cannot be transferred without causing the partnership to dissolve. In theory, limited partnership interests and shares of a corporation are the easiest forms of ownership interest to transfer; however, restrictions on transfer are usually imposed in the small business setting.
Counsel needs to consider the following issues.
1. Do the principles contemplate the need to award ownership interests in the business to key employees to attract and retain them? If so, then corporations and, perhaps, limited liability companies, are the most desirable choices.
2. Will the client need to borrow on the strength of his/her interest in the business? As a general rule, corporate shares are considered to be the most acceptable form of collateral by most lenders.
3. Is the client interested in having certain persons (e.g., family members) share in the profits of the business without allowing them to participate in management of the business. This may be accomplished in a variety of ways, such as non-voting corporate shares, limited partnership interests, or a separate class of membership interests in a limited liability company.
4. Will differences in the outside income of the owners dictate special provisions regarding distributions to the owners? For example, while it is relatively difficult to vary the timing and amount of dividends among shareholders, partnerships and limited liability companies provide opportunities to tailor the allocation of income and distributions to the needs of each of the owners.
H. Continuity of Life
A sole proprietorship terminates upon the death or other withdrawal of the proprietor. Death or withdrawal of a general partner may lead to dissolution of a partnership, although in most cases the remaining partners may be permitted to carry on with the business of the partnership and settle the interest of the deceased or withdrawn partner. Corporations have perpetual life and the death or withdrawal of a shareholder does not, at least as a matter of law, have any effect upon the existence of the corporation.
Limited liability companies also generally will offer substantial continuity of life, although most operating agreements are drafted with a definite term.
I. Administrative Complexity and Expense
There may a good deal of variation in the administrative complexity and expense associated with the choice and use of a particular form of business entity. As a general rule, sole proprietorships and general partnerships are generally the easiest forms of business entity to create and operate, while limited partnerships, limited liability companies, and corporations require compliance with a number of statutory requirements. However, general partnerships may require complex partnership agreements and each business form requires adequate accounting and financial reporting records.
Formation and maintenance costs are a function of a number of variables, including the amount of professional services needed to form the enterprise and document the contractual agreements among the
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participants, the degree of federal and state regulation of the enterprise and the need to use other professionals, such as accountants and investment bankers, in connection with the operation of the enterprise. In turn, the aforementioned variables are dependent upon the needs and objectives of the various participants. Thus, for example, the desire to have detailed periodic financial reports will necessarily increase the accounting costs associated with the enterprise. Also, complex outside financing arrangements may require the services of an investment banking firm, including the significant commissions associated with such an engagement.
J. Hybrid Forms of Organization
The participants are not necessarily limited to a single organizational form. For example, there may be situations where certain elements of the business should be separated, perhaps because of the disparate functional skills associated with the activity or the degree of potential liability. A decision might be made to separate manufacturing and sales activities into two corporations. Similarly, research and development activities might be conducted through the use of a limited partnership which provides tax benefits to outside investors while separating them from participation in the other activities of the business. A separate entity might also be formed to handle activities associated with a specific product line or to gain access to benefits for businesses organized in specific localities.
The decision to use multiple entities must be balanced against the added complexities and other possible disadvantages. For example, multiple business entities can significantly increase administrative costs and create inefficiencies in production and marketing activities. The participants may be unable to use consolidated tax returns, thereby eliminating the ability to use the losses from one venture to offset the profits from another. Additional formalities must be observed when two or more entities are utilized, including the need for multiple qualifications in various states.
K. State of Organization
The choice of entity also requires selection of the state in which the entity will be formed and organized. In the case of many closely held businesses, the state of organization will be the state in which the principles reside. This makes a good deal of sense in that counsel should presumably be aware of how the various statutes and case law precedents with respect to the form of business entity will impact the business to be conducted by the clients. It is possible, however, for the business entity to be formed and operated under the laws of another state, such as when the principals decide to incorporate a new corporation under the corporate laws of Delaware in order to gain the benefits of some perceived advantage in Delaware law relating to governance of the corporation which might not be available under the laws of the state in which the principals reside. Counsel should always caution the principals that the choice of another situs for the formation and organization of the business entity may not always be effective in avoiding the application of local laws, and may also result in added expense due to the costs of operating as a foreign corporation and the need for local counsel in the state in which the entity is formed.
IV. Tax Considerations
The key tax planning consideration in selecting the proper organizational form emanates from the fact that income generated by corporations which do not elect to be treated as a S corporation, sometimes referred to as “C corporations,” is taxed once at the corporate level and again upon distribution to the shareholders, although at the individual tax rates applicable to the income of the recipients, while income which is generated by partnerships and S corporations is not subject to tax at the entity level and is
“passed-through” to the owners and included in their individual tax returns. In addition, the contribution of assets to the business, the transfer of ownership interests and the termination of the business will each have varying consequences to the owners from a tax perspective.
A. Advantages and Disadvantages of Non-Corporate Entities
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The discussion of tax considerations should begin with a brief exploration of the various advantages and disadvantage of each of the non-corporate entities from a tax perspective. In the course of this discussion, counsel should point out that the owners may elect to have their limited liability company treated as either a partnership or corporation for federal tax purposes. An election under the “check-thebox” Regulations will substantially reduce the uncertainties that have long occupied tax practitioners as they struggled to develop organizational and managerial structures that differed from those generally associated with corporations and partnerships.
The sole proprietorship is basically not considered an entity for tax purposes.

The profits and losses of the business are reported by the owner on Schedule C of the owner's individual tax return, and there is no separate income tax reporting requirement for the business.

The business may, however, have to file returns and reports with respect to employment related taxes.

If the business generates a loss, that loss may be used to offset other income on the owner's tax return, and any unused losses may be carried over to prior or succeeding years.
While sole proprietorships have the advantage of tax simplicity, they are denied certain tax benefits available to other forms of business. These include:


Non-qualified retirement plans;
Deferred compensation plans;

Stock option plans;

Medical and dental plans;

Accident and health plans;

Group term life insurance;

Cafeteria plans; and

Employee death benefits.
However, while a qualified retirement plan cannot be set up by a sole proprietorship, many of the same benefits can be obtained through a Keogh plan, and recent changes in the tax laws provide further relief for small businesses that are operated in the proprietorship form, given the growing number of such businesses.
The main advantages of operating a business in the partnership form, which would include limited liability companies for purposes of this discussion, are well known. These include:

A partnership is not a taxable entity, but rather a conduit through which income and loss flows directly to the partners. Thus, the double taxation problem inherent in C corporations is avoided.

Most income, deductions, credits and other tax items retain their character in the hands of the partners/members.

Depreciation on the assets of the partnership or limited liability company is deducted by the owners as depreciation.

Losses of the partnership or limited liability company may be used by the owners to offset other income (although, this is subject to certain limitations).

There is generally no recognition of gain upon formation, without regard to whether the entity is controlled by the transferor immediately after the exchange, which is a condition to nonrecognition treatment upon formation of a corporation.
There are, however, certain circumstances under which gain will be recognized. Also, upon liquidation of a partnership or limited liability company, there is gain only if the cash distributed exceeds the basis of the owner in the partnership or limited liability company. A distribution of property does not result in taxation.
Liquidation of a corporation, on the other hand, calls for a tax on whatever is distributed to the extent it exceeds the shareholder's basis in that shareholder's stock. Further, a liquidation sale by the corporation of its assets means a tax to the corporation (assuming the sale is at a profit) and then a second tax when the funds are distributed to the shareholders.
A partnership is also the most flexible of the major entities.
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
The partners or members can structure their relationship as they please, within certain limitations.

Income and losses from varying sources can be allocated in unequal amounts to the various owners, and even specific tax items can be apportioned unequally.
In a corporation the relationship is set forth in the various classes of stock issued. It is even more restricted in an S corporation, where only one class of stock is permitted, and allocations of pass-through items must be made in accordance with the pro-rata shareholdings.
One of the main disadvantages to the partnership or limited liability company is that owners will be taxed on their share of income even if the entity does not distribute funds, which may result in taxes having to be paid from assets or income from sources other than the business of the partnership or the limited liability company. Another disadvantage is that non-qualified retirement plans, deferred compensation plans, stock option plans, medical and dental plans, accident and health plans, group term life insurance, cafeteria plans, employee death benefits are not available to entities treated as partnerships. However, while a qualified retirement plan may not be adopted by a partnership or limited liability company for its owners; the owners may get the same benefit through adopting Keogh plans.
Interesting issues arise in comparing limited liability companies to S corporations. Each offer limited liability to all of the owners, regardless of whether or not they participate in the business and, in general, the purpose of the S corporation was to permit certain corporations to elect to be treated much like a partnership for tax purposes. Conducting business in the form of an S corporation avoids the problem of double taxation, and S corporations are ideal for spreading income among inactive family members, while avoiding may of the tax, legal, and operating problems that are experienced by family partnerships.
However, limited liability companies do not have the same limitations on the number or qualification of shareholders and, since limited liability companies are actually partnerships for tax purposes, they will possess the same flexibility with respect to allocations that a partnership has, while allocations from an S corporation must still be made on a pro-rata basis.
B. Advantages of Using the Corporate Form
Depending on the circumstances, operating as a corporation can lead to a smaller tax bill than if the corporation did not exist. For example, under current law, the first $50,000 of earnings can be left in the corporation to be taxed at 15%. The remainder can be drawn as salary. Depending on the other income of the taxpayer, part of that might be taxed at 15% also, with the rest going into the 28% and higher brackets. If the taxpayer has other income, leaving even more earnings in the corporation may save taxes
(although leaving too much in the corporation may result in accumulated earnings taxes being applied).
Additionally, the ability to establish deferred compensation plans, a medical plan, group term insurance, and a death benefits plan might, combined, be worth several percentage points of tax.
In situations where the business may face a problem with respect to passive losses, a C corporation may be the entity of choice. Any corporation in which more than 50% of the stock is owned by more than five individuals is not subject to the passive loss limitations. Even one with five or fewer stockholders can offset passive losses against business income (this is not true of a personal service corporation). In contrast, if the business owners have profits from other passive operations a partnership may be preferable so that the losses may be used to offset the passive income.
C. Losses
Losses and other tax items from the operation of businesses conducted as proprietorships, partnerships
(including limited liability companies) or S corporations are “passed through” to the owners for use on their individual tax returns , subject to limitations on the use of losses beyond the owner's “basis” in the ownership interest. Moreover, in general, the partnership form is preferable to the S corporation primarily because: (1) it is easier to obtain “basis” in a partnership than in a S corporation, thereby increasing the available deductions; and (2) partnerships are permitted to make special allocations of the losses and other tax items generated by the business which may not correspond to the basic allocation of profits,
14

subject t o the “substantial economic effect” test. In contrast, losses and other tax items from C corporations must be retained at the entity level and cannot be used by the shareholders on their individual tax returns. This treatment generally parallels the imposition of tax at the entity level for C corporations. C corporations may apply losses against past and future income in some cases.
D. Taxation of Income
The earnings from business operations of a sole proprietorship and a partnership (including a limited liability company) are taxed only at the owner level in the period in which the earnings occur. S corporations also allow earnings to be taxed only to the owners, although there are certain exceptions to this general rule which do not apply to proprietorships and partnerships. In contrast, the earnings from business operations of C corporations are subject to “double taxation,” once at the entity level when the earnings occur and again at the owner level when the earnings which remain after the corporate tax are distributed to the shareholders in the form of dividends. In the case of small businesses operated as C corporations, an effort can be made to minimize the effect of the double tax by paying pre-tax dollars to the employee-shareholders as salaries, thereby permitting the corporation to deduct the amounts paid prior to computation of the corporate tax. In contrast, any dividends paid are generally not deductible at the entity level.
E. Compensation Arrangements
Compensation refers to a broad number of factors, including:

Salaries;

Bonuses and options for those stakeholders actively involved in the operation of the enterprise;

Interest payments for debt holders of the enterprise;

Dividend payments for equity holders of the enterprise; and

The amounts received upon any sale or disposition of the stakeholder's interest in the enterprise.
As the amounts available for compensation are dependent upon the financial performance of the enterprise, consideration must be given to the effect of the tax laws upon the funds and resources available for compensation as well as the tax effect to the enterprise and the recipient of a particular form of distribution.
The range of benefits and compensation available for the employees of the business is generally greater in the corporate form. Certain employee benefits, such as health insurance and pension and profit-sharing arrangements, can be offered to the employees of a corporation on a tax-preferred basis. Moreover, the corporation permits the business to offer compensation in the form of ownership interests, either through stock purchases or options, without significantly impairing the ongoing management control of the business in the hands of the founders. It should be noted that use of an S corporation may limit the deductibility of certain fringe benefits. For example, medical reimbursements, disability retirement benefits, premiums on group term life insurance, and cafeteria plans paid to a stockholder holding a two percent or greater interest in the corporation are taxable to the shareholder but not deductible by the corporation.
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This chart summarizes and compares the key tax and non-tax attributes of the most popular forms of business entity for launching and operating a new business. While the principals should consult with legal counsel and accounting professionals before making a final decision on the choice of entity, a row-by-row review of this chart can be a valuable first step for educational purposes and allows the principals to make a preliminary choice of the form of entity that seems to fit best with their proposed activities. Important non-tax considerations include owner liability for debts of the business, management participation, transferability of ownership interests, administrative complexity, and continuity of interest.
On the tax side, the principals will be most interested in whether or not “pass-through” tax treatment of business income is available or advisable. Differences also exist with respect to allocations of tax items associated with the business, fringe benefits, and self-employment and social security taxes. The principals need to consider that many investors prefer a “C corporation” as their investment vehicle; however, it is possible to use another form of business entity in the early stages and convert to a C corporation as the business grows. Some of the described characteristics may vary depending on the state in which the chosen entity is incorporated or otherwise formed, and guidance regarding statespecific items should be obtained before the final selection is made.
Entity
Description
Limited Liability
Company (LLC)
S Corporation C Corporation Partnership
An LLC can only be formed by making appropriate filing with the state (see below).
Owners are called members and the LLC may be managed by the members, similar to a partnership, or by managers selected by the members, similar to a corporation. Treated as a partnership for tax purposes unless contrary election is made.
Non-tax formalities for formation are identical to C corporation (i.e., filing of articles of incorporation with the state). Assuming all the requirements for
A corporation is formed by making appropriate filing with the state (i.e., articles or certificate of incorporation). Absent
A general partnership may be formed without any governmental filing by oral or written agreement. A limited election are satisfied, shareholders are taxed instead of corporation.
Income from business subject to single level of taxation. an election by the partnership can only be shareholders be treated formed by making as S corporation, income from business appropriate filing with the state (i.e., certificate may be subject to of limited partnership). double taxation at entity Partners are taxed level and again on distribution to the shareholders. instead of partnership.
Income from business subject to single level of taxation. Limited partners have limited liability for debts of the business and income is not taxed at entity level.
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Debts
Entity
Liability for Entity
Participation in
Management
Transferability of
Interests
Limited Liability
Company (LLC)
Members have limited liability for debts of the business.
S Corporation C Corporation Partnership
Shareholders have limited liability for debts of the business.
Shareholders have limited liability for debts of the business.
General partners have unlimited liability for the debts of the business while limited partners have limited liability.
Flexibly determined by members in operation agreement. Members can participate directly in management of the business or may elect to delegate authority to one or more managers.
See C corporation.
Securities law restrictions on transfer and restrictions may also be imposed in the
Securities law restrictions on transfer and restrictions may also be imposed in the operating agreement. A member may assign shareholders agreement, if any. right to distributions, but Shareholders may also the assignee can only agree not to make any become a member if transfers that would other members consent lead to termination of S as provided in operating corporation status. agreement.
Directors and officers have responsibility for the management of the business; shareholders generally are not entitled to actively participate in management unless they are directors or officers or an election is made to operate as a statutory close corporation.
General partners have the exclusive right to manage the business; limited partners' rights are restricted to preserve limited liability.
Securities law restrictions on transfer and restrictions may also be imposed in a shareholders agreement, if any.
Securities law restrictions on transfer of limited partnership interests and restrictions may also be imposed in the partnership agreement.
A partner may assign right to distributions, but the assignee can only become a partner if other partners consent as provided in the partnership agreement.
Ability to Raise
Capital
Preferences
Among Owners
Term
Good if there is no intention to go public.
Venture capitalists are
Very limited -75 shareholders maximum
-one class of stock still unlikely to invest in non-corporate entities; however, an LLC can be easily converted into
U.S. individuals only.
C corporation to admit investors if necessary.
Best if public offering or Equity capital for venture capital funding general partnership is is planned; however, an limited to contributions
LLC can easily convert into C corporation. from the active general partners. As for limited partnerships, see LLC.
Substantial flexibility to create preferences with respect to distributions and allocations in the operating agreement; however, allocations must have “substantial economic effect.”
Determined by operating agreement.
Securities Issues Membership interests are generally considered to be securities.
Very limited due to inability to create more than one class of stock.
Perpetual.
Shares of stock are securities.
Substantial flexibility through use of various classes and series of preferred stock.
Perpetual.
Shares of stock are securities.
Substantial flexibility to create preferences with respect to distributions and allocations in the partnership agreement; however, allocations must have “substantial economic effect.”
Determined by partnership agreement.
Limited partnership interests are considered to be securities, while general partnership interests are not.
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Entity Level
Federal Income
Taxes
Entity Limited Liability
Company (LLC)
S Corporation C Corporation Partnership
No federal tax at LLC level unless LLC elects to be taxed as corporation.
Generally no tax at S corporation level; some excise taxes, and built in gains taxes may apply.
Income tax on earnings at corporate level.
No federal tax at partnership level.
Any number. At least two. Number of
Required Owners
Most states now allow an LLC to be formed with any number of members, including just one member.
No more than 75.
Eligibility
Requirements of
Owners
No restrictions. US citizens or resident individuals, certain trusts, and certain tax exempt entities.
No restrictions. No restrictions.
Entity Level State
Taxes
States often impose business and occupation tax on gross proceeds or gross income or charge a minimum annual fee to maintain good standing of the entity. Check specific requirements.
As at federal level, generally no tax at S corporation level; some states do impose a
Generally income is taxed at corporate level;
See LLC. however a number of states have eliminated corporate level tax on S corporations at lower rates than that imposed on C corporations. corporate income taxes or charge substantially reduced rates.
Tax on
Distributions of
Appreciated
Property
Special
Allocations of
Income or
Deduction
Distribution
Preferences
Generally, no tax to either LLC or member
(certain exceptions apply).
Allowed, subject to substantial economic effect rules.
Allowed.
Taxable gain on distribution passed through to shareholders.
Taxable gain to corporation and dividend to shareholders.
Not allowed
— all allocations are pro rata.
Not allowed.
Not allowed — one class of stock requirement.
Preferred stock allowed.
Generally, no tax to either partnership or partner (certain exceptions apply).
Allowed, subject to substantial economic effect rules.
Allowed.
Deductibility of
Losses by
Owners
Fiscal year
Status of
Owner/Employme nt
Members may deduct Shareholders may their shares of losses to deduct their shares of extent of basis, which losses to extent of includes LLC level debt basis, which does not
(certain other limitations include corporate level apply). debt.
Generally calendar. Generally calendar.
Not clear, but more likely treated as selfemployed.
If ownership interest is greater than 2%, then treated as selfemployed.
No deduction at shareholder level.
Partners may deduct their shares of losses to extent of basis, which includes partnership level debt (certain other limitations apply).
Generally calendar. No restrictions.
Treated as employees; therefore entitled to §
105 (accident and health) § 101 (death benefits) § 125
(cafeteria plans) § 119
(meals/lodging).
Self-employed.
Self Employment and Social
Security Taxes
Earnings generally subject to self employment taxes, except for earnings from passive investment type interests.
Social security taxes imposed on wages of employee-owners/no self employment tax on distributions.
Social security taxes imposed on wages of employee-owners/no self employment tax on distributions.
Earnings generally subject to self employment taxes, except for earnings attributable to limited partnership interests.
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Entity Limited Liability
Company (LLC)
S Corporation C Corporation Partnership
Non-Taxable
Fringe Benefits
(group health insurance, accident or health benefits, meals or lodging, cafeteria plan benefits)
Cash value of fringe benefits generally not excludable from member's income or deducible by LLC.
Option Plans,
NSO's, ISO's
Cash value of fringe benefits generally not excludable from
Deductible by corporation — not included in income of shareholder-employee's shareholder-employee. income or deductible by
Scorporation.
Employees &
LLC interests, but such options are generally more complex. ISO's not available.
ISO's commonly consultants can be granted to employees. given options to acquire NSO's may be granted to consultants and advisors.
ISO's commonly granted to employees.
NSO's may be granted to consultants and advisors.
Cash value of fringe benefits generally not excludable from partner's income or deductible by partnership.
Employees & consultants can be given options to acquire partnership interests, but such options are generally more complex. ISO's not available.
Adjustments to
Basis on Death of
Owner
Inside basis may be adjusted on death or transfer under Code §
754.
No Code § 754 adjustments to basis.
No Code § 754 adjustments to basis.
Inside basis may be adjusted on death or transfer under Code §
754.
Termination on
Transfer of
Interests
LLC terminates for tax purposes on transfer of
50% or more of capital and profits in 12 months.
No termination of entity on transfer of interests.
No termination of entity on transfer of interests.
Partnership terminates for tax purposes on transfer of 50% or more of capital and profits in
12 months.
Increase in Basis for Debt
Treatment of
Foreign Owners
Members increase outside basis by share of LLC debt.
Foreign members subject to US tax on their share of LLC's effectively connected income; branch profits tax may apply.
No increase in basis in No increase in basis in Partners increase stock for corporate level stock for corporate level outside basis by share debt. debt. of partnership debt.
Foreigners cannot be shareholders of
Scorporation.
Foreigners are subject to withholding tax on dividends from US corporation, subject to treaty rate or exemption.
Foreign partners subject to US tax on their share of partnership's effectively connected income; branch profits tax may apply.
N/A. Foreigners cannot be shareholders of S corporation.
Corporate stock is not
US situs asset for gift tax purposes.
Partnership interest maybe subject to US estate and gift taxes.
Foreign Individual
Owners
—
Transfer Taxes
Membership interest may be subject to US estate and gift taxes.
Conversion to
Another Entity
Taxes on Sale or
Liquidation
Generally may be incorporated (by conversion or otherwise) tax free
(certain exceptions apply).
Can convert to C corporation by revoking election; may be tax on converting to LLC.
Can convert to S corporation by making election (built in gains
Easily converted to LLC or generally may be incorporated tax free tax may apply to later dispositions of appreciated property).
Conversion to LLC may be taxable.
(certain exceptions apply).
One level of tax on sale of stock or assets,
One level of tax on sale of stock or assets, generally capital gain except for amount allocable to certain assets. generally capital gain on stock sale.
Potential double tax. One level of tax on sale
Corporate tax on sale of of stock or assets, assets. Shareholder level tax on sale of stock or liquidation. generally capital gain except for amount allocable to certain assets.
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Entity
Exit Strategy
Ease and
Expense of
Organization
Limited Liability
Company (LLC)
Superior for: (a) asset sales — gains subject to single tax; (b) liquidation — not a taxable event. NOTE:
Easy to convert from
LLC to C corporationdifficult to go the other way.
S Corporation
See C corporation.
Can be relatively high if many members and
Medium. preferences. Requires more tax planning.
IRC subchapter K. IRC subchapter S.
C Corporation Partnership
Superior for: (a) public offering but can start as
See LLC.
LLC and convert later
(however, may be taxable); (b) stock sale may be eligible for §
1202 treatment; (c) taxfree reorganization
(e.g., merger).
Medium, unless preferred stock in which
See LLC. case expenses can increase.
IRC subchapter C. IRC subchapter K. Governing Tax
Statute
Documents (not including purchase documents)
Certificate of Formation
Agreement; Form SS-4
(optional for single member).
See C corporation. Also or Articles of
Organization; Operating
Form 2553.
Articles or Certificate of
Incorporation; Bylaws;
Shareholder
Certificate of Limited
Partnership;
Partnership Agreement;
Agreement; Stock
Certificates; Form SS-4.
Form SS-4.
20

1. SOLE PROPRIETORSHIP
Advantages:
1. No organizational formalities.
2. Decision making is informal and owner has sole authority, subject to any delegation to agents.
3. No qualification requirements for doing business in other states.
4. Minimal reporting to governmental entities.
5. Business profits are subject to only one tax, at the individual level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
6. Losses are available on the owner's personal income tax return and can offset other income
(subject to the passive loss rules).
Disadvantages:
1. Owner has unlimited liability for obligations and liabilities of the business.
2. Death or disability of owner terminates business.
3. Sale or other transfer of business requires transfer of individual assets.
4. No opportunity to utilize equity capital contributed by persons other than the owner.
5. Business profits are taxed as income to the owner and, as a result, are subject to selfemployment tax as well as income tax.
2. GENERAL PARTNERSHIP
Advantages:
1. Multiple owners can provide a combination of individual resources and talents.
2. Minimal formalities are required for organization.
3. Decision-making may be informal, although partnership agreement is generally used to establish procedures for making decisions.
4. No qualification requirements for doing business in other states.
5. Minimal reporting to governmental entities.
6. Business profits are subject to only one tax, at the individual partner level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
7. Losses are available on the partners' personal income tax returns and can offset other income
(subject to the passive loss rules).
8. Special allocations may be made for income tax purposes.
9. Disproportionate distributions may be made to partners.
Disadvantages:
1. Partners have unlimited liability for obligations and liabilities of the business.
2. Death, disability, or withdrawal of a partner may terminate partnership, although this can usually be handled by appropriate provisions in partnership agreement.
3. All partners have the right to participate in management.
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4. All partners have broad authority to act on behalf of, and incur debts and liabilities for, the partnership.
5. Business profits are taxed as income to the individual partners and, as a result, may be subject to self-employment tax as well as income tax.
3. LIMITED PARTNERSHIP
Advantages:
1. Limited partners enjoy limited liability.
2. Only general partners participate in management so that limited partners can be equity owners without the general partners giving up control.
3. There are no limitations on the number or types of partners.
4. Existence is unaffected by the death or transfer of interest by a limited partner.
5. Business profits are subject to only one tax, at the individual partner level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
6. Losses are available on the partners' personal income tax returns and can offset other income
(subject to the “at risk” and passive loss rules).
7. Special allocations may be made for income tax purposes.
8. Disproportionate distributions may be made to partners.
Disadvantages:
1. Formalities are required for organization.
2. Qualification is required for doing business in other states.
3. Regular reporting to governmental entities is required.
4. General partners have unlimited liability for obligations and liabilities of the business.
5. Death, disability, or withdrawal of a general partner may terminate partnership.
6. Limited partners have limited ability to participate in management or decision making.
7. Business profits are taxed as income to the individual partners and, as a result, may be subject to self-employment tax as well as income tax to the extent they are allocated to general partners.
8. Transfer of interests may be subject to securities law regulation.
4. LIMITED LIABILITY COMPANY
Advantages:
1. All members enjoy limited liability.
2. No limitation on the number or types of members.
3. Centralized management is available if an LLC is manager managed.
4. Assuming LLC is taxed as a partnership (see above), business profits are subject to only one tax, at the indi-vidual member level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
5. Losses are available on the members' personal income tax returns and can offset other income
(subject to the “at risk” and passive loss rules).
6. Special allocations may be made for income tax purposes.
7. Disproportionate distributions may be made to members.
Disadvantages:
1. Formalities are required for organization and operation.
2. Qualification is required for doing business in other states.
3. Regular reporting to governmental entities is required.
4. Termination results from the death, disability, or withdrawal of a member under the laws of some states.
5. Interests are not freely transferable.
6. Business profits are taxed as income to the individual members and, as a result, may be subject to self-employment tax as well as income tax.
7. Transfer of interests may be subject to securities law regulation.
22

5. C CORPORATION
Advantages:
1. All shareholders enjoy limited liability.
2. Ownership interests are freely transferable.
3. Perpetual existence unaffected by the death of shareholders or transfer of shares.
4. Centralized management.
5. No limitation on the number or types of shareholders.
6. Flexibility of financing is available through the sale of various types of securities to many investors.
7. Tax-favored fringe benefits are available to employee-shareholders.
8. Income is taxable at corporate rates, which are for the most part for the most part lower than individual rates.
Disadvantages:
1. Formalities are required for organization and operation.
2. Qualification is required for doing business in other states.
3. Regular reporting to governmental entities is required.
4. Income is subject to double taxation.
5. Losses of business may not be deducted by individual shareholders.
6. The distribution of property by a C corporation to its shareholders is generally a taxable event for income tax purposes as to both the corporation and the shareholders. Thus, withdrawing property from a corporation can be extremely expensive from a tax standpoint.
6. S CORPORATION
Advantages:
1. All shareholders enjoy limited liability.
2. Ownership interests are freely transferable (subject to restrictions imposed by contract to preserve S corporation status).
3. Perpetual existence unaffected by the death of shareholders or transfer of shares.
4. Centralized management.
5. Business profits are subject to only one tax, at the individual shareholder level, and are not subject to double tax as would be the case if the profits were realized by a C corporation.
6. Losses are available on the shareholders' personal income tax returns and can offset other income (subject to the “at risk” and passive loss rules).
Disadvantages:
1. Formalities are required for organization and operation.
2. Qualification is required for doing business in other states.
3. Regular reporting to governmental entities is required.
4. Strict qualification rules must be met on a continuing basis, which among other things limit the number and types of shareholders.
5. The distribution of property by an S corporation to its shareholders is generally a taxable event for income tax purposes.
23

A CLIENT'S GUIDE TO SELECTING THE BUSINESS ENTITY BY [NAME OF LAW FIRM]
This Guide has been prepared by [name of law firm] for informational purposes only and does not constitute advertising, a solicitation, or legal advice. Transmission of the information contained herein is not intended to create, and receipt thereof does not constitute formation of, an attorney-client relationship.
Readers should not rely upon this information for any purpose without seeking legal advice from a licensed attorney in the reader's state. The information contained in this Guide is provided only as general information which may or may not reflect the most current legal developments; accordingly, information in this Guide is not promised or guaranteed to be correct or complete. [Name of law firm] expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this Guide.
[Address of law firm]
[Phone number of law firm]
Publication Last Update: [date of last update]
I. Introduction
One of the most important decisions in the lifecycle of any business is the choice of the business entity for the proposed enterprise. The selection of the proper form of business entity requires a careful balancing of tax and nontax considerations. In most cases, the choice will be made from among the following alternatives:

A sole proprietorship, which is relevant only in situations where there is to be a single owner of the business

General and limited partnerships
 Limited liability companies (“LLCs”)
 Various corporate forms, including general business or “close” corporations
Other alternative business forms, such as business trusts, registered limited liability partnerships, or professional corporations, are generally only useful in specialized situations; however, if one of these entities is selected for use attention will need to be paid to the specialized statutory regimes established in
[name of state] and other states. Well-known entities such as joint ventures and Subchapter S corporations are really just special cases of the four business forms listed above. For example, a joint venture may be formed and operated as a general or limited partnership or as a corporation operating under a detailed shareholders' agreement.
The process of selecting the proper form of business entity generally requires a comparison of the entities in relation to a variety of distinguishing factors as they apply to the specific business and the requirements of the owners. Although each form of business entity has its own unique legal framework and requirements as to formation and operation of the enterprise, many of the historic differences among the entities are eroding.
It is also important to remember that the choice of the business form does not itself guarantee the success of the enterprise, although the improper form may contribute to its ultimate failure. The proper
24

form should provide a means for the participants to achieve the desired results and should not unduly constrain the freedom of the participants to establish a network of contractual relationships that suit their own unique business considerations.
The sole purpose of this publication is to assist business owners and managers in understanding the distinguishing factors among the most common types of business entities and some of the differences that need to be taken into account when selecting the form of entity for a new enterprise. Although we believe that this information will be helpful, it should not be relied on as the exclusive resource in making the selection decision and readers are strongly advised to contact professional advisors before proceeding with formation and use of any of the entities described herein.
Also, please be aware that it is assumed that the selection is being made among entities formed under, and governed by, the applicable laws and regulation of the state of [name of state] . For example, any reference to the “Secretary of State” is to the [name of state] Secretary of State. State laws regarding business organizations may differ substantially and advice of local experts should always be obtained before selecting an entity that is to be organized under laws other than those of the state of [name of state] .
II. Distinguishing Factors among Business Entities
Each of the potential business entities can generally be distinguished by reference to the following issues and characteristics:
(1) The formalities and procedures involved in forming and organizing the entity;
(2) The manner in which the entity facilitates the fulfilment of the financing and credit requirements of the underlying business, either through the issuance of ownership interests or by credit arrangements based on the assets of the business and its owners;
(3) The rights of the principals to participate in management of the activities of the enterprise, as well as the ability of the principals to enter into contracts and other arrangements with outside parties;
(4) The allocation of profits and losses from the activities of the business among the principals;
(5) The extent to which the principals will be personally liable for the debts and obligations of the business;
(6) The ability of the owners to transfer their ownership interests in the enterprise without causing a disruption or termination of the business;
(7) The effect of the death, withdrawal or retirement of any of the owners on the continued existence of the business; and
(8) The income tax consequences associated with forming, operating, making distributions from, and terminating, the entity, as well as the income tax consequences of transferring an ownership interest in the business back to the entity or to another party.
III. Nontax Classification of Business Entities
A. Sole Proprietorship
The sole proprietorship, with a single owner, is clearly the simplest form of business enterprise. A sole proprietorship can be organized informally and is subject to minimal regulation. The proprietor owns all the assets used in the business, other than those that are rented from others, has absolute control over the management of the business, and retains all of the profits generated by the activities of the business.
As with any form of business organization, the proprietor may enter into agreements with employees, landlords, and lenders to compensate them with a share of profits in lieu of fixed wages, rents, or interest.
25

In addition, the proprietor must comply will all applicable permit and licensing requirements imposed under local, state, and federal laws. A proprietorship terminates upon the death or withdrawal of the proprietor or upon the sale of the underlying assets to another party.
In stark contrast to many of the other business organizations, a proprietor is liable as a principal on all the business contracts of the enterprise, including those made by employee-agents, and must bear all of the debts and obligations of the business, including liabilities for any torts committed by agents of the proprietor within the scope of their engagement, from his or her own personal assets. As such, use of a proprietorship is not generally recommended absent sufficient insurance and business activities that are highly unlikely to result in personal liability to the proprietor.
B. Partnerships
A partnership is an association of two or more persons to carry on a business for profit as co-owners.
Although specialized partnership forms have been recognized, the two basic choices are the general partnership and limited partnership. A general partnership may (but should not) be created by oral agreement, and creation of a general partnership does not require the intervention of any public agency although it is now possible to publicly specify the rights and obligations of the partners through various filings with the Secretary of State. In contrast, a limited partnership, which has two classes of partners (i.e.,
“general” and “limited”), can only be created by appropriate registration with the Secretary of State.
1. General Partnerships
General partnerships originated under the common law and consist of two or more partners, referred to as general partners, each of whom is generally actively involved in the business. Formation of a general partnership does not require the completion of any statutory formalities; it simply requires the agreement of the parties, which can be inferred from their conduct as well as from any oral or written contract. Like proprietors, general partners are subject to unlimited personal liability for the obligations of the partnership. Unless limited by agreement, each general partner is entitled to participate fully in the management of the partnership business, and general partners stand in a fiduciary relationship to one another. New general partners cannot be admitted to a partnership without the consent of the other partners, and the death, withdrawal, or retirement of any general partner will cause dissolution of the partnership, although the partners may provide by contract to continue the partnership upon the occurrence of such an event.
2. Limited Partnerships
In contrast to general partnerships, limited partnerships are a creation of statute and must therefore be organized under the statutory provisions imposed by the various states. In most cases, organization of a limited partnership requires the completion of strict statutory formalities including, in most jurisdictions, the execution and filing of a certificate of limited partnership with the appropriate state authorities. A limited partnership consists of one or more general partners and one or more nongeneral partners, referred to as limited partners. General partners of a limited partnership have the same rights of control and exposure to liability as general partners of a general partnership. On the other hand, limited partners are passive investors who contribute cash and other assets to the partnership for use by the general partners in the conduct of the business. Limited partners have few rights to exercise any degree of control over the partnership business. In turn, the liability of the limited partners is restricted to their investment in the business. The interest of a limited partner is freely transferable, and the death, withdrawal, or retirement of a limited partner has no effect upon the operation of the partnership business.
3. Partnership Laws and Agreements
The basic rules regarding the formation and operation of general and limited partnerships have been codified in various state statutes. As a general matter, these statutes with respect to general and limited partnerships are based on various model acts, such as the Revised Uniform Partnership Act,
26

the Revised Uniform Limited Partnership Act, and the Uniform Limited Partnership Act (2001).
However, a number of variations upon the model acts have been adopted in many states, and the common law remains important in determining the effect of various statutory provisions, particularly with regard to general partnerships.
Partnership statutes generally allow the partners to enter into separate partnership agreements that permit them to fashion their relationship in a manner that suits their specific needs. For example, although general partners are deemed to all be mutual agents of the partnership and the other partners and are therefore able to bind the partnership in contracts with third parties, the partnership agreement may impose restrictions on the ability of the general partners to exercise managerial control over the partnership; however, such restrictions are not effective against third parties without notice of the restrictions imposed in the agreement if the acts of the general partner are within the apparent scope of such partner's authority. Any general partner acting in violation of a restriction in the partnership agreement may be liable to the other partners for breach of contract. In addition, partners have a good deal of latitude in allocating profits and losses from the business among the partners, including the ability to depart from the proportional contributions to the capital of the business.
C. Limited Liability Companies
The LLC is a creation of state law that combines limited liability protection for all of the equity owners without sacrificing the right of any owner to participate in the management of the enterprise.
An LLC is a separate, legal entity formed by filing articles of organization with the Secretary of State. LLC statutes contemplate, but do not require, the adoption of an “operating agreement” or “regulations” to govern the operation and management of the LLC.
The members may reserve all management powers to themselves, in which case the members become mutual agents for one another in much the same way as a general partnership. Alternatively, members may opt for the decentralized management of the corporate form by delegating management powers to one or more appointed managers, and the managers will be solely responsible for contracting for debts or incurring liabilities on behalf of the entity.
Regardless of the management structure of the LLC, as a general matter, neither the members of an LLC nor its managers are liable for the debts or liabilities of the LLC. Assuming that all of the statutory requirements are satisfied, the LLC member's liability to the LLC is generally limited to the extent of any unpaid capital contributions, including any capital required to be paid in the future on conditions stated in the articles of organization.
With respect to changes in ownership and continuity of existence, LLCs tend to be similar to general partnerships. In most cases, absent a contrary provision in the operating agreement, the LLC statutes provide that unless a proposed transfer has been unanimously approved by the other members, a transferee of a member's interest cannot participate in the management of the LLC or become a member, although the transferee is entitled to receive the share of profits attributable to the transferred interest. As for the death, retirement, or other event of withdrawal of a member of an LLC, the LLC will be dissolved unless the statute provides for continuation of the business by all or some portion of the remaining members.
Although the LLC was originally an alternative to multi-owner entities such as partnerships, recent changes in LLC and tax laws have led to widespread recognition of single-member LLCs which provide limited liability for the owner-member and proprietorship tax treatment.
D. Corporate Forms of Business Organization
The corporation is the most widely used form of business organization in the United States. Several different types of corporations are recognized in [name of state] , including professional corporations and
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non-profit corporations. However, for most new businesses, the relevant choices are the general business corporation or a statutory close corporation. The commonly men tioned “S corporation,” which is discussed below, is a tax classification that may apply to either a general or close corporation.
1. Regular Business Corporations
A regular business corporation, like a limited partnership, an LLC, and all other corporate forms, is a creature of statute that is formed upon the filing of the appropriate documents with the Secretary of
State. Each state has enacted elaborate rules that govern the management and operation of a corporation, although the shareholders, who are the owners of the corporation, are free to enter into additional agreements with respect to voting rights, compensation, and transfer of ownership interests.
A corporation has centralized management in that the decision-making authority is vested in a board of directors, whose members are elected by the shareholders. In turn, the directors select officers and other agents to assume responsibility for the day-to-day operations of the business. Shareholders may also be directors and officers of the corporation, although the shareholders are free to recruit independent managers to serve in such positions.
Assuming compliance with statutory formalities, shareholders enjoy limited liability with respect to the debts and obligations of the corporation, even if they participate in the management of the corporation as directors and officers. Ownership interests are freely transferable, although the shareholders may place reasonable restrictions on share transfers. Corporations have perpetual lives and, therefore, death or withdrawal of one or more shareholders will not automatically cause the termination of the corporation.
2. Statutory Close Corporation
Shareholders seeking the limited liability offered by the corporate form while eliminating a good deal of the various procedural formalities associated with a corporation may wish to utilize the “statutory close corporation” provided for in certain jurisdictions. The characteristics of a close corporation will vary from state to state, but statutes usually require that the corporation can only have a limited number of shareholders and that the shares be subject to various restrictions upon transfer. These close corporations are created by statute and are to be distinguished from such informal terms as
“closely held” and “close” corporations, each of which refer to corporations “whose shares are not generally traded in the securities markets” but which may not have been organized under a state's specific close corporation provisions.
A statutory close corporation is usually permitted to conduct its day-to-day operations pursuant to the terms of a detailed shareholders' agreement. As a result, shareholders are able to provide for a great deal of flexibility with respect to management of the business, voting rights, restrictions on the transferability of shares and the omission of corporate formalities. The use of the statutory close corporation does carry with it a number of risks and costs:
(1) Shareholders who are given managerial responsibilities will be subject to potential personal liability associated with acting as an officer or director;
(2) The law with respect to statutory close corporations is not as developed as the law governing the general corporate form, leading to potential uncertainties with respect to the interpretation of the shareholders' agreement; and
(3) The drafting of the shareholders' agreement may be quite costly.
IV. Tax Classification of Business Entities
With the obvious exception of sole proprietorships, which are not separate tax reporting or paying entities, business entities are treated as either partnerships or corporations for tax purposes. The Internal
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Revenue Service (“IRS”) has established guidelines and regulations governing the determination of whether an entity is to be taxed as a partnership or a corporation and essentially allow an entity other than a per se corporation to choose how it will be classified for tax purposes. These rules are referred to as “check-the-box” rules and are intended to simplify the classification process. Once a classification has been chosen, an entity may change the classification (generally once every five years). However, there may be a tax consequence for such a conversion. If an entity fails to elect a particular classification, it will be classified under a default system based not on corporate characteristics by on various other factors, such as the number of members, where the organization is formed (i.e., domestic or foreign), and, for foreign entities, whether its members have limited liability.
The laws and regulations governing taxation of business organizations and their owners are quite complex and the descriptions included herein should always be supplemented by expert advice from tax specialists. The IRS and the [name of state] tax authority both distribute various publications on taxation of self-employed persons (i.e., proprietors), partnerships, corporations, and LLCs.
A. Sole Proprietorships
For income tax purposes, a sole proprietorship is not treated as a separate entity, and the profits and losses of the business activity are reported on the owner's individual income tax return by preparation and filing of a Schedule C. The owner may deduct any reasonable and necessary expenses attributable to the business operations. Amounts paid to the owner are not considered salary and cannot be deducted. The annual profit or loss of the business is taxed at the business owner's applicable rate.
B. Partnerships
For tax purposes, partnerships (general and limited) are treated as conduit or pass-through entities unless an election is made to have the partnership treated as a corporation. As such, a partnership is not a taxable entity and does not generally incur a direct tax liability with respect to its business activities.
However, the partnership must compute the amount of its gross income, gains, losses, deductions, and credits and must file an information return reporting these items. Additionally, the partnership must calculate the distributive share of each partner with respect to thes e various “tax items.” Ultimately the distributive shares of each partner must be reported on the individual income tax return of that partner, whether or not the partner actually receives any money or property from the partnership.
A partner's distributive share is generally determined by the partnership agreement. If, however, those distributive shares lack substantial economic effect, the IRS has the power to reallocate the partnership items in accordance with the partner's deemed economic interest in the partnership. Although the application of these reallocation rules is extremely complex, certain safe harbors have been established.
In addition, the ability of limited partners to use partnership losses may be affected by the passive activity limitations because, by definition, limited partners will not be materially participating in the business.
C. Limited Liability Companies
For tax purposes, multimember LLCs are taxed either as a corporation or as a partnership. Although the tax characterization of LLCs was, for some period of time, a matter that raised great controversy, much of the uncertainty has now been alleviated by the “check-the-box” regulations. Single-member LLCs are treated as proprietorships for tax purposes, unless corporate tax treatment is elected.
D. Corporations
Depending on the circumstances, shareholders of a corporation may be subject to very different income tax rules. The default rules call for corporations to be taxed as a separate entity. In that situation, the tax is imposed on the taxable income of the corporation (sometimes referred to as a “C corporation,” so named because taxation of their income is controlled by Subchapter C of the Internal Revenue Code) at the corporate tax rate. In computing taxable income, the corporation may deduct all ordinary and necessary expenses that are reasonable. However, dividend payments to the shareholders are not
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deductible. Thus, use of the corporate form may result in double taxation: once when the earnings and profits are taxed at the corporate level, and a second time when a dividend distribution is made. In many cases, this may not be a major issue for closely held corporations, because the shareholders are likely to also be employees of the corporation. Thus, revenues of the corporation can be paid out to the employee/shareholders as compensation, which is then deducted by the corporation. These payments may, however, be limited and may be examined more closely by the IRS.
It is important to remember, of course, that shareholders of a corporation may elect to have the corporation treated as a socalled “S corporation,” which will cause the business activities to be taxed as a partnership (i.e., an S corporation is regarded as a conduit entity and is not subject to an entity level tax).
Tax items associated with an S corporation are passed through to the shareholders and are reported by the shareholders on their individual income tax returns. The tax items are allocated to the shareholders based on their pro-rata shareholding in the corporation. Losses from an S corporation may be used by the shareholders to offset other income, although use of the losses is subject to the passive loss limitations under 26 U.S.C.A. § 469. Although the specific application of the passive loss limitation rules is very complex, the general rule is that passive losses cannot be used to offset nonpassive losses such as salary, wages, or income from an activity in which the taxpayer materially participates.
The ability to elect S corporation status is available only to corporations that satisfy certain criteria, including the following:

An S corporation may not have more than 100 stockholders, all of whom must be individuals, estates, or certain types of trusts, and must be US citizens or resident aliens

It must be a domestic corporation;

It cannot be used for banking;

Only one class of stock is permitted.
In light of these limitations, it is anticipated that business owners looking for both limited liability for all owners and pass-through taxation may opt for use of an LLC.
V. Advantages and Disadvantages of Various Business Entities
A. Sole Proprietorship
The main advantage to a sole proprietorship is its simplicity. Because the profits and losses of the business are reported by the owner on Schedule C of the owner's individual tax return, there is no separate income tax reporting requirement for the business. The business may, however, have to file returns and reports with respect to employment related taxes. If the business generates a loss, that loss may be used to offset other income on the owner's tax return. Any unused losses may be carried over to prior or succeeding years. However, a business that generates continued losses may be characterized as a hobby. In such instances, the owner may not be allowed to use those losses to offset other income.
The main disadvantage to a sole proprietorship is that it affords no limitation on the liability of the owner.
Thus, the owner is personally liable for all of the debts, obligations, and liabilities of the business.
Additionally, sole proprietorships are denied certain tax benefits available to other forms of business.
These include nonqualified retirement plans, deferred compensation plans, stock option plans, medical and dental plans, accident and health plans, group term life insurance, cafeteria plans, and employee death benefits. These shortcomings have slowly led to proprietors selecting a single-member LLC as their choice of entity.
B. Partnerships
1. Advantages
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There are three major advantages to operating a business in the form of a partnership. One of the advantages is that a partnership is not a taxable entity, but rather a conduit through which income and loss flows directly to the partners. Thus, the double taxation problem that is inherent in C corporations is avoided. Additionally, most income, deductions, credits, and other tax items retain their character in the hands of the partners. For example, depreciation on partnership assets can be deducted directly by the partners. Further, partnership losses may be used by the partners to offset other income (although this is subject to certain limitations).
Another major advantage of partnerships is that there is generally no recognition of gain upon formation, without regard to whether the entity is controlled by the transferor immediately after the exchange. There are, however, certain circumstances under which gain will be recognized. Also, upon liquidation of a partnership, there is gain only if the cash distributed exceeds the partner's basis in the partnership. A distribution of property does not result in taxation. Liquidation of a corporation, on the other hand, calls for a tax on whatever is distributed to the extent it exceeds the shareholder's basis in that shareholder's stock. Further, a liquidation sale by a corporation of its assets means a tax to the corporation (assuming the sale is at a profit) and then a second tax when the funds are distributed to the shareholders.
Finally, a partnership is also the most flexible of the major entities. Within certain limitations, the partners can structure their relationship as they please. Income and losses from varying sources can be allocated in unequal amounts to the various partners. Even specific tax items can be apportioned unequally. In a C corporation the relationship is set forth in the various classes of stock issued. It is even more restricted in an S corporation, where only one class of stock is permitted, and allocations of pass-through items must be made in accordance with the pro-rata shareholdings. The partners are generally free to devise their own structure and procedures for management of the business; however, limited partners in a limited partnership will be restricted as to their actual participation in management decisions.
2. Disadvantages
One of the main disadvantages to the partnership is that partners will be taxed on their share of income even if the partnership does not distribute funds, which may result in taxes having to be paid from assets or income from sources other than the partnership. Another disadvantage is that nonqualified retirement plans, deferred compensation plans, stock option plans, medical and dental plans, accident and health plans, group term life insurance, cafeteria plans, and employee death benefits are not available to partnerships. Although a qualified retirement plan may not be adopted by a partnership for its owners, the partners may get the same benefit through adopting Keogh plans.
There are also major nontax disadvantages to a partnership. The most important is that general partners are jointly and severally liable for all of the partnership debts. That liability extends not only to the value of the partner's investment in the partnership, but to all of his or her personal assets.
Although most catastrophic liabilities can be insured against by a partnership, the risks of partnership form can still be significant. This general liability feature of the partnership works to undermine the entrepreneurial spirit. However, passive investors, unwilling or unable to be involved in the day-to-day management of the business, can be given limited partner status to cap their liability at the amount of their investment in the business.
In addition, the creation of new ownership interests and the transfer of those interests within a partnership can also be quite cumbersome, thereby reducing the attractiveness of the partnership form as the entity of choice in situations where there is to be a large number of owners and/or there is a desire to issue equity interests to employees and vendors. Problems are exacerbated in the case of a limited partnership, because limited partnership interests are securities for securities law purposes and thus are subject to additional regulation.
C. Corporations
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The corporation is probably the best known and most common of the business entities. The general familiarity of all persons involved in commerce, finance and banking creates a feeling of acceptance and comfort when dealing with a corporation. For the foreseeable future —absent massive changes in federal and/or state tax laws —the corporation will remain the entity form of choice.
1. Nontax Advantages
As a general proposition (to which there are some exceptions), a corporation's shareholders have
“limited liability.” They are not personally liable for the debts of the corporation, but rather can only see their investment rendered worthless (or diminished) should the creditor pursue the corporate debtor. However, in a start-up environment, where the new corporation may have few assets and no credit history, the reality is that the founders may well find themselves asked to personally guarantee such obligations, as a building lease, bank line of credit, or supplier credit. With fiscal success of the business, such guarantees may be expected to fall away.
Corporations enjoy relative ease in raising and operating capital and in transferring the ownership interest represented by its shares. In other words, it is relatively easy to buy and sell shares of stock as compared with the sale of assets or partnership interests. However, issuances and transfers of corporate securities must be done in a manner that complies with applicable federal and state securities laws.
Corporations also offer ease of control at both the ownership level and in the management area for the majority shareholders. Voting rights depend on applicable state law. In some states, a majority of the shareholders can elect all members of the board of directors. In other states, however, cumulative voting provisions assure minority shareholders of some representations on the board. In either case though, the majority of the shares can control the board and the selection of the management team.
The shareholders, as a class, have no right to participate in the day-to-day management of a corporation as, for example, partners would in a general partnership. Moreover, in corporate form, outside investors can be issued nonvoting preferred shares so that the founders, despite a much smaller cash investment, can retain voting control.
Finally, another unique facet to the corporate form is the ability to limit the personal liability of directors with respect to actions brought by or in the right of the corporation for breach of the director's duties to the corporation and its shareholders. The scope of protection is determined by applicable state law; however, it normally does not extend to intentional misconduct, bad faith acts contrary to the corporation's best interests, transactions from which a director derives improper personal benefit, reckless disregard of a director's duties, or an unexcused pattern of inattention to one's duties as a director.
2. Tax Advantages
Operating as a corporation can lead to a smaller tax bill than if the corporation did not exist. For example, the first $50,000 of earnings can be left in the corporation to be taxed at fifteen percent
(15%), and the remainder can be drawn as salary. Depending on the other income of the taxpayer, part of that might be taxed as low as ten percent (10%), with the rest going into the fifteen percent
(15%) and higher brackets. If the taxpayer has other income, leaving even more earnings in the corporation may save taxes (although leaving too much in the corporation may result in accumulated earnings taxes being applied). Additionally, the ability to establish a deferred compensation plan, a medical plan, group term insurance, and death benefits plan might, combined, be worth several percentage points of tax. A corporate retirement plan also has several minor advantages over a
Keogh plan.
In situations where the business may face a problem with respect to passive losses, a C corporation may be the entity of choice. Any corporation in which more than fifty percent (50%) of the stock is owned by more than five (five) individuals is not subject to the passive loss limitations. Even one with
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five or fewer stockholders can offset passive losses against business income (this is not true of a personal service corporation). In contrast, if the owners have profits from other passive operations, a partnership may be preferable so that losses may be used to offset passive income.
3. Nontax Disadvantages
Corporations may be more expensive to maintain than other business forms. Costs to incorporate, exclusive of professional fees, can run to $2,500 depending on the state of incorporation. Prudence dictates that records be kept of meetings of directors and shareholders, as well as share issue and transfer records. For a start-up company, it is rare that the founders will have these skills, so they must either be purchased or deferred, with the later creating its own set of problems. Partnerships, on the other hand, require little documentation to maintain the entity.
4. Tax Disadvantages
The two major tax disadvantages to conducting a business in corporate form are double taxation and the tax imposed upon liquidation of the corporation. Although double taxation is not a very attractive proposition, in practice, most corporations are small and are merely incorporated partnerships or sole proprietorships. In these types of situations, the corporation pays no tax at all, because the earnings are taken out by the shareholders in the form of deductible salary, bonuses, or other benefits.
Dividend distributions are rarely, if ever, made so that double taxation never takes place.
The other major tax disadvantage to corporations is that the liquidation of the corporation is a taxable event to the stockholders. This is also true of mergers and consolidations that do not meet statutory requirements. Corporations may also be subject to additional rules if they become personal holding companies, if they fail to distribute earnings, if they issue preferred stock, or if they engage in many other actions covered by the Internal Revenue Code.
5. S Corporations
S corporation status may be available in certain situations, depending on the number and identity of the shareholders and their willingness to accept a relatively simple capital structure. Conducting business in the form of an S corporation avoids the problem of double taxation, because an S corporation is treated as a conduit entity in much the same way as partnerships. Therefore, an S corporation combines many of the best features of both a partnership and a corporation from a tax perspective. Limited liability is achieved through the corporate form, and the double tax of the corporate form is eliminated.
Operating the business in the form of an S corporation can be beneficial for family owned businesses.
S corporations are ideal for spreading income among inactive family members, while avoiding many of the tax, legal, and operating problems that are experienced by family partnerships. The S corporation may also be a good choice during the early years of the entity when losses are expected.
The losses may be used by shareholders to offset their other income, subject to the passive loss limitation imposed on inactive members.
S corporations also have certain disadvantages. The need to adopt a simple capital structure has already been mentioned, and the transferability of ownership interests will be limited by the need to insure that all shareholders satisfy the requirements listed in the Internal Revenue Code. Another disadvantage to S corporations is that the deductibility of certain fringe benefits is limited. Medical reimbursements, disability retirement benefits, premiums on group term life insurance, and cafeteria plans paid to a stockholder holding a two percent (2%) or greater interest in the corporation are taxable to the shareholder but not deductible by the corporation. Also, there are differences in the tax treatment of distributions to the shareholders of an S corporation that may result in the recognition of gain, where a similar distribution to partners of a partnership would not be a taxable event. Finally, an
S corporation's income is taxed to the shareholders regardless of whether the corporation distributes funds to the shareholders for use in paying the tax liability.
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D. Limited Liability Companies
In many ways, an LLC offers the best of both worlds. It is an entity that affords all of its owners the limited liability of a corporation, yet, it can be taxed as a partnership if the owners so choose. Although the concept of LLCs has been around for several decades, there has only recently been any significant interest shown in this entity. As it becomes more widespread, it is likely to be the entity of choice for small and medium-sized businesses, particularly because it is now possible for businesses formerly operated as proprietorships to secure the benefits of limited liability by organizing as single-member LLCs. In fact,
LLCs have already become attractive vehicles for real estate ventures, joint ventures, venture capital funds, and international investments.
1. Advantages of LLCs Over Corporate Forms
The fact that an LLC can be treated as a partnership for tax purposes provides it with several tax advantages over C and S corporations. Of course, because it is treated as a partnership for tax purposes, an LLC will not be subject to double taxation and the members are free to allocate income and loss under the rules applicable to partnerships. Also, an LLC that is taxed as a partnership does not generally recognize gain or loss upon liquidation. Only the members may be subject to tax on distributions received from the LLC's liquidation. In addition, a C corporation may have a portion of the salary deduction for an officer-shareholder disallowed as unreasonable compensation. Any disallowed portion would typically be treated for tax purposes as a dividend rather than as salary. In contrast, a LLC member's income is either taxed as a guaranteed payment or as the member's distributive share of LLC income.
LLCs are often compared to S corporations, because both offer limited liability and pass-through taxation. In general, LLCs offer a great deal of flexibility in relation to S corporations. For example, while S corporations are subject to certain restrictions on the number and type of shareholders they may have, as well as the number and variety of ownership interests that may be issued, LLC's are not subject to any of these restrictions. In addition, S corporations generally may not hold more than eighty percent (80%) of the total voting power and total value of another corporation's stock unless certain conditions have been satisfied with respect to wholly-owned subsidiaries. LLCs are not subject to this restriction. Furthermore, unlike LLCs, S corporations are not permitted to specially allocate income, gain, deduction, or loss among their shareholders or make disproportionate distributions to their shareholders. Finally, S corporations are subject to certain penalty taxes for builtin gains and excessive passive income that do not apply to LLCs.
On the nontax side, LLCs are attractive in that they are not subject to the same formalities as corporations, such as the requirements for calling and conducting meetings, and annually electing directors and officers. The rights, duties, privileges, and preferences of an LLC's members are usually defined in the operating agreement, which is not a publicly filed document. Although amendments to the articles of incorporation of a corporation that may adversely affect one or more classes of stock generally require approval of at least a majority of all shareholders, amendments to an LLC's operating agreement may generally be done without a separate class vote unless specifically required in the operating agreement.
2. Disadvantages of LLCs in Relation to Corporations
Although LLCs enjoy significant advantages over corporations, there are some disadvantages that need to be considered. For example, members of an LLC treated as a partnership for tax purposes will not enjoy all the advantages of the numerous fringe benefits available to shareholder-employees of a C corporation. For example, the members may not receive tax free life insurance and medical benefits; may not participate in a cafeteria plan established for the LLC's employees; and will find significant restrictions with respect to qualified retirement plans (e.g., inability to borrow from the retirement plan). Members of an LLC may also be subject to higher marginal tax rates than corresponding corporate tax rates.
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In addition, while LLCs have become much more widely known in recent years there are still practical inconveniences in using an LLC rather than a corporation for certain transactions or business activities. For example, banks are not accustomed to dealing with LLCs, and such unfamiliarity may delay or prevent the LLC from obtaining loans. There are likely to be many situations in which business promoters and investors will prefer the more formal structure and certainty of corporations over the relative uncertainty of LLCs.
3. Comparing LLCs to Partnerships
The most important distinction between LLCs and general partnerships is that the partners of a general partnership are personally liable for the debts of the general partnership whereas the members of an LLC generally have limited liability. Partners acting in the ordinary course of business may bind the general partnership. However, a member who is not acting as a manager has no power to bind a manager managed LLC in transactions with third parties. Finally, a general partner in a general partnership may cause a dissolution of the general partnership when no definite term or particular undertaking is specified. A member of an LLC does not have any such right.
The striking distinction between LLCs and limited partnerships is that while every limited partnership must have at least one general partner who is potentially liable for all the obligations of the partnership, all members of an LLC have limited liability regardless of their participation in the management of the business. Although this problem can usually be resolved through the use of a corporate general partner, this increases the organizational complexity and administrative and compliance costs. Moreover, despite changes in the California limited partnership statute that permit greater participation in management by limited partners, limited partners may jeopardize their limited liability status if they actively participate in the business of the limited partnership.
VI. Selection Process
Once the principals have a good understanding of the various alternatives available to them in the entity selection process, they should work with their professional advisors to collect and evaluate all the information necessary to make an informed decision. The legal or accounting professional will generally distribute a list of required information, including business and financial information on the proposed business and each of the principals. If possible, a business plan and detailed projections should be prepared so that proper consideration can be given to specific risks and amount and timing of profits and losses from the enterprise.
Once the information is collected, a good deal can be sorted out by asking the following basic questions:

Are there any nontax factors that would require utilizing the corporate form? These might apply when the business activities are particularly risky or the principals intended to raise significant amounts of capital from outside investors.

Will the business generate losses during the early years of operation that makes it desirable that one of the forms of “pass-through” entities (i.e., partnership or S corporation) be used?

Are there any special tax planning considerations that must be taken into account? Anticipated transfers to family members for estate planning purposes may dictate the use of a limited partnership. If flexibility with employee benefits is desired, a corporation may be the best choice of entity.

Are there any special nontax considerations that must be considered when no clear choice has emerged from the balance of the above referenced factors? Formation and administration costs are sometimes very important for very small businesses.
Even when a preliminary choice has been made based on the foregoing analysis, a variety of other issues
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must be considered, if not already taken into account. They include the following:

The participation of various types of entities, such as a corporation, a nonresident alien, or certain types of trusts, may prevent use of a S corporation, as may the number of participants.

Participants who must be actively involved in managing the business must be general partners, members, or shareholders, with the choice depending upon the need for limitations on liability from the entity itself, rather than from insurance. The degree of involvement in the business may also impact the deductibility of losses for partners under the “passive activity” rules.

Transfers of ownership interests may result in a variety of adverse tax consequences when the partnership form is used. Also, planning for the withdrawal, retirement, or death of a principal may have an impact on the form of business entity selected.

The need to reinvest profits from the operation of the business may require using a C corporation, since the “pass-through” forms will tax the profits at the ownership level, thereby necessitating some distribution of assets to meet the current tax liabilities.

If the principals are related to each other, any disproportionate relationship between the property and services contributed to the entity and the proprietary interests of the owners in the business may result in a reallocation of income between the parties if the partnership or S corporation is used.
Evaluating each of these factors requires extensive consultation with professional advisors. They can assist the principals in comparing the various alternatives, often by reference to a chart that lists how each of the entities addresses specific tax and nontax issues. Software programs are also available to create projections of the anticipated tax liabilities for the entity and each of the owners based on an assumed selection of a particular organizational form.
The participants are not necessarily limited to a single organizational form. For example, there may be situations where certain elements of the business should be separated, perhaps because of the disparate functional skills associated with the activity or the degree of potential liability. A separate entity might also be formed to handle activities associated with a specific product line or in order to gain access to benefits provided for businesses organized in specific localities. However, before two or more entities are used, consideration must be given to the added complexities, including the need to keep multiple sets of books and records.
Selection and use of any entity organized under laws other than those of the state of [name of state] is also a possibility; however, as mentioned above, this decision should not be made with consulting experts in the law of the chosen jurisdiction. For example, businesses contemplating an eventual public offering of their securities may incorporate under Delaware law because of perceived advantages of Delaware corporate law as it relates to public companies; however, certain states such as California have provisions in their corporation laws effectively override Delaware law with respect to corporations domiciled in
California until the specific conditions based on the number of shareholders and situs of business activities are satisfied.
Finally, the principals need to remember that while the initial selection of the form of business entity is important, changes in the form of entity can be made as the needs of the business and its owners evolve over the life of the enterprise. For example, [name of state] law allows for conversion of one form of entity into another with a minimum of regulatory paperwork as long as the economic interests of the owners remain essentially the same after the conversion. Also, a sole proprietorship may be converted into another entity to admit additional owners and/or limit the liability of the principals.
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