BUSINESS ORGANIZATION:
THE RIGHT STRUCTURE FOR
THE RIGHT IDEA
Presented by:
Benjamin W. Bates
Jonathan Stagg
Stoel Rives LLP
October 30, 2010
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SUMMARY OF COMMON TYPES
OF BUSINESS ORGANIZATIONS
• Organizations Formed under State Law.
–
–
–
–
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Corporation
Limited Liability Company
Limited Partnership
Note: Each of these entities generally have the benefit of
limited liability and are formed by filing a certificate with the
applicable state.
SUMMARY OF COMMON TYPES OF
BUSINESS ORGANIZATIONS (Continued)
• Organizations Created by Private Agreement or
Action
– Sole Proprietorship – merely a person with an
assumed business name.
– General Partnership – an agreement by two or more
persons to act as partners on an ongoing basis. Action
of each partner binds partnership. Withdrawal of
partner causes termination. No partners can join
without consent of all other partners.
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SUMMARY OF COMMON TYPES OF
BUSINESS ORGANIZATIONS (Continued)
– Joint Venture – an agreement by two or more persons
or entities to act as partners on a single project or
series of projects; may or may not be governed by a
written agreement.
– Note: In modern business practice, there is rarely any
reason to use any of these three forms of organizing a
business, primarily because of the absence of limited
liability.
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FACTORS THAT INFLUENCE CHOICE
OF BUSINESS FORM
• Tax consequences (e.g., certain entities, such
as C corporations, are generally less tax
efficient than other entities, such as limited
liability companies)
• Limited liability
• Ease of organization
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FACTORS THAT INFLUENCE CHOICE
OF BUSINESS FORM (Continued)
• Practical concerns and future plans (e.g.,
despite tax consequences, entities seeking
venture capital or seeking to go public
often need to be C corporations
6
TAX CONSIDERATIONS USUALLY
THE PRIMARY DRIVER
C corporation; ordinary income or capital gain
Net income
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$
1,000.00
Entity-level tax (@ 34%)
$
340.00
Net cash available for distribution
$
660.00
Shareholder tax (dividend @ 15%)
$
99.00
Net cash to equity investor
$
561.00
TAX CONSIDERATIONS USUALLY THE
PRIMARY DRIVER (Continued)
S corporation and partnership (including multiple
member LLC); ordinary income
8
Net income
$
1,000.00
Entity-level tax (@ 0%)
$
0.00
Net cash available for distribution
$
1,000.00
Shareholder tax (ordinary income @ 35%)
$
350.00
Net cash to equity investor
$
650.00
TAX CONSIDERATIONS USUALLY THE
PRIMARY DRIVER (Continued)
S corporation and partnership (including multiple
member LLC); capital gain
9
Net income
$
1,000.00
Entity-level tax (@ 0%)
$
0.00
Net cash available for distribution
$
1,000.00
Shareholder tax (capital gain @ 15%)
$
150.00
Net cash to equity investor
$
850.00
C CORPORATIONS
• A corporation is automatically taxed as a C
corporation, unless it makes an election to be taxed
in accordance with subchapter S of the Internal
Revenue Code.
• Advantages of C corporations
– Ability to engage in tax-free reorganizations under the
Internal Revenue Code.
– Ability to easily structure favorable stock compensation,
including the granting of stock options.
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C CORPORATIONS (Continued)
– If publicly traded (which is not easily permitted for other
forms of organization), corporation can reinvest for
growth and then shareholders can sell appreciated
stock, on which they pay lower capital gains rates.
– Venture capitalists, angel investors and individuals
more accustomed to investing in C corporations.
– In order to go public, a company almost always needs
to be a C corporation.
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C CORPORATIONS (Continued)
• Disadvantages of C corporations
– DOUBLE TAXATION! Current distributions of
operating income generally subject to double tax; first
to corporation and then to shareholders as ordinary
income dividends.
– State statutes require adherence to certain corporate
formalities, including annual shareholders’ meetings
and boards of directors.
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C CORPORATIONS (Continued)
– For Utah corporation, cannot give control to single individual
or entity (unlike LLC or LP) – must have board of directors of
at least 3 persons (if at least 3 shareholders).
• Despite tax disadvantages, a company that
expects a venture capital investment, a tax-free
reorganization or a public offering in the near
future should usually be formed as a C
corporation.
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S CORPORATIONS
• An S corporation is created when a corporation
makes an election with the IRS to be taxed as a
partnership under subchapter S of the Internal
Revenue Code.
– This election generally needs to be made within two months
and 15 days from the beginning of the tax year.
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S CORPORATIONS (Continued)
• Advantages of S corporations
– SINGLE LAYER OF TAXATION! If subchapter S
requirements are met, entity is disregarded for tax purposes
and all losses and profits flow through to equity owners.
– Dividends not subject to self-employment tax; salaries,
however, are subject to employment taxes. IRS may
recharacterize dividends payments as salary to collect
employment taxes.
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S CORPORATIONS (Continued)
– Ability to engage in tax-free reorganizations under the
Internal Revenue Code.
– Ability to easily structure favorable stock compensation,
including the granting of stock options.
• Disadvantages of S corporations
– Because of restrictions applicable to S corporations,
professional advice and monitoring needs to occur over the
life of the entity.
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S CORPORATIONS (Continued)
– Shareholders limited to U.S. individuals, estates, certain
trusts and certain charitable organizations (i.e., no
corporations, partnerships, LLCs, retirement accounts,
among others).
– Cannot have more than 100 shareholders.
– Cannot have more than one class of stock; rule prohibits not
only formal stock (e.g., preferred) but also “instruments,
obligations and arrangements” that are in essence a
separate class of stock; voting and non-voting common OK.
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S CORPORATIONS (Continued)
– Practical need for shareholders agreement in order to
prevent transfers that would endanger S Corporation status
and to require payment of dividends to pay tax on passthrough income.
– Losses limited to shareholder’s basis, which does not
include entity-level debt to third parties.
– No tax-free liquidation or distribution of appreciated property
(which are available for LLCs and LPs).
– Special employee rules for shareholders owning 2% or more
of stock; generally treated as partners.
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S CORPORATIONS (Continued)
– State statutes require adherence to certain corporate
formalities, including annual shareholders’ meetings and
boards of directors.
– For Utah corporation, cannot give control to single individual
or entity (unlike LLC or LP) – must have board of directors of
at least 3 persons (if at least 3 shareholders).
– Must distribute at a significant percentage of profits, rather
than accumulate for reinvestment, in order to permit
members to pay taxes.
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S CORPORATIONS (Continued)
• S corporations are most commonly used for
closely-held businesses owned by a family or few
partners. Because of the restrictions listed above,
LLC is generally a better option.
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LIMITED LIABILITY COMPANIES
• The limited liability company came into existence
in response to a demand for an organization that
affords its owners limited liability but is not
subject to the double tax regime applicable to C
corporations.
– First LLC statute enacted in Wyoming in 1977.
– In 1988, the IRS finally stated that properly organized LLCs
would be taxed as partnerships, which quickly led to all
states adopting LLC statutes.
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LIMITED LIABILITY COMPANIES
(Continued)
• LLCs have since become what many consider to be
the preferred business choice for many businesses.
• Advantages of limited liability companies
– SINGLE LAYER OF TAXATION! Entity is disregarded for
tax purposes and all losses and profits flow through to equity
owners, without S corporation limits on number of members,
type of owner and classes of stock.
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LIMITED LIABILITY COMPANIES
(Continued)
– In contrast to S corporations, most professional advice relating
to structuring occurs at inception – less concern about loss of
status.
– No management formalities required by statute.
– Distributions of property usually tax free.
– No 80% control requirement to achieve tax free organization
(in contrast to corporation).
– Flexibility in structure of management. Possible management
structures include control by single person or entity, control
among partners, or control by board of directors.
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LIMITED LIABILITY COMPANIES
(Continued)
– Flexibility in structure of allocation and distribution
provisions compared to corporation.
– Good vehicle for joint ventures.
• Disadvantages of limited liability companies
– Relatively complicated operational tax provisions.
– Creation of operating agreement can be complicated
and expensive if structure is complex.
– Self-employment taxes for certain controlling LLC
members.
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LIMITED LIABILITY COMPANIES
(Continued)
– No user-friendly counterpart to stock options (in
corporations) for compensation of employees.
– Must distribute a significant percentage of profits,
rather than accumulate for reinvestment, in order
to permit members to pay taxes.
25
LIMITED LIABILITY COMPANIES
(Continued)
• Unless a venture capital investment, a tax-free
reorganization or a public offering are reasonably
foreseeable, a limited liability company is often
the best choice of entity due to the favorable tax
treatment and flexibility in management and
structure.
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LIMITED PARTNERSHIPS
• A limited partnership is a partnership organized
under state law with one or more general
partners, who have sole management control
over the entity, and limited partners, who must
not have management responsibilities to
preserve limited liability.
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LIMITED PARTNERSHIPS
(Continued)
• Most commonly used for private equity funds or
other investment partnerships because of
historical prestige of form and desire to allocate
profits to general and limited partners based
upon formula rather than capital contribution.
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LIMITED PARTNERSHIPS
(Continued)
• Advantages of limited partnerships
– SINGLE LAYER OF TAXATION! Entity is disregarded for
tax purposes and all losses and profits flow through to equity
owners, without S corporation limits on number of members,
type of owner and classes of stock.
– No management formalities required by statute.
– Distributions of property usually tax free.
– No 80% control requirement to achieve tax free organization
(in contrast to corporation).
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LIMITED PARTNERSHIPS
(Continued)
– Flexibility in structure of allocation and distribution
provisions compared to corporation.
• Disadvantages of limited partnerships
– Although limited partnership agreements are flexible
(with essentially no statutory limitations), they are often
very complicated because there are few statutory
default rules.
– Unlike LLCs, management may not be shared among
partners (limited partners must be uninvolved).
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LIMITED PARTNERSHIPS
(Continued)
– Relatively complicated operational tax provisions.
– Self-employment taxes for general partner.
– No user-friendly counterpart to stock options (in
corporations) for compensation of employees.
– Must distribute a significant percentage of profits,
rather than accumulate for reinvestment, in order to
permit limited partners to pay taxes.
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LIMITED PARTNERSHIPS
(Continued)
• Due to an increase comfort level with LLCs in
recent years, the number of limited partnerships
being formed has declined significantly. Limited
partnerships are still used relatively frequently for
investment funds, but typically LLCs can be used
to accomplish the same objectives with less
effort.
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