Considerations in Choice of Entity Revisited
I. TYPES OF ENTITY.
This outline will compare the legal and tax considerations in selecting the type of entity for use in connection with the ownership and operation of a business or the holding of investment assets. The available types of business arrangements include the following forms of business organizations:
- Sole Proprietorship. The sole proprietorship, which is not a separate entity, is the simplest form of operating a business. It involves a single individual owner who is personally liable for all of the debts and liabilities of the business. The income of the owner is reported on Schedule C (Form 1040 – Profit or Loss From Business), and attached to the owner’s federal income tax return reflecting the income or loss of the business for each taxable year.
- General Partnership. A general partnership is a common form of operating a business or owning investment assets by two or more persons. There may be no written partnership agreement. A general partnership is governed by the laws of the state in which the partnership is formed, usually the Uniform Partnership Act. A partner in a general partnership is personally liable for all of the debts and liabilities of the business or enterprise.
- Limited Partnership. A limited partnership is formed under the laws of the state in which it is organized and governed by state partnership law, usually the Uniform Limited Partnership Act or the Revised Uniform Limited Partnership Act. The general partner or partners are personally liable for all of the debts and liabilities of the business. Provided the limited partners do not take part in the active conduct of the business in a way that would cause them to be treated as general partners under the applicable state partnership law, the limited partners will not be liable for the debts and obligations of the business.
- Limited Liability Company (“LLC”). An LLC is formed under the authority of state law. All 50 states and the District of Columbia recognize LLCs. Minimal formalities are usually required in forming an LLC under state law, including the filing of articles of organization and entering into some type of operating agreement, which may be oral. The primary advantage of the LLC over the limited partnership or general partnership is the limitation of liability of all members and managers, regardless of the extent to which they take part in the business, unless, of course, they undertake to personally guarantee the debts or liabilities of the enterprise. A single member limited liability company is disregarded as a separate entity for federal tax purposes, unless it elects to be treated as an association taxable as a corporation. A disregarded entity is treated in the same manner as a sole proprietorship, branch, or division of the owner.
- C Corporation. Corporations are formed under state corporation laws, often some variation of the Model Business Corporation Act. Unless an S election is made or a parent subsidiary group elects to file a consolidated return for federal tax purposes, corporations are taxed as separate entities subject to a separate rate schedule, and entitled to deductions for salaries and compensation paid to employees who may also be shareholders.
- S Corporation. A corporation may elect to be taxed under Subchapter S of the Internal Revenue Code of 1986 as a pass-through entity, similar to a partnership, with the shareholders recognizing their pro rata share of the net income or loss of the corporation for each taxable year even if no dividends are paid currently. An S corporation is treated the same as a C corporation for state corporate law purposes, including limited liability for shareholders and directors (except to the extent that they personally guarantee the liabilities of the business).
- Combination of Entities. Many different combinations of entities may be appropriate for a particular situation. Where a parent corporation owns 80% or more by vote and the total value of stock of a number of other subsidiary corporations, the affiliated group may be taxed as a single entity for federal tax purposes by electing to file consolidated returns. S corporations may be general or limited partners in a partnership or LLC and may own C corporation, S corporation, and single member LLC subsidiaries. S corporations may also be used as general partners of limited partnerships and members of LLCs. The current trend in most jurisdictions is to use an LLC in lieu of a general partnership or a limited partnership to operate a business, thereby eliminating the need for an S corporation general partner. The limitations under current law on the ownership of S corporation shares prevent partnerships, LLCs, and C corporations from owning shares in an S corporation.
II. FACTORS TO BE CONSIDERED IN CHOICE OF ENTITY.
The following factors should be considered in selecting the type of entity or combination of entities to be used in connection with the operation of a business or the holding of investment assets:
- The number and types of owners.
- Whether the business is already operated or the investment assets are already owned in a particular type of entity.
- The nature of the business to be operated by the entity.
- The capital requirements and structure of the business.
- The anticipated profit and losses of the business.
- The types of assets to be contributed to the business.
- The anticipated appreciation in the value of the assets to be held by the entity.
- The duration of the enterprise and the tax costs of dissolution and distribution of the assets to the owners.
- The form of compensation to be paid to the owners of the business.
- Whether the owners are actively involved in the enterprise, or whether they are passive.
- Any restrictions that may be desired to be imposed on transfers of ownership interests in the entity.
- The structure of management.
- Whether the owners wish to impose restrictions on ability to compete or recruit customers or employees.
- The degree of experience and sophistication of the owners in business matters.
- Other business and investment activities of the owners.
- The exit strategy of the owners from the business.
- Desire on the part of the owners for simplicity and low cost of organization and operation.
- Limited liability of the owners for debts and liabilities of the entity.
- Distributions and desire for flexibility in making distributions of earnings to the owners.
- Desire to avoid multiple levels of tax on earnings.
- Availability of tax losses to the owners.
- Passive income and loss limitations.
- Intentions of the owners to give minority interests to family members during lifetime and to transfer ownership interests to family members or heirs upon death.
- Desire to minimize tax costs of dissolution and distribution of assets to the owners.
- Intentions of owners regarding retirement.
- Desire to avoid reciprocal agency relationship.
- Fiduciary relationships.
- 28. Deaths of owners.
- 29. Choice of law considerations.
- 30. Treatment of contributions of property to the entity.
- 31. Treatment of liabilities of the entity.
- 32. Treatment of distributions from the entity.
- 33. Multiple classes of equity ownership interests.
- 34. Losses on small business stock.
- 35. Gains on qualified small business stock.
- 36. Limitations on methods of accounting.