Private Equity Choosing The Right Business Entity

Wednesday, February 1, 2006 - 01:00

Choosing the right business entity to operate a new business venture can be one of the most daunting decisions that a business owner must make. The decision is complicated by the current legal environment where periodic changes in federal and state laws have from time to time materially altered some of the significant factors in the analysis. This article is intended to provide a general summary of some of the advantages and disadvantages of three specific types of business entities that are most commonly used by business owners today: (1) the C corporation; (2) the S corporation; and (3) the limited liability company (LLC). Please note that this article is presented for informational purposes only, and is not intended to constitute legal, tax or accounting advice.

C Corporation

A C corporation is a standard, general for profit, business entity that has been formed as a corporation under the laws of a particular state. To be formed, an incorporator must file a certificate of incorporation with a state and must pay all requisite state filing fees. C corporations are the standard business entities because they provide owners with the benefit of having limited liability without restrictions on the types of people or entities that can hold stock in the company. The other main benefit of a C corporation is that most owners or potential owners are familiar with them. Individuals have been forming corporations to shield themselves from liability for approximately 400 years. The Massachusetts Bay Company, for example, was formed in England in 1628 for the purpose of colonizing New England. Due to their long history, people find C corporations easily accessible. People know that C corporations are governed under the direction of a board of directors who have a fiduciary duty to the stockholders; they know that ownership interests of a C Corporation are held through shares of stock; and most importantly, they know that once shares are purchased, an owner in a C corporation will not have any further liabilities to, or obligation to invest additional money in, the C corporation. Due to this familiarity, it is often much easier to encourage people to invest in C corporations then in other types of business entities, which is an important feature for any new business venture.

The major drawback with C corporations is that they are subject to two levels of taxation, one at the entity level and one at the shareholder level. For example, if a C corporation generates profits during a fiscal year, the C corporation would have to pay taxes on its profits, and then if it elected to distribute the remaining profits to its shareholders as a dividend, the shareholders would have to individually pay an additional tax on the dividend that they received.

The double taxation feature of a C corporation also reduces the number of exit strategies for an owner. When purchasing a business, a buyer will usually prefer to purchase assets rather than stock because they can limit the types of liabilities that they will assume in the transaction and can also receive a step-up in the basis of the assets that they acquire. This step-up in basis allows purchasers to reduce their taxable earnings for periods following the closing. C corporation sellers will often attempt to negotiate a stock sale instead of an asset sale so they can avoid subjecting the purchase price to double taxation, but even if successful, such sellers may have to accept a lower purchase price in order to achieve their desired structuring.

S Corporation

An S corporation is incorporated in the same manner as a C corporation, but once incorporated, the corporation's shareholders will file a Form 2553 with the Internal Revenue Service electing to be taxed as an S corporation. An S corporation election must be made within 75 days after the date in which the corporation is formed if it wishes to be taxed as an S corporation during its first fiscal year. Otherwise, an S corporation election must be made within the first 75 days of any subsequent fiscal year. The primary benefit of an S corporation is that it is a pass through entity for tax purposes. Unlike a C corporation, the income of an S corporation is passed through to the owners of the business and reported on the owners' personal income tax returns, thus eliminating the double taxation that is incurred by owners of a standard C corporation. However, there are certain requirements in order to qualify as an S corporation, including that: (i) S corporations cannot have more than 100 shareholders; (ii) shareholders in S corporations can only be individuals, estates and certain qualified trusts and tax-exempt entities and the individuals must be United States citizens or resident aliens; and (iii) an S corporation can only have one class of stock (note that voting and non-voting common shares are considered one class for this purpose).

Operating a business as an S corporation solves many of the problems discussed above for C corporations. The profits of the business will only be subject to a single layer of taxation, and in the event that the business is sold, the purchase price will also only be subject to a single layer of taxation. This is true regardless of whether the sale is structured as a stock sale or asset sale. However, there are some significant drawbacks in operating a business as a S corporation, including the following:

1. If an S corporation generates profits during a fiscal period, the shareholders of an S corporation will be required to pay taxes on their allocable portion of the profits, whether or not the S corporation actually distributes cash.

2. Some jurisdictions, such as New York City, will disregard the federal S corporation election and will charge a separate corporate tax to the entity.

3. There are some limitations on the types of businesses that an S corporation can own.

Limited Liability Companies

A limited liability company (LLC) is a hybrid entity that combines the tax advantages of a S corporation without any of the ownership restrictions. Like corporations, LLCs are also creatures of state law and are formed by the filing of a Certificate of Formation with a state. In addition to the state filing fees that an owner (or member) must pay in connection with the Certificate of Formation, some jurisdictions such as New York have an additional requirement that members of an LLC put the public on notice that they are transacting business as a limited liability company by publishing a notice of such fact for a period of time in a local periodical. Depending on where the LLC's business is located, this publishing requirement could add as much as $1,500 in initial start-up costs. In addition to the filing of a Certificate of Formation and possible publishing requirements, the members of an LLC are required to enter into an 'Operating Agreement,' which governs the terms of their relationship as members. In an Operating Agreement, members of an LLC have wide flexibility in defining the ownership and management structure of the company. Members do not necessarily have to adhere to the corporate formalities that are customarily associated with corporations. Many people believe this to be an important benefit of transacting business through an LLC.

Similar to S Corporations, LLCs are also pass through entities for tax purposes, and accordingly, the profits of the company both during normal business operations and in the event of a sale will only be subject to a single layer of taxation. However, the are some distinct differences between an S Corporation and an LLC. The following describes some of the advantages of LLCs:

1. Members of an LLC can allocate profits and losses among themselves in any manner they choose, provided that such allocations have substantial economic effect to the actual ownership interest. Profits of an S corporation on the other hand must be allocated and distributed according to the actual ratio of stock ownership even if the S corporation's owners believe it is more equitable to distribute the profits in a different manner.

2. There are no ownership restrictions on what type of individual or entity can hold an ownership interest in an LLC.

3. An LLC can issue different classes of equity interests.

4. Under certain circumstances, a member of an LLC's tax basis in his membership interests can be increased by such member's allocable share of the LLC's indebtedness. In contrast, a shareholder's basis for stock in a S corporation does not include corporate liabilities.

In addition to the advantages of operating a business as an LLC, there are also some significant disadvantages. Perhaps the most prominent disadvantage is that owners of an LLC who are employed by the LLC must pay the self-employment taxes on their entire share of the profits of the LLC. On the other hand, shareholders in an S corporation who are employed by the corporation are only required to pay the self-employment taxes on money that is paid to them as compensation for services. Another drawback of operating a business as a LLC is that LLCs are prohibited from issuing tax-favorable incentive stock options (or ISOs) to its employees. ISOs allow employees to receive capital gain treatment on the sale of the stock underlying the option if they meet certain holding restrictions. ISOs are commonly used by corporations to incentivize their employees.

Conclusion

Choosing the right entity to operate a business is a very important decision for an owner. When making this decision, it is important to consider who will be operating the business and how the business will be managed. Will the business be owner-operated or will it be run by non-owner employees? Will the business incur substantial indebtedness or will it be capitalized primarily through equity investments? Will the business look for outside investors, and will these investors be friends and family of the owners, strategic industry partners or venture capitalists? Finally, what will be the ultimate exit strategy for the owners? These and other questions need to be considered when determining the type of business entity that best fits a particular business.

The authors are attorneys in the New York-based firm of Davis & Gilbert LLP. Brad J. Schwartzberg is a Partner in and Co-Chair of the firm's Corporate Department. He may be reached at (212) 468-4966. Jason M. Abramson, an Associate in the Corporate Department, may be reached at (212) 468-4841.

Please email the authors at bschwartzberg@dglaw.com or jabramson@dglaw.com with questions about this article.