Choice of Business Structure

The founders of a business need to determine at the outset what form they want the business to take. Although business structures are governed by state law and may therefore vary from state to state, the basic choices are:

Corporations come in two basic flavors: C Corporations and S Corporations.

C Corporations

C Corporations are owned by shareholders, who may be individuals or other business entities such as corporations or partnerships. The shares of a corporation’s stock may be publicly traded on stock exchanges or over the counter, or may be closely held. For closely held corporations, shareholder agreements are often of critical importance in planning for management succession, control over the distribution of stock, handling fundamental disagreements between key stockholders, and in some cases providing liquidity for shareholders. C Corporations are considered separate entities for most legal and tax purposes. Venture capital investors often prefer C Corporation status for their portfolio companies because of tax considerations. Thus, C Corporation status is usually recommended for entrepreneurs who seek to attract venture capital. If a business has already been structured as something other than a C Corporation, such as a limited liability company, many states will permit the business to convert into a C Corporation.

S Corporations

S Corporations are similar to C Corporations except that they are generally taxed as partnerships. This can present considerable advantages. If the corporation is expected to generate tax losses in its early years, the shareholders may deduct their proportionate share of the corporation’s losses on their personal income tax returns (subject to certain limitations). If the corporation generates substantial operating earnings, those earnings can be distributed to the shareholders and subjected to only one level of federal tax. Finally, when the time comes to sell the business, the sale of the S corporation can be structured as an asset sale while still imposing only one level of federal tax on the sellers (rather than taxing gains at both the corporate level and upon distribution to the shareholders, as would usually be the case for a sale by a C Corporation). Structuring the sale in this manner also allows the business to command a higher selling price, because an asset sale gives the buyer the benefit of depreciating the cost of the acquired assets.

In exchange for an S Corporation’s tax advantages, the corporation must meet certain ongoing requirements. For example, the S Corporation may not issue more than one class of stock (such as preferred stock for founders or investors, and common stock for employees), and all of the corporation’s shareholders must be either individuals or certain trusts. If an S Corporation does not live within these rules it may automatically become a C Corporation, which can have unfavorable tax consequences.

Limited Liability Companies

Limited Liability Companies (LLCs) are a hybrid form of entity that combines some characteristics of a corporation with other characteristics of a partnership. On the corporate side, the LLC offers limited liability for all of its members and the option of centralized management (which the LLC may choose not to adopt). On the partnership side, the LLC offers partnership tax status (similar to that offered by an S Corporation) with a great deal of flexibility in handling unequal contributions of capital, different classes of capital, and customized operating agreements that the S Corporation cannot match. The price to be paid for this flexibility is that a customized operating agreement must be drafted to spell out the unique arrangements of the LLC, whereas corporations may often be formed with standardized documents. While LLCs are extremely flexible, they do not qualify for certain statutory benefits available only to corporations. For example, an LLC cannot issue incentive stock options. While many of the features of such options can be replicated by an LLC, the means for doing so are complex.

Partnerships come in three flavors: Limited Partnerships, Limited Liability Partnerships, and General Partnerships. The key element that they have in common is that there is no entity-level federal taxation of partnerships. These entities, like S Corporations, file a federal tax return that allocates the entity’s income, deductions, gain and loss to its partners, who then must report such items on their personal tax returns. This generally results in tax savings, but may present hardships in years when the entity has taxable income but lacks cash to distribute to the partners to help them pay the tax on the income. This problem, called “phantom income”, may occur, for example, if a real estate asset is sold at foreclosure under circumstances where the lender writes off a portion of a loan made to the partnership, resulting in debt forgiveness income.

Limited Partnerships

Limited Partnerships have many of the same characteristics of Limited Liability Companies, but must include one partner (the general partner) having unlimited liability for the debts of the partnership.

Limited Liability Partnerships

Limited Liability Partnerships (LLPs) are general partnerships that have elected LLP status under State law. Partners of an LLP have unlimited liability for their own actions taken in furtherance of the business of the LLP, but they do not have joint and several liability for the actions of their partners. LLP status is appropriate for businesses that have traditionally been conducted as general partnerships if the partners wish to limit their potential liability for each others’ actions. Special rules govern the LLP election by partnership of licensed professionals.

General Partnerships

General Partnerships may be based upon the simplest of arrangements. No registration of general partnerships is necessary in most states, including Massachusetts, and the partnership agreement may be oral (although we wouldn’t advise it). If the partners do not have a detailed agreement, the Uniform Partnership Act, which is in effect in some form in most states, will supply numerous default rules that will govern the relationship of the partners. A more detailed partnership agreement may override these default rules.

Business Trusts
Business trusts are unusual creatures. The IRS views them as corporations, which enables them to make S elections and even issue incentive stock options. Under state law, however, they are viewed as trusts, which means that, at the state level, their income is taxed to the trust, but distributions to beneficiaries (shareholders) are not taxed. To qualify as trusts, the business trust must be governed by trustees who are not subject to control by the beneficiaries. This choice of entity is often used by mutual funds.

Sunstein has experience in the formation of each of these types of business structures, and can help you decide what structure is most appropriate for your operational and financial needs. Please contact our Business Practice Group for more information about these options.