"The Frustration of Choosing an Entity Format for Your Business" by Andrew N. Karlen, Esq.

Originally published in Westchester Commerce, February 2008

Have you ever been frustrated when deciding between several special meals on a restaurant menu? Why is it that at first blush three or four entrees seem enticing but when you look closer, none of them really promises to deliver the gourmet experience you desire?

Choosing a legal format for a business presents that kind of dilemma. On this menu, however, the “specials” are called sole proprietorship, partnership, limited partnership, corporation (C or Sub-Chapter S) and limited liability company (“LLC”). And, the specials are comprised of dishes with names like “limited liability” and “flow-through taxation.” The former, of course, are the alternative business formats. The latter are some of the characteristics which each alternative format either has or doesn’t have and which in any given situation will be either a pro, con or not relevant.

Much like choosing a special meal, business owners must choose the business format that has the best combination of characteristics for their business. A healthy choice is often one that includes limited liability, meaning that the owners are not personally liable for the business’ debts. Be aware, however, that limited liability comes with warnings.

The first warning is that if the owners of the entity use it to defraud or cheat creditors, the creditors can “pierce the corporate (or LLC) veil” and hold the owners personally liable for debts of the entity. The second warning cautions that an owner who personally guarantees a debt of the entity will be personally liable for that debt. And creditors (landlords and others) who eat in the same restaurant are well-aware of the benefit personal guarantees hold for them.

Often, the most desirable entrée is one that features not only limited liability but flow-through taxation. This means that the business entity pays no income tax. Instead all income, loss, deductions, gains and credits are reported on the owners’ personal tax returns.

The first two “specials” on the menu are the sole proprietorship, an individual doing business for him rather than under a separate business entity, and the partnership where two or more people conduct a business together. The sole proprietor or partners, as the case may be, are personally responsible for the business’ debts. More pertinent, each partner can legally bind the partnership (and therefore the other partners) and each partner is legally responsible for all debts and liabilities incurred by each other partner on behalf of the partnership business.

The sole proprietorship and partnership formats do, however, offer flow-through taxation, a very significant benefit, and for businesses with two or more owners a partnership offers the most flexibility in terms of governance and operation. Moreover, a filing under state law is not necessary to create a sole proprietorship or partnership, as is the case with other entities discussed below. In the case of a partnership, a partnership agreement is advisable but not required.

The next entrée on the menu, the limited partnership, at first seems to be an enticing combination of flow-through taxation and limited liability. The ingredients include at least one “general partner” who is liable for all debts of the limited partnership and at least one “limited partner” whose liability is limited to the amount of his investment in the limited partnership.

The rights and obligations of the general and limited partners are set forth in a limited partnership agreement. The limited liability enjoyed by the limited partners comes at the price of ceding virtually all management authority to the general partner(s). A limited partner who becomes actively involved in the affairs of the business risks losing his status as a limited partner. Once a popular vehicle for real estate investments and certain other business ventures, the limited partnership has, for the most part, been supplanted by the LLC (discussed below).

Now, we come to the chef’s signature offerings, the corporation and the LLC. Both afford all owners limited liability.

There are, however, important differences in taxation and other areas. Corporations and LLCs are created and governed in accordance with the laws of state in which the entity is formed. State statutes provide for the creation of a corporation or LLC by filing a statutorily prescribed document in a designated office. In New York, the certificate of incorporation of a corporation, or articles of organization of an LLC, as the case may be, must be filed with the Department of State in Albany.

From a state law perspective, all corporations are born the same. Each corporation must have stockholders who own it, directors who set policy and officers who execute that policy. These functions always exist, although in the smallest of companies, one person may be the sole stockholder, director and officer.

In addition to its certificate of incorporation (called a charter in some other states), the governance rules for a corporation are set forth in its by-laws. It is also advisable, but not required, that the stockholders execute a stockholders agreement, which can set forth additional rights and obligations of stockholders, including rights to and restrictions on transferring stock.

For tax purposes corporations come in two varieties. The default tax status is as a “C” corporation. C-corporations do not have the characteristic of flow-through taxation. The corporation must pay tax on its income and the stockholders must pay tax on the dividends they receive.

This so-called double taxation makes the corporation undesirable for many businesses, particularly smaller ones. Recognizing this, Congress enacted Subchapter S of the Internal Revenue Code, which allows a corporation to file an election to be taxed as a small business corporation. By filing a “Subchapter S election,” the corporation elects flow-through taxation.

There are, however, restrictions on Subchapter S corporations that make them problematic for many businesses. These restrictions include limitations on the number (100 maximum) and the type of stockholders (no non-resident aliens; only certain kinds of trusts). In addition, an S corporation can only have one class of stock.

This means that there cannot be common and preferred stock, although voting common stock and non-voting common stock is permissible. This can make it difficult to separate ownership and management functions or transfer stock for estate planning purposes. Another problem is that if a Subchapter S corporation does not distribute to its stockholders at least enough cash to enable them to pay tax on the earnings allocated to them, the stockholders may be in the unenviable position of being required to pay tax on income they did not actually receive.

This also makes it very difficult to accumulate money in the corporation for future business needs. In addition, the flow-through taxation available to S-corporations is not always as advantageous as the flow-through taxation on partnerships. One reason for this is that the rigidity of the corporate form of entity does not allow for the flexibility in the allocation of profits and losses distribution of cash flow to owners that the partnership form permits.

The numerous restrictions on the use of Subchapter S corporations highlight the situations in which the C-corporation may be desirable. Examples of this are: when it is desired that a corporation’s stock be widely-held; when the boundaries among ownership and management need to be clear; and when it is desired to accumulate cash within the corporation.

While the C-corporation and Subchapter S corporation have been menu favorites for many years, the LLC is a comparatively recent alternative that was added to the New York menu in 1994. Here at last is the right combination of limited liability and flow-through taxation.

Owners of an LLC, called members, have the same limited liability that stockholders of a corporation enjoy. Moreover, an LLC is taxed as a partnership, providing the same flow-through taxation and flexibility that partners in a partnership have. And, none of the restrictions that make Subchapter S corporations apply.

LLC’s allow substantial flexibility in ownership and management. There can be as many classes of members as desired, including those with voting rights and those without, and those with different distribution or liquidation preferences. An LLC can be managed by its members, which is similar to a partnership, or by managers who may or may not be members, which is more akin to a corporation. Each member can be as involved in management as he wishes without consequence.

In New York, however, it is more expensive to form an LLC than a corporation, largely because of a statutory requirement that notice of formation be published once a week for six consecutive weeks in a newspaper designated by the clerk of the county in which the LLC’s principal office will be located. Failure to publish such notice and file a certificate thereof with the Department of State can lead to the loss of LLC status. It is most unfortunate that the cost of compliance with the publication requirements cause some business owners to opt away from the LLC.

The governing document of an LLC is called an operating agreement. An LLC operating agreement serves the purposes of corporate by-laws and can also contain provisions akin to those found in partnership and stockholders agreement. The New York Limited Liability Company Law requires each LLC to have a written operating agreement.

In addition to assessing the legal and tax pros and cons of each menu option, business owners should consider how the entity can be structured to serve the operational needs of the business and the potentially different interests of the owners. For example, where there will be majority and minority owners, or where some owners will be actively involved while others will not, careful thought should be given to how decisions will be made. Boundaries should be set between day-to-day operational decisions that those who are operating the business are authorized to make and non-routine decisions that require higher-level approval, i.e. the directors or stockholders of a corporation or the members of an LLC. Further, it should be recognized that owners may legitimately have different personal agendas based on the nature of their interest in the entity and liquidity needs. An owner who is actively involved in the business may want higher compensation while one whose role is as an investor may be more interested in return-on-investment. Or, an owner who has a child in college may want to sell some or all of his interest. It is far better for business owners to address these and other structural concerns early-on than to have them surface later as conflicts.

Choosing the best entity format for a business has many similarities to ordering one of several special meals on a restaurant menu. The stakes, however, are much higher (no pun intended). The form of entity in which a business is structured has far-reaching impacts on the way the enterprise is owned, taxed, governed and managed.

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The form of entity in which a business is structured has far-reaching impacts on the way the enterprise is owned, taxed, governed and managed.