6. I understand that if I organize my business as an LLC, I will not be able to provide my employees with options or some other form of equity participation. Is that correct?

No. LLCs and partnerships can offer equity-based compensation plans. Indeed, the flexibility associated with LLCs and partnerships permits tailoring of compensation plans that can reduce or eliminate current income tax at the time of a grant.

7. If I am setting up an LLC, is there any reason to form it under the laws of one state rather than another?

In most instances there is no reason for a business to organize in another state rather than the one in which is operates.

8. Should you ever form a general partnership?

Not in today’s world, no.

The general rule is that all partners in a partnership are liable jointly and severally for all obligations of the partnership.  Limited liability partnerships are a type of general partnership that provides its general partners with limited liability for certain obligations of the partnership.  It has the benefits of a partnership and limitations on liabilities.  For example, partners in LLPs are not liable for the debts caused by the negligence of other partners.

9. I have heard about LLCs and LLPs, but what in the world is an LLLP?

Investment vehicles have traditionally been structured as limited partnerships. A limited partnership must have at least one general partner. Promoters have often minimized liability exposure by using an adequately (but not robustly) capitalized corporation as the general partner. Some states, such as Delaware, now expressly authorize limited partnerships to file a statement of qualification and become “limited liability limited partnerships,” or LLLPs. In these states, even the general partner is shielded from partnership liabilities.

10. If the Secretary of State allows me to reserve a name for a new entity, do I need to worry about any further name searches?

Maybe. Typically, Secretaries of State will reserve a name for anyone who wishes to form a new business entity. By reserving the name prior to organizing the entity, one can be assured that the Secretary of State’s office has checked its database and determined that the name is available for use.

The Secretary of State’s office, however, usually does not determine whether the chosen name may infringe upon federally registered or common law trademarks. If a new business anticipates building a broad identity around its entity name (think, for example, about Ben & Jerry’s Homemade, Inc., or Amazon.com, Inc.), then it should consider performing trademark searches before committing to a name. It may be cheaper to analyze the trademark issues now than to adopt a new corporate identity later.

Naturally, I have heard many more questions all over the map.  The ones we’ve just discussed are the ones I hear the most often.

1.  I understand the difference between an S and a regular C corporation, but what is a close corporation and how is it different?

There is a distinction between the classifying a business entity for state law purposes (which deals with issues like limited liability and requirements for running and maintaining the business) and the company’s federal tax classification.  Virtually all states permit the formation of “close corporations.” A close corporation has a limited number of shareholders typically no more than thirty-five, can operate without a board of directors, does not need to adopt bylaws, and generally operated with less formality than a “regular” corporation—without loosing any of the liability protection offered by “regular corporations.”  If you ran a entity without a board of directors, bylaws or failed to follow any of the required “corporate formalities,” you may be subject to personal liability.  By statue, statutory close corporations are exempted from taking such factors into account if the question of piercing the corporate veil ever arises.

For tax purposes, a close corporation’s status is an independent question.  A close corporation will be treated as a C corporation unless it qualifies for treatment as an S corporation and timely elects the “pass-through” treatment available under Subchapter S of the Internal Revenue Code (“IRC”).

2. With the drop in individual income tax rates does it make sense to organize my business as a regular C corporation?

When the top marginal rate for individuals was 39.6% and the top marginal rate for corporations was 35%, it was frequently advantageous to organize a business as a C corporation as long as the entity did not hold assets expected to appreciate in value and the business plan called for retaining earnings for capital investment. When the top tax bracket was reduced to 35% in 2006 many of the reasons were lost.  There are, however, still some attributes of a C corporation that are attractive, such as the availability of tax-advantaged fringe benefits for owners of the business and the potential 50% capital gains exclusion. The reduction in individual tax rates, however, makes entities that offer pass-through taxation more attractive than ever.

3. Why do the venture capital providers prefer funding C corporations?

I hear this one a lot.  For start-up businesses generating losses, a flow-through entity such as an LLC generally provides tax benefits that make it preferable to a C corporation.  A profitable C corporation may distribute after-tax earnings to shareholders in the form of dividends. In computing their tax liability, however, shareholders must generally include C corporation distributions in income, and cannot use C corporation losses as deductions.  Since LLCs can have multiple classes of equity interests and it is possible to fashion an LLC membership interest comparable to convertible preferred stock, one might think that the LLC form would be attractive to investors.

Nonetheless, venture capital providers generally make conversion to a C corporation a condition for providing funding. One reason is the non-recognition treatment available to C corporations for mergers and other kinds of reorganizations under IRC § 368.  This non-recognition treatment is not available to LLCs–or to corporations that have converted to C corporations in anticipation of a re-organization. Second, only C corporations can take advantage of the 50% capital gains exclusion under IRC § 1202. Venture capital providers seem willing to sacrifice short term tax benefits in hopes of maximizing the after-tax return to investors when a liquidity event occurs.

The preference for C corporations also appears to be driven by non-tax reasons. Investors, familiar with the structure of corporations, find it easier to get deals closed and manage their investments if all their portfolio companies are organized as corporations.

4. I sometimes get told that it is too expensive to form an LLC as a vehicle to operate hier sole proprietorship. Are they right?

No way! If an LLC is taxed as a partnership under the Internal Revenue Code, then the LLC does not pay any federal income taxes. The LLC, however, would generally be subject to a nominal fee to the state of filing.  If the LLC is a single member LLC, it is a disregarded entity for federal income tax purposes; it is not taxed as a partnership but as a sole proprietor is.

If an individual forms an LLC as a vehicle to operate what would otherwise be a sole proprietor-ship, the activities of the LLC are reported on Schedule C to the individual’s IRS Form 1040. There is no need to prepare and file a separate federal or state tax return for the LLC, or obtain a separate employer identification number.  The benefits of operating through a limited liability entity far outweigh the small formation costs.

5. What is the deal with self-employment tax and LLCs?

This one is murky. Once a determination has been made that a pass-through entity is an appropriate choice advisors have steered clients away from LLCs to S corporations in order to minimize federal payroll taxes.  A shareholder of an S corporation can be an employee of the S corporation, so the shareholder may report some of their share of business income as a shareholder distribution and some as compensation for services as an employee. Only that portion deemed to be compensation is subject to FICA (the contributions for old age, survivors and disability insurance, and hospitalization insurance) and unemployment taxes.

In an LLC taxed as a partnership, a member is considered self-employed rather than employed by the LLC. A member who performs services for the LLC is subject to SECA (the self-employment counterpart of FICA) on “net earnings from self-employment,” which includes (with certain exclusions) the member’s distributive shares of income or loss from any trade or business carried on by the LLC.  Thus, there is no question that a shareholder of an S corporation can shelter some income from employment taxes by taking some of the business income as a shareholder distribution rather than compensation for employment. In contrast, except as noted below, a member’s share of LLC profits will be subject to self employment taxes regardless of whether the member considers herself an “employee” of the LLC.

An S corporation must be a small business corporation, which can have only one class of stock. If an S corporation issues a second class of stock, it ceases to meet the definition of a small business corporation, and its S corporation status is automatically terminated triggering significant adverse tax ramifications for its owners.  A corporation that has issued only one class of stock may conduct its business or enter into agreements that treat certain shareholders or creditors in a manner that causes the company’s actions/agreements to be considered a second class of stock.

The one-class-of-stock rule prevents the corporation from having the complexity related to  allocating earnings to multiple classes of owners.  A corporation has only one class of stock if all outstanding shares provide for identical rights to stockholders regarding distribution and liquidation proceeds.  However, differences in voting rights among shares of stock of a corporation do not automatically indicate that there is more than one class of stock.

A corporation may have voting and nonvoting common stock, a class of stock that may vote only on certain issues, irrevocable proxy agreements, or groups of shares that differ with respect to rights to elect members of the board of directors.  Relevant to a determination of whether all outstanding shares of stock are of the same class requires that the stock confer identical rights to distribution and liquidation proceeds (versus voting rights) and is based on the terms of the articles of incorporation, bylaws, applicable state law, and any binding agreements relating to distribution and liquidation proceeds.

An Interesting Case.

A shareholder used the second-class-of-stock rule in a court case when the shareholder’s parents had a janitorial and paper-supply company that elected S status.  As the shareholder’s parents aged, the shareholder and her brother took control of the company, each owning half of the stock.  The corporation retained most of its earnings, but did distribute enough dividends to enable shareholders to pay their personal income tax on their shares of corporate income.  The corporation suddenly stopped making the tax-payment dividends, leaving the shareholder with substantial income tax liabilities and no company distributions to cover the taxes. The shareholder knew this was part of an effort by the father and brother to squeeze the shareholder  out of the business.

As a stockholder, the shareholder took a very unusual position: that the S election had been lost, and the tax on corporate earnings be imposed on the corporation rather than on the shareholders. According to the shareholder, certain extra payments made to the parents from the S corporation indicated that the parents had preference as to dividends.  This preference meant there was a second class of stock.  If the shareholder won, then the S election had been lost and no taxes would be owed.
The court found little evidence on which to base a conclusion regarding the nature of the extra corporate payments to the parents. The shareholder was unable to meet the burden of proof needed to show that there was a second class of stock and was liable for the income taxes.  Too bad for the shareholder, but an interesting legal argument since shareholders rarely try to terminate an S election as they usually fight to maintain it.

Situations that create a second class of stock.

1.  S Corporation has a binding agreement with its shareholders to modify its normal distribution policy by making upward adjustments of its distributions to those shareholders who bear heavier state tax burdens. The adjustments are based on a formula that will give the shareholders equal after-tax (i.e. after state tax) distributions. The agreement relates to distribution or liquidation proceeds and is a governing provision that alters the rights conferred by the outstanding stock of S to distribution proceeds therefore, those rights are not identical thereby treating the company as having more than one class of stock.

2. Interest on debt is paid only if the corporation has earnings, or is interest payments are tied in some way to dividend policy. The corporation may be treated as having more than one class of stock.

Cases that typically do not create a second class of stock.

The IRS regulations list the following situations that do not involve a second class of stock.   Caution is advised, because the result may be different if the circumstances indicate there is an attempt to avoid the one-class-of-stock requirement, etc. When in doubt seek appropriate counsel.

1. Straight Debt. Debt is not treated as a second class of stock if: it is a written unconditional obligation, regardless of whether embodied in a formal note, to pay a sum certain on demand, or on a specified due date; it does not provide for an interest rate or payment dates that are contingent on profits, the borrower’s discretion, the payment of dividends with respect to common stock, or similar factors; It is not convertible (directly or indirectly) into stock or any other equity interest of the S corporation; it is held by an individual (other than a nonresident alien), an estate, or certain trusts.

2. Debt held proportionately. Obligations of the same class that are considered equity under general principles of federal tax law, but are owned solely by the owners of, and in the same proportion as, the outstanding stock of the corporation, are not treated as a second class of stock.

3. Buy-sell agreements. Agreements among shareholders restricting the transferability of stock, are disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation.

4. Redemption Agreements. Bona fide agreements to redeem or purchase stock at the time of death, divorce, disability, or termination of employment are disregarded in determining whether a corporation’s shares of stock confer identical rights.

5. Fringe Benefits. S Corporation is required under binding agreements to pay accident and health insurance premiums on behalf of certain of its employees who are also shareholders. Different premium amounts are paid by S Corporation for each employee-shareholder. S Corporation is not treated as having more than one class of stock.

6. Employment Agreements. A and B are shareholders of S Corporation. A is also an employee of the company. By agreement, the company will redeem A’s shares on the termination of employment. The agreement is disregarded in determining whether all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.

7. Change in Stock Ownership. An S corporation governing instrument provides that the amount of distribution will be adjusted to take into account the fact that a stockholder owned stock for less than the full year. The corporation is not treated as having more than one class of stock.

Voting Rights

The Subchapter S Revision Act of 1982 added the flexibility of allowing a company to issue voting and non-voting stock without running afoul of the one-class-of-stock requirement. Voting stock may be given to those family members who are most qualified to run the business, with non-voting stock given to other family members. However, the stock must have the same rights to distributions, or the S election will be lost.

Given the impact that losing an S election can have on a company and its shareholders, one is well advised to seek counsel before undertaking matters that could cause the loss of the election.

The next form is a “limited liability company.  An LLC is an entity separate from its owners, so ownership can involve one, two or more owners. As a separate entity, the LLC (not its owners) is responsible for the liabilities of the business.  If the business fails you may lose your investment, but your assets are not at risk. Corporations are the oldest form of business entity and as a result, people are generally at ease with a corporation.

Corporations provide the strongest protection against personal liability but may or may not have the same tax advantages of an LLC.   An “S-Corp.” is made for small business and can’t have more than 100 shareholders; however, it does feature pass-through tax treatment like an LLC.   A “C” corporation has a big disadvantage for start-ups; that is, that the income or loss of a C corporation only taxable to the corporation and does not pass through to shareholders.  Shareholders cannot use start-up or other losses to against income received by sources other than the corporation.  Neither an LLC nor a corporation is the best choice for all businesses.

The form of entity that is appropriate for your business will depend upon your situation.   One would be well advised to seek counsel before starting up a company because the tax and legal ramifications of the choice are significant.