Corporation, Limited Liability Company, or Partnership: What Type of Business Entity Should I Form?

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1 Corporation, Limited Liability Company, or Partnership: What Type of Business Entity Should I Form? Kandace P. Watson, Partner Kilpatrick Townsend & Stockton LLP kwatson@ktslaw.com February 27, Kilpatrick Townsend

2 General Partnerships: The Default Entity Formation: A partnership is formed when two or more persons agree to carry on a business together. The agreement can be written or oral. Informal Entity: No local or state filings (other than appropriate tax returns) are required to create this type of partnership. Unlimited, Personal Liability: Each partner is personally liable for all the debts of the partnership, including any debts incurred by any of the other partners on behalf of the partnership. Liability for Debts, Contracts and Negligence: Each partner is personally liable for the entire amount of any partnership obligation, including liability for another partner s negligence. No Tax on Partnership, but Tax on Partners: All profits and losses in a partnership are passed to its partners. Partners are taxed on all of the partnership s taxable income, discounted in proportion to their ownership stake in the partnership.

3 Taxation C Corp LLC S Corp Separate taxable entity: Corporation is taxed independent from its stockholders. Double Taxation: Once at corporate taxable income level and again at the dividends/distribution level. Exception to Double Taxation: C Corp generates net operating losses rather than net income. Nonetheless, these losses cannot be used to offset taxable income of individual shareholders. High State Franchise Taxes: Higher state franchise taxes than LLCs or S corps. Single Taxation: Flow through taxation; earnings are only taxed once, and at the member level. Tax Election: LLCs can elect to be taxed as a C corp, an S corp or a partnership. Allocation of Income or Loss: LLCs may specially allocate items of income or loss among its various members. Taxable losses can be used to offset taxable income of the individual LLC members. Increased Compliance Costs: due to the application of complex partnership tax rules that also apply to LLCs. Special Tax Status - Single Taxation: Flow through taxation; earnings are only taxed once. Allocation of Income or Loss: Must allocate taxable income to individual stockholders according to their ownership stakes in the company. Taxable losses may be used to offset personal taxable income of the individual stockholders, but only to the extent of the tax basis of their interests in the entity. 3

4 Ownership (Stockholders) C Corp LLC S Corp Unlimited Stockholders: May have unlimited number of stockholders and the stockholders can be non-us citizens/residents. Corporation is subject to SEC reporting requirements if stockholders exceed 500. Stockholder Role: Owners do not need to have a relationship with one another nor have a role in running day-to-day affairs of the company. Transferability of Ownership: Stockholders may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Perpetual existence: Death or withdrawal of a stockholder does not affect the company s existence. Unlimited Members: May have unlimited number of members. Transferability of Ownership Interests: Not as flexible as a C corp or S corp. Generally, a member needs the approval of other members before selling an interest in the LLC. Termination of LLC: Death, withdrawal, expulsion, or other departure may constitute a termination of the LLC and a deemed liquidation for federal tax purposes. Limited Stockholders: Limited to 100 domestic stockholders. Stockholder Criteria: Generally, must be individuals and U.S. citizens or residents. Transferability of Ownership Interests: Stockholders may transfer their ownership freely and readily (by selling their stock) without affecting the continuing existence of the business or the title to its assets. Perpetual existence: Death or withdrawal of a stockholder does not affect the company s existence. 4

5 Fundraising C Corp LLC S Corp Preferred Entity for Venture and Institutional Investors: Favored because C Corps have separate classes of stock which allow for various levels of preference, protections, and share valuations. Initial Public Offering: Easiest type of entity to take public in an initial public offering. Preferred Entity for Small Number of Corporate Investors and/or Individuals: Complicated operating agreements make the operation of the LLC difficult with a high number of members. Unattractive to Tax-Exempt Venture Fund Investors: Investment may produce unrelated business taxable income. Also, venture fund investors may be less familiar with LLCs and therefore less willing to invest in them. Unattractive to Tax-Exempt Venture Fund Investors: Investment may produce unrelated business taxable income. Also, venture fund investors may be less familiar with LLCs and therefore less willing to invest in them. Unattraticive due to Stock and Stockholder Limitations: S Corps are limited to one class of stock and 100 stockholders which makes this entity unattractive to venture fund investors. 5

6 Governance / Structure C Corp LLC S Corp Structural Accountability: Governance responsibilities held separate and apart from owners. Managers are accountable to the board of directors and can transact business without stockholder participation in each decision. Observance of Corporate Formalities: C corps must hold meetings of boards of directors and maintain corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc. Management: LLCs operate more informally than C corps; either managed directly by owners. No Required Observation of Corporate Formalities: Unlike C corps, LLCs are not required to hold regular ownership and management meetings. Observance of Corporate Formalities: Like C Corps, S corps must hold meetings of boards of directors and maintain corporate bylaws, corporate minute books, stock ledger books, separate bank accounts, etc. 6

7 Employee Compensation C Corp LLC S Corp Equity Compensation: C corps can use stock options to attract and retain talent. Deferment of Tax on Equity Compensation: C corps can offer incentive stock options that allow employees to defer tax on the equity compensation until they sell underlying stock. Fringe Benefits: C corps may offer certain fringe benefits to employees that are taxdeductible to the company and also tax-free to the employee. Membership Interests: LLCs may reward employees by offering them membership interests in the LLC. No Incentive Stock Options: LLCs are not able to offer certain forms of equity compensation available to C corps, such as incentive stock options. Equity Compensation: Unattractive to employees in an LLC. Limited Equity Incentives: Stock options can only be granted to U.S. residents. Fringe Benefits: S corps must either report fringe benefits as taxable compensation to the employees or forfeit fringe benefit deduction available to the company. 7

8 Who Should Consider a C Corp? A C corporation might be the right type of business for you if you: Seek Venture Capital: If you may need venture capital for financing, this is the preferred entity for venture capital investors. Want to Allocate Business Earnings Between the Corporation and Stockholders: A C corp gets taxed twice, once at the corporate taxable income level and again at the dividends/distribution level. Want to be able to offer stock options to employees Anticipate Non-U.S. Investors or a large number of stockholders Want to go public: This is the easiest type of entity to take public in an initial public offering. 8

9 Who Should Consider an LLC? An LLC might be the right type of business for you if you: Anticipate Losses: Your startup company anticipates losses for at least two years and you want to be able to pass the losses through yourself and the other owners. Desire Management Flexibilty: You want management flexibility, since LLCs offer more flexibility than corporations in terms of how the management of the business is structured. Do Not Want to Observe Corporate Formalities: Unlike corporations, LLCs do not face strict ongoing meeting and documentation requirements. 9

10 Who Should Consider an S Corp? An S Corp might be the right type of business for you if you want: Benefits of a C Corp and an LLC: If you want the benefits of a corporate business, but want pass-through taxation, an LLC may be the right business for you. Flexibility to set salaries for employee/owners: This will minimize Social Security and Medicare taxes. Lower risk of IRS audit exposure: S corporations must file an informational tax return. 10

11 Questions or Comments? ATLANTA AUGUSTA CHARLOTTE DENVER DUBAI NEW YORK RALEIGH SAN DIEGO SAN FRANCISCO SEATTLE SHANGHAI SILICON VALLEY STOCKHOLM TAIPEI TOKYO WALNUT CREEK WASHINGTON D.C. WINSTON-SALEM