Choice of Business Entity. Choice of Business Entity

Transcription

1 Choice of Business Entity Dallas Area Paralegal Association September 29, 2010 Presented by: Jim Browne Strasburger & Price LLP Tel: Choice of Business Entity Client: I m starting a widget manufacturing business. Do I need to form a legal entity to conduct the business, and if so, what s the best type of entity to use?

2 Choice of Business Entity Summary In most cases, a limited liability company (LLC) is the preferred business entity No entity level federal income tax or restrictive eligibility requirements A corporation should be used only if The entity s equity interests are publicly traded The entity is a consolidated subsidiary of an existing corporation, or Corporate form is required by applicable legal requirements Choice of Business Entity Types of Business Entities in Texas

3 TX Bus. Org. Code Texas Business Organizations Code ( TBOC ) Consolidation of multiple prior laws Effective for entities formed on or after 1/1/06 And LLPs filing or renewing registration on or after 1/1/06 Effective for existing entities 1/1/10 Procedures provided for early adoption TX Bus. Org. Code Types of entities under the TBOC Corporations Associations For profit corporations Cooperative associations Nonprofit corporations Unincorporated nonprofit associations Limited liability companies Professional entities Partnerships Professional associations General partnership Professional corporations Limited partnership Professional limited liability companies Limited liability partnership Real estate investment trusts

4 TX Bus. Org. Code Texas Business Organizations Code Structure Title 1 - All Entities Title 2 Corporations Title 3 Limited Liability Companies Title 4 Partnerships Title 5 Real Estate Investment Trusts Title 6 Associations For Profit Corporations Nonprofit Corporations Title 7 Professional Entities General Partnerships Cooperative Associations Professional Corporations Professional Associations Professional Limited Liability Companies Limited Partnerships Unincorporated Nonprofit Associations Limited Liability Partnerships Choice of Business Entity Choice of law for a business entity For an entity doing business only in Texas, it is generally most efficient to organize the entity under Texas law Avoids duplicate filing and registration fees (an out-of-state entity doing business in Texas must register here) For entities doing business in multiple states, Delaware is a common choice Delaware has well developed laws and knowledgeable judges

5 Choice of Business Entity Sole Proprietorship Sole Proprietorship Non-tax factors No formal organizational requirements No limited liability No continuity of life owner s death terminates business Transferability of interests only by sale of business assets Access to capital limited Management/Governance no formal requirements

6 Sole Proprietorship Taxation Number/type of equity owners: >1 owner = partnership No entity level tax (federal or state); earnings taxed directly to owner (Form 1040, Schedule C) All earnings are subject to self-employment tax 15.3% on base amount ($106,800 for 2010) 2.9% on earnings in excess of base amount Evaluation Lack of limited liability generally makes this form of conducting business inadvisable Choice of Business Entity C Corporation

7 C Corporation Non-tax factors Organization Certificate of Formation Supplemental Provisions (TBOC 3.007) Limited liability, continuity of life, and free transferability of interests Access to capital most flexible Management/governance Very formal requirements Failure to observe formalities can result in loss of limited liability C Corporation Taxation Number/type of equity owners: no limitation Federal income tax - double taxation Entity level tax (35% max.); no income or loss flow through Distributions of earnings to owners taxed (currently 15% max.) Property contribution or distribution generally taxable Sale of business Sale of stock: taxable to stockholders; carryover tax basis to buyer Sale of assets: taxable to entity; stepped up tax basis to buyer; if sale proceeds are distributed to shareholders, taxable gain to shareholders

8 C Corporation Taxation (con t) Federal income tax special incentives Section 1202 stock: no tax on gain or up to greater of $10 million or 10x basis from sale of a qualified small business stock (QSBS); numerous restrictions Section 1045 rollover: no tax on proceeds from sale of QSBD if reinvested in other QSBS State taxation generally same as federal Employment taxes Wage withholding on compensation payments to employees Distributions of residual profits (i.e., dividends) not subject to employment tax C Corporation Evaluation Imposition of double taxation makes using a C corporation inadvisable Generally used only when The entity s equity interests are publicly traded The entity is a consolidated subsidiary of an existing corporation, or Corporate form is required by applicable legal requirements

9 Choice of Business Entity S Corporation S Corporation Summary S corporation = corporation that files an election with the IRS (Form 2553) as an S corporation Advantages No corporate level tax on the S corporation s earnings No employment taxes on residual earnings (?) Disadvantages: Restrictions on number and types of shareholders, and classes of stock limit the corporation s ability to attract capital and transferability of stock Less tax efficient than an LP or LLC

10 S Corporation Non-tax factors Organization Same as C corporation File IRS election (subject to eligibility requirements) Limited liability and continuity of life No free transferability of interests (due to IRS eligibility requirements) Access to capital: limited (due to IRS eligibility requirements) Management/governance same as C corporation S Corporation Taxation Eligibility requirements Domestic corporation Not more than 100 shareholders Generally only individuals as shareholders Individuals must be U.S. citizen or resident alien Only one class of stock Not a bank on reserve method or an insurance company Other

11 S Corporation Taxation (con t) Federal income tax partial flow through taxation SC s income is reported by shareholders; stock basis adjusts Cash distributions taxed only if > stock basis (excluding entity level debt) Losses limited to stock basis (excluding entity level debt) Property contribution or distribution generally taxable No special allocations Sale of business Single level of tax whether stock sale or asset sale Deemed asset sale election available under Sec. 338(h)(10) (requires 80% stock purchase by a corporation and 100% gain recognition) S Corporation Taxation (con t) State taxation Texas same as C corporation Other varies; most same as federal Employment taxes same as C corporation Residual profits (after payment of reasonable compensation) should escape self-employment tax even if owner is actively involved in the operation of the business

12 S Corporation Evaluation Numerous drawbacks Strict eligibility requirements No stock basis for entity level debt Taxation of property contributions/distributions No tax basis step up for gain on stock sales of <80% or to non-corporate buyer, or on redemptions (effect = double taxation) Self-employment tax treatment often cited as an advantage, but this assertion is debatable except as to a sole owner LLC (see below) Result = LLC or LP generally a preferable alternative S Corporation Uses C corporation with significant built-in gain Conversion to S corporation does not trigger gain recognition, whereas conversion to an LLC or LP would trigger gain Thereafter, corporation s earnings incur no corporate level tax and can be distributed before accumulated earnings After 10 years, built-in gain at time of conversion is released from corporate level taxes Business that must be conducted in corporate form

13 Choice of Business Entity Limited Liability Company Limited Liability Company Non-tax factors Organization Certificate of formation Supplemental provisions (TBOC 3.010) Limited liability and continuity of life Transferability of interests: can t be publicly traded Access to capital: Limitation on publicly traded status Flow through taxation may require special handling for tax exempt and foreign investors

14 Limited Liability Company Non-tax factors (con t) Management/governance: less formality than a corporation Can be member managed (similar to a general partnership) or manager managed (similar to a corporation) Limited Liability Company Taxation No limitation on number or type of equity owners (subject to limitation on publicly traded status) Tax classification: Single member LLC = disregarded entity If owner = individual, LLC = sole proprietorship (with limited liability) If owner = entity, LLC = unincorporated division or branch Multiple member LLC = partnership LLC can elect to be treated as a corporation; rarely advisable

15 Limited Liability Company Taxation (con t) Federal income tax (default) full flow through taxation LLC members report entity s income and adjust tax basis Losses flow though to extent of tax basis (including entity level debt), subject to at risk and passive activity rules Special allocations permitted if substantial economic effect Cash distributions taxed only to the extent > tax basis (including entity level debt) Property contributions/distributions generally tax free Sale of business Single level of tax whether equity sale or asset sale Stepped up basis tax election under Sec. 754 (no 80% requirement) Limited Liability Company Taxation (con t) State taxation Texas generally same as C corporation Other varies; most same as federal Employment taxes Single member LLC same as sole proprietorship; all earnings = self-employment income Multiple member LLC Reasonable compensation subject to employment taxes Residual profits should not be subject to selfemployment tax (?)

16 Limited Liability Company Evaluation LLC is generally the preferred business entity No special eligibility requirements Full flow through taxation Tax exempt and foreign investors often invest through a corporation ( blocker ) Self-employment tax on residual earnings can generally be mitigated Choice of Business Entity Limited Partnership

17 Limited Partnership Non-tax factors Organization Certificate of formation Supplemental provisions (TBOC 3.011) Limited liability and continuity of life Requires at least one general partner with unlimited liability Corporate or LLC general partner can be used Transferability of interests: can t be publicly traded Access to capital generally same as LLC Management/governance similar to manager managed LLC Limited Partnership Taxation Number/type of equity owners: must be >1 owner; can t be publicly traded (similar to multiple member LLC) Can elect to be taxed as a corporation; rarely advisable Federal income tax (default) full flow through taxation Same as multiple member LLC State taxation Texas generally = C corporation, unless a passive entity Other generally same as federal Employment tax similar to S corporation

18 Limited Partnership Evaluation Similar to, but more cumbersome than, an LLC Might be used if an LLC is subject to state income tax as a corporation (as was formerly the case in Texas) Example: an LLC cannot qualify as a passive entity for Texas franchise tax purposes Choice of Business Entity Publicly Traded Partnership

19 Publicly Traded Partnership Description Limited partnership that is publicly traded Often referred to as a master limited partnership or MLP Publicly traded partnership normally taxed as a corporation Taxed as a partnership if 90% of income is from: Interest, dividends, or real property rent or gains Exploration, development, mining, production, processing, refining, transportation, or marketing of any natural resource Commodities, or futures, forwards, and options on commodities Publicly Traded Partnership Evaluation Limited to industries that generate qualifying income E.g., natural gas pipelines; timber; securities trading/private equity Favorable tax status but enormous tax complexity Tracking tax adjustments necessary to keep shares fungible requires significant accounting expense Schedule K1 much more complex than Form 1099-DIV Tax-exempt and foreign owners have issues (UBTI/ECI)

20 Choice of Business Entity General Partnership General Partnership Non-tax factors No formal organizational requirements No limited liability (joint and several liability) No continuity of life death or withdrawal of any GP terminates business (can reconstitute) No free transferability of interests Access to capital: limited Management/governance No formal requirements Any partner can bind the partnership

21 General Partnership Taxation Number/type of equity owners: same as limited partnership Can elect to be taxed as a corporation; rarely advisable Federal income tax (default) full flow through taxation Generally no at-risk or passive activity limitations on losses State taxation Texas taxable entity, except for passive entities and general partnerships of all natural persons Other generally same as federal Employment tax similar to sole proprietorship General Partnership Evaluation Rarely advisable for a business entity, primarily due to joint and several liability

22 Choice of Business Entity Limited Liability Partnership Limited Liability Partnership Description and effect Either a limited partnership or a general partnership that registers as an LLP. See TBOC Partners have limited liability, except for negligence etc. of another partner where The partner was supervising or directing the other partner The partner was directly involved in the specific activity in which the negligence etc. was committed by the other partner Tax effect: generally same as limited partnership

23 Limited Liability Partnership Evaluation LLC is generally preferable to an LLP Use LLP when: Business can t operate as an LLC (e.g., law firm or other professional services firm) State tax implications favor LLP Professional Entities Professional corporation or association Definition: Professional corporation: provides non-medical licensed professional services (e.g., architecture, law, accounting) Professional association: provides medical services Protects owners from entity debts and acts of other shareholders; entity has joint and several liability with owners (similar to LLP) Taxation: generally same as a corporation with some special rules; can elect S corporation status Professional limited liability company Professional entity formed and taxed as a limited liability company

24 Choice of Business Entity Summary Do I need to form and entity and what type? In most cases, a limited liability company (LLC) is the preferred business entity No entity level tax or restrictive eligibility requirements A corporation should be used only if The entity s equity interests are publicly traded The entity is a consolidated subsidiary of an existing corporation, or Corporate form is required by applicable legal requirements Disclaimers This document is not intended to provide advice on any specific legal matter or factual situation, and should not be relied upon without consultation with qualified professional advisors. Any tax advice contained in this document and any attachments was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under applicable tax laws, or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter.