Issue No.10 - Oct. (2012 vol.45)
Published by the IEEE Computer Society
Brian M. Gaff , Edwards Wildman Palmer LLP
Karl P. Fryzel , Edwards Wildman Palmer LLP
DOI Bookmark: http://doi.ieeecomputersociety.org/10.1109/MC.2012.353
The tenth in a series of articles providing basic information on legal issues facing people and businesses that operate in computing-related markets discusses the different types of corporate entities. The Web extra at http://youtu.be/eO5tKt5UJAQ is an audio recording of authors Brian M. Gaff and Karl P. Fryzel discussing the different types of corporate entities.
When starting a business, one of the first things to do is to choose an entity structure. The choice is usually whether the business will be a corporation, a limited liability company, a partnership, or have some other structure. There are legal and tax consequences to this decision, so it's best to make a choice only after consultation with an attorney.
This month's column provides a brief overview of the different corporate structures to consider and describes some advantages and disadvantages of each. Those entities include C corporations, S corporations, limited liability companies (LLCs), general partnerships, and limited partnerships.
Be sure to check the IEEE Computer Society's webpage for the podcast that accompanies this article at www.computer.org/portal/web/computingnow/computingandthelaw.
A C corporation is the most well-known corporate structure. An S corporation is handled differently for tax purposes. Its name is based on a subchapter of the US Internal Revenue Code.
A C corporation is incorporated under state law. In a corporation, stock is issued to shareholders, who are generally insulated from liability of the corporation except where the corporation is deemed to act as the alter ego of the shareholders or is severely undercapitalized. The corporation is managed on a day-to-day basis by officers who are overseen by and report to the board of directors.
There are several advantages to setting up a business as a C corporation. For example, most investors are familiar with C corporations and are comfortable working with them. There is great flexibility in the kinds of securities that a C corporation can issue, including multiple classes of common stock, preferred stock, and options. Certain investors, including practically all institutional venture capital investors, will either not invest in businesses that are treated as flow-through entities for tax purposes (such as S corporations and LLCs) or limit their investments in such entities. Such investors prefer investing in C corporations.
A disadvantage of a C corporation, however, is that it is subject to taxes on profits at a corporate level. Therefore, distributions to shareholders can be taxed twice—once at the corporate level and again at the shareholder level.
S corporations are set up to avoid this. Although they're incorporated in the same manner as C corporations, S corporations make an affirmative election to be treated as a pass-through entity for tax purposes. Although there's no federal corporate-level tax on an S corporation, some states do impose a tax.
All profits and losses of an S corporation are allocated among its shareholders, similar to an LLC. The founders will be able to take the losses to the extent of any cash invested in the corporation. Otherwise, the losses are deferred until there are offsetting profits. As in a C corporation, stock is issued to shareholders, and the corporation is managed on a day-to-day basis by officers who are overseen by and report to a board of directors.
Clearly, the advantages of an S corporation include having the familiar organization of a board of directors, officers, and shareholders. Because it can have only one class of stock, this is one of the simplest structures to form and maintain. Also, as a flow-through entity for tax purposes, there is no federal entity-level tax as in a C corporation.
However, S corporations do have some disadvantages. For example, to qualify as an S corporation, a business can't have more than 100 shareholders, only US citizens and US resident aliens can be shareholders, and most businesses (including corporations and LLCs) can't be shareholders. S corporations can't issue preferred stock. These limitations on the classes of stock and number and types of shareholders can make an S corporation an unattractive investment vehicle.
Limited Liability Companies
If the goal is to get flow-through tax treatment, an LLC is usually a more attractive choice than an S corporation. LLCs are also formed under state law, but they didn't exist in most states in the US before the 1990s.
LLCs combine elements of corporations and partnerships. LLC members—not managers, as would be the case in a partnership—control the organization. An operating agreement can define the LLC's corporate governance.
Most LLCs elect to be treated as flow-through entities for tax purposes. Thus, there is no federal entity-level tax, although some states do impose a tax. Other advantages of an LLC include having a liability shield that previously was the sole domain of corporations and the organizational flexibility that only partnerships traditionally provided.
Indeed, LLCs are extremely flexible and, unlike S corporations, distinctions can be made between various types of membership interest, priority of payment of distributions, and allocations of profits and losses. Certain membership interests can be issued as compensation without application of the special deferred compensation rules and tax under Section 409A of the US tax laws.
LLCs can't issue incentive stock options, but they can allow flexible compensation arrangements with favorable tax treatment similar to incentive stock options using so-called profits interests. In fact, recipients of profits interests generally have better tax results compared to receiving corporate options. LLCs also allow option and deferred compensation plans similar to nonqualified stock options and phantom stock. LLCs can distribute most types of appreciated property tax-free to members as well.
Keep in mind, however, that LLCs usually have more burdensome tax reporting requirements, such as quarterly estimated tax returns, annual K-1 filing, and potential self-employment taxes for LLC members (though not for option holders). Also, certain investors, including many venture capital investors, will either not invest in entities that are treated as a flow-through for tax purposes or limit their investments in such entities because either they or their limited partners who are tax-exempt entities want to avoid unrelated business taxable income being allocated to them. Also, non-US investors typically want to avoid being taxed in the US on effectively connected trade or business income.
In part because of their flexibility (and because LLC statutes provide less default corporate governance than corporate statutes), LLC operating agreements can become more complicated than corporation formation documents, so forming an LLC can be more expensive. Because the governance structure of LLCs is generally less familiar to many investors and business partners as well as to a start-up's own founders and employees, a corporate structure can be grafted onto an LLC by means of a contract through the LLC's operating agreement. This can usually be done at little additional cost.
It's possible to form one type of entity and decide later to convert to a different type of entity. For example, an S corporation can easily be converted to a C corporation. The conversion of an S corporation to a C corporation and vice versa is a change in tax election, and for corporate law purposes, doesn't involve a change in business entity. However, while a C corporation can convert to an S corporation, there may be complications and tax inefficiencies if the C corporation has different classes of stock (remember that an S corporation can only have one class of stock) or if the corporation has retained earnings or appreciated property.
Conversion of an S corporation or a C corporation to an LLC is a taxable event. It's as if the corporation were being liquidated, thereby triggering a potential tax on the corporation and another tax on the shareholders.
An LLC can convert to a C cor-poration or an S corporation. This conversion doesn't cause a taxable event, provided that the interests before such conversion mirror the interests after the conversion.
General partnerships and limited partnerships are other kinds of entities to consider. However, in practice, they're usually less attractive for the typical start-up company.
The proper choice of entity is a complicated decision. It requires a careful review and analysis of the business, including its goals and funding mechanisms. Tax laws change frequently, so what was once a good choice can quickly become undesirable. Consultation with an attorney who understands the intricacies of the applicable laws and how they could affect your business, particularly as your business evolves, is critical.
Brian M. Gaff is a senior member of IEEE and a partner at the Edwards Wildman Palmer LLP law firm. Contact him at email@example.com.
Karl P. Fryzel is a partner at Edwards Wildman Palmer LLP law firm. Contact him at firstname.lastname@example.org.