What’s the Best Type of Corporate Form?

Corporate Buildings

One of the first and most complex matters is to choose a form of incorporation. There are many options available and the sponsors of the potential business should consult with a professional on how to choose the best option. There are some variations on corporate form between the States, below are some of the basic corporate forms available, who they are for, and pluses and minuses.

C-Corporation

A C-Corporation is a business organized as an entity which is taxable as a corporation under the Internal Revenue Code. C-Corporations pay taxes on income earned at the corporate level, while shareholders (owners) of the corporation also pay taxes on dividends/distributions at the individual level. Under State laws, shareholders of C-Corporations are generally immune from personal liability for the actions of the corporation.

Who should be a C-Corporation? Businesses that plan to have a large group of passive investors in the corporation, companies seeking outside financing (venture capital), businesses that will hold cash/assets at the corporate level and do not want to burden their investors with taxes until the cash/assets are distributed.

Issues to keep in mind: C-Corporations must follow corporate formalities in order to keep their status and protect their shareholders from lawsuits. This includes, keeping proper records, holding regular Board Meetings and making certain filings. Profits of a C-Corporation are taxed at the corporate level and again at the shareholder level (double taxation).

S-Corporation

The S-Corporation is a flow-through version of the C-Corporation. S-Corporations are similar to sole proprietorships and partnerships in that corporate earnings are taxed at the individual level (pass through taxes). Otherwise, S-Corporations enjoy the same limited liability and incur the same formal obligations as C-Corporations.

Who should be an S-Corporation? Small or family-owned businesses that do not plan on having more than 100 shareholders. The S-Corporation form is advantageous for limiting liability while allowing the shareholders of the business access to earnings without double taxation.

Issues to keep in mind: Because of limitations on share issues, S-Corporations may face limited outside investment opportunities. S-Corporations are generally limited to no more than 100 shareholders, the shareholders must be U.S. residents and the S-Corporation cannot be held by an outside entity. In addition, S-Corporations are expected to follow many of the corporate formalities of C-Corporations.

Partnership (LP/LLP)

A limited partnership is a business association with a general partner (one who takes responsibility for operation of the partnership and is personally liable for the partnership’s debts) and any number of limited partners. The limited partners have no role in business operations and their liability for the partnership may be limited. Many States have a similar entity called the limited liability partnership (LLP) which allows general partners to limit their personal liability.

Who should be an LP/LLP? The partnership form is generally used by law firms, professional firms and certain kinds of investment funds. Historically, professional organizations were required to adopt the LP/LLP structure (law firms, doctors, accountants, etc, …). The partnership structure is advantageous for those seeking pass through tax treatment similar to the S-Corporation.

Issues to keep in mind: Traditional partnerships may expose general partners to the liability of the partnership. As a pass-through entity, individual partners are taxed based on their share of the partnership’s income. This ca be advantageous, but potential partners should be mindful of phantom income issues. In some cases, a partnership may report earnings of a partner, but not distribute cash to cover tax liability.

Limited Liability Company (LLC)

A limited liability company is a corporate association formed more on the basis of contract principles. LLCs may choose partnership (flow-through) or corporate (double) taxation treatment by election. Relations between all of the participants in a LLC are governed by the LLC’s operating agreement, a contract which specifies roles, obligations, holdings and other issues of corporate policy. LLCs are composed of members (participants/investors) and managers (day to day operations). A member of an LLC may also be a manager and a manager need not be a member. LLCs also shield their members and managers from personal liability, similar to the protection offered by a C-Corporation. Some jurisdictions have a professional or regulated version of the LLC called the professional limited liability corporation (PLLC). PLLCs often require that professional members/managers be subject to professional liability claims, but not general liability claims.

Who should be an LLC? Start-up companies are often good candidates for the LLC form. The company gains the advantages of incorporation without the hassle of maintaining C-Corporation corporate formalities. A LLC may also base the relationship between the participants on a contract basis, simplifying ownership. Professional firms may also choose the PLLC form for similar reasons.

Issues to keep in mind: LLCs must remember to elect their preferred tax treatment at the time of incorporation. A flow-through entity (partnership taxation) can optimize taxes on corporate earnings. However, where there would be phantom income issues, for instance, an LLC member who cannot afford their share of the LLC’s generated tax liability, or where the LLC will need to retain a large amount of cash, the LLC can elect corporate taxation (double taxation). LLCs are governed by their operating agreements, so it is important to make sure that this document is accurate and up to date. There is some concern that LLCs are not an ideal form for fundraising from outside parties, for example, venture capital. However, a well constructed LLC should not raise investor concerns and should be capable of managing a transition to a C-Corporation or other preferred form.

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