CHOICE OF ENTITY CONSIDERATION


Are you seeking an experienced business lawyer to assist with selecting the appropriate business entity for your business?

ENDEAVORLEGAL provides entrepreneurs and small business owners the legal and business advisory services new and experienced entrepreneurs need to form a business entity appropriate to their particular needs. We advise clients with regard to selecting the appropriate type of entity for the venture prior to the formation of a new business. A corporation may be appropriate for one business while a limited liability company may be the right entity for another. Our attorneys work with entrepreneurs on a case by case basis in choice of entity considerations.

An entrepreneur must consider many issues when determining how to organize a new business venture. What type of business will be conducted? Who will participate in the ownership and operation of the business? What type of tax burden will the venture carry? What level of organizational complexity will be necessary to accomplish the owners’ objectives? These are just a few of the questions that must be answered prior to selecting the proper organizational form for the new business venture.

The information on this page sets forth a number of the issues that should be considered in making business planning decisions.

Related Materials

Incorporating in Massachusetts
Organizing a Limited Liability Company in Massachusetts
Choice of Entity: Taxation Considerations

Formation of the Business Entity

C Corporation

Incorporating documents must be filed with the Secretary of State and a minute book must be prepared including by-laws and shareholder and board of director resolutions. The corporation must also obtain an Employer Identification Number (EIN) number from the Internal Revenue Service (IRS). If the corporation is to conduct business in a state other than the state of incorporation it must be qualified to do so; this is accomplished by filing a document with the Secretary of State of the alternate state.

S Corporation

In addition to the organizational actions that must be taken by a C Corporation, in order to create an S corporation, the shareholders of the corporation must file Form 2553 with the IRS electing to be taxed under Subchapter S of the Internal Revenue Code. In order to qualify for S corporation status, the corporation must meet the following requirements:

  • Be a domestic corporation

  • Have only allowable shareholders

    • including individuals, certain trusts and estates, and

    • may not include partnerships, corporations or non-resident aliens

  • Have no more than 100 shareholders

  • Have only one class of stock

  • Not be an ineligible corporation

    • certain financial institutions

    • insurance companies

    • domestic international sales corporations

Limited Liability Company

Organizational documents must be filed with the Secretary of State and a LLC operating agreement must be prepared. In addition, the LLC must obtain an EIN number from the IRS. If the LLC is to conduct business in a state other than the state of organization it must be qualified to do so; this is accomplished by filing a document with the Secretary of State of the alternate state.

Limited Partnership and Limited Liability Partnership

Organizational documents must be filed with the Secretary of State and a limited partnership agreement must be prepared. In addition, the limited partnership must obtain an EIN number from the IRS. If the limited partnership is to conduct business in a state other than the state of organization it must be qualified to do so; this is accomplished by filing a document with the Secretary of State of the alternate state.

General Partnership

No organizational documents are required to be filed in the formation of a general partnership. A general partnership is formed when two or more people agree formally or informally to associate in a profitable business enterprise.

Multiple Classes of Ownership Interests

C Corporation

  • Advantage: Numerous classes of stock may be created to provide different rights to different types of owners (i.e. investors vs. owner-operators).

  • Disadvantage: Corporate stock terms can be very rigid. Their mechanics cannot easily be modified to create stock giving its holders economic rights that track corporate earnings or appreciation associated with designated company assets.

S Corporation

  • Disadvantage: The IRS permits S corporations to authorize and issue only one class of capital stock. In addition, there are limitations on the number and type of shareholders a S corporation may have.

Limited Liability Company, Limited Partnership, Limited Liability Partnership, General Partnership

  • Advantage: Allocation and distribution rules for these types of entities are very flexible, and LLC operating agreements and partnership agreements can be drafted to include special types of ownership interests that track earnings or appreciation associated with designated company assets.

  • Disadvantage: These type of business entities can not issue incentive stock options.

Governance

C Corporation

  • Advantage: State law governing corporations is very detailed and provides a road map as to how company affairs must be conducted and transactions approved.

  • Disadvantage: If statutorily mandated procedures are not followed, shareholders may lose their limited liability protections.

S Corporation

  • Disadvantage: In addition to the requirements of state law, the IRS imposes certain rules for the continued maintenance of the corporation’s election to be taxed under Subchapter S of the Internal Revenue Code.

Limited Liability Company, Limited Partnership, Limited Liability Partnership, General Partnership

  • Advantage: Generally, state law governing the governing these types of entities provides flexibility to owners in determining how company affairs will be conducted. LLC operating agreements and partnership agreements can be drafted to limit the amount of records that must be maintained and what actions must be taken prior to consummating transactions.

Federal Taxation Considerations

Click Here to view “Choice of Entity: Federal Tax Considerations.”

Limited Liability Concerns

C Corporation

  • Advantage: All holders of the stock of a corporation have limited liability protections.

  • Disadvantage: If state mandated corporate governance rules are not followed the “corporate veil” may be pierced and shareholders will lose limited liability protections leaving their personal assets subject to seizure for the debts and obligations of the corporation. A violation of a statutory rule can be as simple as the failure file an annual report with the Secretary of State or to maintain accurate records of board of director or shareholder votes.

S Corporation

  • Advantage: All holders of the stock of a corporation have limited liability protections.

  • Disadvantage: If state mandated corporate governance rules are not followed the “corporate veil” may be pierced and shareholders will lose limited liability protections leaving their personal assets subject to seizure for the debts and obligations of the corporation.

Limited Liability Company

  • Advantage: All holders of membership interests in an LLC have limited liability protections. In addition, state mandated rules for LLC governance are flexible, providing the owners of the LLC with the ability to determine their own governance structure by entering into an LLC operating agreement.

Limited Partnership

  • Advantage: The limited partners who possess only an investment ownership interest in the limited partnership and do not actively participate in the business of the enterprise receive limited liability protections.

  • Disadvantage: The general partner who actively participates and controls the business of the enterprise does not receive limited liability protections leaving him or her open to unlimited personal liability for the debts and obligations of the limited partnership. Often, a corporation with limited assets is organized to serve as the general partner of the limited partnership. This arrangement is a bit clunky and in many cases has become obsolete by the advent of the limited liability company.

Limited Liability Partnership

  • Advantage: The each partner in the partnership receives limited liability protections. Of course, each partner is still personally liable for his or her own wrongful or negligent act or omission, but the other partners are shielded from liability for those acts.

General Partnership

  • Disadvantage: The partner may take part in the management of the business but is also responsible for all the liabilities of the general partnership. If one partner is sued, all partners are held liable. General partnerships are a very undesirable form of association for this reason.

Impact on Investors

C Corporation

  • Advantage: Venture funds and angel investors are very familiar with the corporate form. C corporations can issue stock with a hierarchy of rights permitting investors to have rights preferential to those of the founders of the business venture.

  • Disadvantage: C corporation’s profits are taxed at the entity level. In additions, distributions to shareholders are taxed at the individual level resulting in a two-tiered taxation regime that investors may wish to avoid.

S Corporation

  • Advantage: Investors may want to avoid the two-tiered tax regime associated with holding shares of a C corporation.

  • Disadvantage: Investors may not be interested in the “flow-through” taxation associated with being a shareholder of an “S corporation.”

    Non-US investors often must avoid investments that would cause them to be treated as “engaged in a trade or business within the United States.” Each member of a flow-through entity is treated as engaged in any trade or business in which such entity is engaged.

    The IRS permits a S corporation to issue only one class of capital stock. Investors often mandate that their investment in a venture is evidenced by stock with rights superior to those of the founders.

Limited Liability Company, Limited Partnership, Limited Liability Partnership, General Partnership

  • Advantage: Investors may want to avoid the two-tiered tax regime associated with holding shares of a C corporation. In addition, investors may find the ease of creating various classes of ownership interests beneficial to their business and investing objectives.

  • Disadvantage: Investors may not be interested in the “flow-through” taxation associated with being a member of a LLC or a partner in a partnership.

    Non-US investors often must avoid investments that would cause them to be treated as “engaged in a trade or business within the United States.” Each member of a flow-through entity is treated as engaged in any trade or business in which such entity is engaged.

Initial Public Offering

There is no significant benefit to selecting one entity over another when it comes to considering an initial public offering as an exit strategy. If the company were organized as a LLC or a partnership, it would be “rolled-up” into a corporation on a tax free basis prior to a public offering, either by having the members of the LLC or partners of the partnership sell their LLC or partnership interests to a new C corporation or by having the LLC or partnership transfer its assets to a new C corporation. If the company maintained an election to be taxed under Subchapter S of the Code, it would no longer be qualified to do so.