The importance of being flexible: choice-of-entity considerations.

• Author: Baily, Brianna

Generally, the first consideration in setting up a business is the choice of entity in which to conduct the business. To that end, there are tax and nontax considerations. This item presents an overview of some of the tax points that should be kept in mind when choosing an entity. It focuses primarily on the taxation of the partnership and corporate forms of doing business, the pros and cons of each, as well as the distinctions between C corporations and S corporations.

To set the stage, the item sets forth some nontax considerations for partnerships, corporations, and limited liability companies (LLCs). For tax purposes, an LLC may afford more flexibility because, through a simple election, it can be taxed either as a partnership, a C corporation, or an S corporation. Next, this item focuses on tax considerations, contrasting the income taxation of partnerships, C corporations, and S corporations, and exploring issues such as compensatory options and attracting investors. Finally, this item examines a few critical post-formation considerations, focusing on the implications of foreign operations and certain issues related to separating business lines.

Nontax Considerations

A business must take many factors into account when deciding which form of entity is appropriate. The ease and cost of entity formation may cause some business structures to stand out to entrepreneurs, particularly when they are starting out with very little capital. However, the flexibility of the structure is of significant importance, as startups are dynamic and have different needs at different stages of growth. Accounting for these needs from the start may reduce the likelihood of incurring avoidable costs in changing the type of business entity. The following business entities are the structures that entrepreneurs most commonly consider.

Partnership: A partnership is a legal entity for a business entered into by two or more persons. There are two types of partnerships: general or limited. In a general partnership, all the partners are personally liable for partnership debts. In a limited partnership, however, at least one partner must be designated as the general partner, and that general partner has unlimited personal liability for partnership debts. The limited partners, on the other hand, are liable only to the extent of their investment in the company. However, a limited partner might lose his or her "limited" status and thus be personally liable for partnership debts if he or she is viewed as playing a role in management, i.e., acting as something other than a purely passive investor.

Corporation: Corporations are legal entities independent from their owners and provide some protection from personal liability. Thus, a shareholder's risk of loss is limited to his or her direct investment in the corporation. However, to sustain that liability shield, certain legal formalities must be observed, e.g., a corporate charter, bylaws, and a board of directors, as well as compliance with regulatory reporting requirements. Compliance with these formalities often comes with significant legal costs, which may be daunting for a startup

company.

Additionally, shareholder and stock restrictions under Sec. 1361 come into play when comparing an S corporation to a C corporation. C corporations allow for an unlimited number of shareholders, with no restrictions on the type of ownership, whereas S corporations have a limit of 100 shareholders, all of which must be either U.S. citizens or permanent residents, certain trusts, bankruptcy estates, other estates, and certain tax-exempt organizations, not corporations (including LLCs) or partnerships. Although a C corporation does not restrict stock issuance, an S corporation can have only one class of stock.

LLC: LLCs have become increasingly common, particularly in the startup realm. In general, it is far easier and less expensive to set up an LLC than it is to set up a corporation. An LLC only requires an operating agreement outlining the expected duties of managers and the general governance of the company, thereby avoiding some of the...