Everyone always wants to know: which entity should I pick? Let’s try and answer that once and for all. Here, we’ll talk about the types of entities. Down the road, we’ll talk about how to think about them.
First, you should know that all business entities are creatures of state law and their rules and the application of their rules vary from state to state. Even though there are serious movements to make all of the laws uniform across the states, there are often variations. Second, there are essentially four types of entities with a bunch of sub-types. The four main types are (1) corporations; (2) partnerships; (3) limited liability companies; and (4) trusts. Now, get some coffee, because here is where this post slows to a crawl.
A corporation is the graying workhorse of business entities – tough, weathered and predictable. It gives owners limited liability. The owners are “shareholders” or “stockholders.” Shareholders elect directors who sit on a Board of Directors and direct policy and hire and supervise management. The entity may be closely held, where there are only a few Owners, or may be publicly held, where there are a large amount of Owners and the stock is sold on a public market. On the downside, corporations have to comply with “corporate formalities,” including annual votes by the Owners. A corporation can be either a C-Corporation or S-Corporation, both of which are tax classifications.
C-Corporation. If you just set up a corporation (by filing articles of incorporation), you would have a “C-Corporation.”
S-Corporation. An S-Corporation is a C-Corporation that has been converted to pass through tax treatment. You get that pass through tax treatment by filing an S-election on IRS Form 2553.
The tax man has lots of rules about what you can and can’t do with an S-Corp. First, no business can own shares in an S-Corp – only people, some trusts and estates can own an S-Corp. That means that if you want to get funding from a venture capital firm or anyone who wants to invest through their company, you cannot be an S-Corp. Second, you can’t have more than one class of stock, though you can have voting and nonvoting stock so long as all stock has equal rights to money. Third, you can’t have more than 100 owners of an S-corporation. Fourth, there are limits to what the S-Corporation can do. For instance, S-Corporations cannot be internationally based, a financial institution or an insurance company. These limitations led frustrated business owners to demand the LLC.
LIMITED LIABILITY COMPANIES
A limited liability company (“LLC”) is a combination of a corporation and a partnership. LLC owners have limited liability and pass through tax treatment. The great advantage of an LLC is its flexibility. You can pretty much shape and reshape the inner workings of the LLC in a variety of ways, including structure of management and allocations of profits, losses and distributions of cash to members. If an entity can be hip, this is it. Its disadvantages are that it is still not desirable on the IPO market, so LLCs typically have to get converted to C-Corporations before the IPO. Because it has only been around since the 1990’s, there is just a smattering of case law to look to for guidance. The filing fee is usually a little more expensive than other entity filing fees.
Single-Owner LLC. To the taxman, an LLC that has just one owner is a disregarded entity, a/k/a “tax nothing.” The owner of the company is looked at as the owner of the company’s assets. The LLC is treated like a branch of the owner. As a result, the singly owned LLC doesn’t have to file a tax return – the taxes get reported on the owner’s return. Caution though: the single owner LLC also has less limited liability protection than LLCs with more than one owner. So, if you are rich and you are the sole owner of a business teaching small children and big moguls how to juggle knives, you may want to go with a corporation.
LC3, A Hybrid. The LLC is also the source (or repository) of experiments in business entity design. For instance, there is a new entity called the Low Profit Limited Liability Company (a/k/a LC3) that is essentially an LLC that can take money from traditional investors AND foundations and charities. The goal of the LC3 is to foster social entrepreneurship, which is business run for both social good and profit. Like all entities, LC3s are creatures of state government, but they depend heavily on IRS rules around foundation investing, which are complex and dicey. LC3s only exist in a few states, like Illinois, Vermont, Michigan, Wyoming, Utah and Louisiana. (Corporate Law Fun Fact: LLCs started in Wyoming, so it’s a nice bit of symmetry that they are also pioneering LC3s.)
General Partnership. A partnership is two or more people joined together to operate a business for profit. It is the default form of business entity if you do nothing to set up an entity and you own your business with other people or companies. Partnerships have pass through tax treatment, and are not separate, taxable entities. The partners pay their pro rata share of the income and loss on their own income tax return. The advantages of partnerships are that they are cheap and easy to set up and partners usually have equal management rights, which can also be a disadvantage. To vary egalitarian management, you have to write a partnership agreement. Partnerships have no limited liability – a partner can be on the hook for all of the business debts, regardless of how small his ownership piece. I haven’t set up a partnership in about 10 years.
Limited Partnership (“LP”). A limited partnership is a special kind of partnership that must be formed by filing a document with a state. In a limited partnership, at least one owner has to be the “General Partner” and at least one owner has to be a “Limited Partner.” The General Partner usually runs the business. Often, though not always, the limited partner is “silent,” in that they invest in the business, but they don’t work in or manage the business. The General Partner doesn’t get limited liability – it is on the hook for the entity’s obligations; but the limited partner does get limited liability if he is really silent. Limited partnerships have pass through tax treatment. Limited partnerships are a decent option for investors who have no real role in management. Further, if you have foreign partners, this may be the only option for limited liability and pass through tax treatment. LPs are losing a little luster in the age of LLCs.
Limited Liability Partnership (“LLP”). This is a combination of a corporation and a partnership, usually only for professional entities – like lawyers and doctors. Limited liability varies considerably from state to state. Owners have pass through tax treatment and some flexibility in the ability to structure management, profits, losses and cash to owners. I rarely use these, although my law firm is an LLP.
And, finally, there are trusts. A trust has four components: a trustee, a beneficiary, assets and rules. The rules come mostly from a document that establishes the trust and lays out it purposes and powers. The trust document names a trustee who controls and sort of owns all the assets. A trustee does everything with the assets solely for the beneficiary. The beneficiary is the person who gets all the good things flowing from the trust. For instance, if real estate investors set up land trusts to hold property, the beneficiaries probably get the distributions of cash from rents. Every trustee has a bunch of legal obligations to protect the assets, which demotivates the trustee from taking risks. Plus, the limited liability elements of a trust are funky and have to be put into the trust document in a way that doesn’t violate a century of law. As a result, trusts are not good entities for running a business. However, trusts are used frequently by lawyers crafting sophisticated asset protection plans for rich people. Since that’s not my purpose in life, I don’t use them that often.
So, those are the 4 types of entities. Next up: What do I do with them?