Selecting the Legal Form of Your Company

When a business plan is developed, consideration must be given to the form in which the business is to be conducted. There are several possibilities, which are described below.

S Corporations

A special subtype of the incorporated entity is called the "S Corporation" (formerly "Subchapter S" Corporation), the name taken from the location of the governing provisions in the Code. For most purposes, S Corporations are garden-variety corporations under state law, the distinguishing factor being that if they configure themselves to meet special rules of the Internal Revenue Code, no corporate tax is assessed, thereby passing through corporate income and losses directly to the shareholders. Under the Tax Reform Act of 1986, S Corporations became increasingly popular because, for the first time since 1916, personal tax rates were lower than the corporate tax rates, thereby putting a premium on the ability of a business entity to pass through its income to its shareholders without the imposition of tax. Moreover, while losses from passive activities may not be offset against income other than from passive activity under the Tax Reform Act of 1986, losses garnered by an S Corporation and allocable to a shareholder who materially participates - as an officer, for example - in the S Corporation's business may elude the "passive activity" trap and thus be more widely useful. However, such losses are generally limited to the shareholder's tax basis in his stock and any loans he has made to the corporation.

When contemplating tax issues, keep in mind that the treatment of S Corporations for local tax purposes can complicate the issue, since New York City and some states refuse to recognize S Corporations as "flow-through entities". Moreover, a large element of any individual or corporate tax strategy has to do with the treatment of fringe benefits. A person owning 2 percent or more of the voting stock of an S Corporation is a "partner" for certain fringe-benefit purposes, such as group term life insurance and medical insurance, and a partner fares less well with fringe-benefit than does a stockholder/employee of a C Corporation.

The good news is that S Corporation status is relatively easy to achieve and, when necessary, to surrender; a timely election approved by the shareholders and filed with the IRS is all that is required. However, if a C Corporation builds up unrealized appreciation in its assets and then switches to S status prior to a sale of those assets in order to avoid double tax, the IRS has statutory weapons.

Limited Liability Companies (LLCs)

The limited liability company, in effect an incorporated partnership, has gained considerable momentum since 1988, when the Internal Revenue Service ruled that a corporation organized under a special Wyoming statute qualified for pass-through tax treatment as a partnership even though the entity possessed the corporate characteristic of limited liability. The following discussion of a limited liability company is oriented toward the Delaware statute (the Act). In the following discussion, it should be assumed that unless otherwise indicated or unless the context suggests otherwise (i.e., fundamental rules on how the entity is to be organized), any provision of the Act can be modified by agreement of the parties.

Under the law in some states, a limited liability company must have at least two "members" (i.e., owners), an inheritance from the underlying concept of liability company which implies two or more participants. As a structuring issue, if only two partners are involved, the agreement between them should not name a mutually acceptable third party to become a member if one member dies or withdraws, if only for purposes of liquidating the entity.

The members may directly manage the company or they may delegate all or a portion of that task to "managers" (an equivalent of directors or general partners). Limited liability companies can be organized in Delaware for any purpose other than banking or insurance.

A limited liability company is formed by filing a certificate of formation with the secretary of state. The certificate must set forth the name of the company (which shall contain the words "Limited Liability Company" or "LLC"), the address of its registered office, and the name and address of its registered agent for service of process. The certificate need not identify the names and business addresses of the initial members or managers, nor the purposes for which the LLC was organized. The omission of members' and/or managers' names is the better practice. The list of limited partners required in the certificate by outdated versions of the Uniform Limited Partnership Act only served to identify prospects for salesmen pushing securities.

The Act contemplates that the affairs and conduct of the business of a limited liability company will be governed by a written operating agreement (the Agreement). There is no requirement that the Agreement be made public; some practitioners may, however, wish to publicize portions of the Agreement, by incorporating the same in the Certificate of Formation, in hopes that constructive notice to, say, creditors and vendors, will prove helpful at some point down the road. If an LLC is to be used as a special-purpose, bankruptcy-remote vehicle, for example, the sponsors might want a purpose clause on the public record indicating to all the world that the company is not authorized to borrow money or run up bills except in certain specified ways.

The Agreement may contain any provisions for the regulation and management of the company which are not inconsistent with the Act. The entity may be governed like a general partnership, all members voting on all matters in proportion to their profits' interests, with no delegation to managers. However, the norm is expected to be delegation of management functions to managers (a.k.a. directors). The Act does not mention officers specifically; but there is no reason not to appoint the same if deemed useful, much as partnerships appoint officers from time to time.

The Agreement will generally specify how profits and losses will be allocated and distributions made. An important query at this point is if the Agreement should be like a typical partnership agreement in providing for such items as adjustments to keep the system in sync with the Treasury Regulations under I.R.C. §704, the appropriate profit allocation upon a distribution in-kind, and the like.

Once a Delaware limited liability company has creditors, no distributions or returns of capital can be made if that action would cause the fair value of its net assets to be less than zero. Indeed, under applicable fraudulent-conveyance statutes, the constraint on distributions extends to those which might make the firm insolvent or leave it unreasonably short of capital. Other than that restriction, however, distributions by a limited liability company can be structured in any way the members or managers choose. If no allocation is specified in the Agreement, the Act specifies that distributions and profits and losses will be allocated by proportionate share of the "agreed value" of membership interests. But discriminatory distributions are allowed if the governing documents so provide. If a member resigns, he is entitled to receive within a reasonable time the fair value of his membership interest based on his right to share in distributions. (As stated above, this and most other rights can be modified or curtailed by the Agreement.)

This Act also clarifies relationships between members and the company. It is, for example, acceptable for a member to transact business with the company. In such a role, the member has the same rights as any nonmember. And, to the extent members have a right to distributions, they have creditor status.

The Act specifies that new members may be admitted only with the unanimous consent of the existing members unless the Agreement otherwise provides. The Agreement may provide any admission procedure imaginable; for example, under the Act, one can become a member by orally agreeing to become a member. Stock or other certificates are not specifically mentioned. Moreover, unlike corporations in some states, membership interests can be issued for whatever consideration the members choose, including a promissory note or future services. At this point, careful counsel will consider creating formalities in the Agreement so that, for example, when the time rolls around for an opinion to issue on, say, the status of certain issues, the lawyer concerned will have something to go on.

The Act has established a procedure whereby limited liability companies organized in other jurisdictions can qualify to do business in Delaware. And, the Act is specific on such issues as the LLC's ability to merge with LLCs and C Corporations (foreign and domestic). The Act provides for partnership-type rights of members to look at the books and lists of members, subject only to "reasonable" limitations.

Limitation of liability for members is a cornerstone of the Act. Members of limited liability companies are not risking their personal assets; they are not liable to creditors "solely by reason of being a member or acting as a manager." Members are, on the other hand, liable for any contributions they agreed in writing to make and the obligation survives death or disability; if required property or services are not contributed, the company may require a cash contribution of equal value. The Act also recognizes that there are contractual elements to the relationship of the members. For example, the Act allows for the resignation of a member or manager unless the Agreement provides he may not, in which case the company may recover damages for breach from the manager and offset those damages from other distributions. The Act imposes liability on managers and members to return improper distributions, but, in the case of members, only if the member knew at the time the distribution was improper.

In the event of bankruptcy of an LLC, the rules pertaining to corporations (versus liability company) apply. Most states (Florida being a prominent exception) treat LLCs as liability companies for tax purposes.

One major drawback is the risk that a court outside Delaware considering an action against a Delaware LLC may hold the members and/or managers liable as general partners. The risk is reduced since all states have adopted limited liability company legislation. Moreover, if the sponsors of the LLC observe the customary and usual rules to avoid the corporate veil being pierced, the risk of an LLC being treated as a general partnership should be manageable.

Corporation Versus Limited Liability Company

There are a number of alternatives not discussed in this text, including general and limited partnerships, business trusts, sole proprietorships, etc. In the final analysis, the choice usually comes down to an S or C corporation or a limited liability company. The following summary of certain important issues is intended to help you make the final decision.

Liquidity

Most practitioners perceive public trading in shares of corporate stock as more efficiently accomplished than trading in limited liability company interests. Corporate shares were designed to be liquid; not so limited liability company interests.

Flexibility versus Formality

Except to the extent the general corporation law of a given state provides relief, corporate existence entails a higher degree of formality and expense) than life under a limited liability company. Corporations require a formally elected board of directors, statutory officers, stockholders meetings, class votes on certain issues, and records of meetings. These formalities are often neglected, but at some peril; if there is no evidence of formal directors' meetings, plaintiffs can contend the board was negligent in carrying out its fiduciary duties to the stockholders because one of the functions of a board is to hold formal meetings.

Familiarity

Corporate law has been more thoroughly developed than limited liability company law in the litigated cases. There is more predictability from a legal standpoint. Counsel can forecast with a higher degree of confidence what the Chancery and Supreme Courts in Delaware will do on a given state of facts. Indeed, for every case construing a Limited Liability Company Act, there are hundreds construing the general corporation laws.

Tax Issues

Organizational tax issues will revolve principally around the fact that earnings by a business operated in corporate form generate federal and state income tax on the corporate level. When those earnings are distributed (if they are) by way of dividends (or in liquidation), they ordinarily generate additional tax again, this time levied upon the shareholders, and such dividends are not deductible corporate expenses. Avoidance of "double taxation" will drive the preference of planners toward the liability company format. There are ways to avoid double taxation, but the gate is substantially narrower than it was before January 1, 1987.

Starting one's business in noncorporate form will prove to be popular for yet another reason. Upward pressure on corporate rates, plus the post-1986 difficulty in extracting profits from corporate solution without paying double tax, puts a premium on avoiding corporate tax altogether. Partners do pay tax on revenue whether it is distributed or not and it may be necessary to retain earnings in the entity to expand the business. That is not, however, a major problem in most instances. The limited liability company simply distributes enough cash to the partners to pay tax at an assumed rate (28 to 34 percent, plus something for state taxes) and retains the rest, the danger being that the limited liability company will have taxable income but no cash, in a year of large principal payments on debt, for example.

Migration from one form of organization to another is a one-way street. A limited liability company can organize a corporation and transfer its assets thereto without tax, assuming that the partners contributing cash and/or the property hold 80 percent or more of the resultant voting stock and the liabilities of the limited liability company do not exceed the fair value of its assets; if a corporation wants to organize itself as a limited liability company, however, there is a double tax under the new tax law. Appreciated assets are taxed at the corporate level and the shareholders taxed on the liquidation distributions.

Further, election of the limited liability company structure allows somewhat greater flexibility in allocating items of income and loss among the partners. The dream of the organizers of a business is to be able to strike a deal between the suppliers of capital and the managers in a tax-neutral setting. The founder and the investors want to be able to arrange the split between them of calls on the company's future income (in the person of shares of capital stock or interests in limited liability company profits) without worrying about the consequences of that allocation as a taxable event to either party. In a limited liability company, interests in profits can be allocated and reallocated more or less as the parties agree, without regard to the respective contributions of capital. The allocation must have "substantial economic effect," which means not much more than that a scheme directly keyed to the tax status of the partners is questionable. A corporation can distribute stock disproportionate to paid-in capital but only within certain limits.

On the other hand, limited liability companies are not eligible to participate in tax-postponed reorganizations under I.R.C. §368. Because a limited liability company can be incorporated without tax, that problem may not be insuperable, but attempts to incorporate a limited liability company on the eve of a statutory merger could run afoul of the "step transaction" test. Moreover, venture funds usually do not invest in LLCs because such investments create intractable tax problems for some of their own investors.

Finally, one of the most significant disadvantages of a LLC is associated with the issuance of membership interests to employees of a LLC upon exercise of employee options. Generally, the grant of an option to purchase LLC equity to an employee does not have an immediate taxable consequence for the LLC or the employee. However, upon the exercise of such an option by an employee, who then becomes a holder of LLC equity, several significant tax consequences appear likely. Although the issue is not free from doubt, once an employee acquires LLC equity, he or she is likely to be treated as a partner for tax purposes.

One straightforward solution is to forestall option exercises until after the date the LLC converts to a C corporation in anticipation of an IPO or acquisition or merger. Options would "vest" under a schedule to be determined, but would not be exercisable until the "first exercise date." For option holders who leave employment prior to this first exercise date, the post-termination exercise period would continue until the conversion of the LLC. By extending the post-termination exercise period, no departing employee will feel compelled to exercise the option that would otherwise expire due to termination of employment. Preventing option exercises also will save the LLC the costs associated with accounting and reporting obligations to a holder of a relatively small interest in the LLC. It also simplifies the management of the LLC when membership votes are required.

The complexity of the choice - corporation versus limited liability company - is multiplied by the fact that there are issues other than federal income tax to take into account, such as the impact of state taxes, medical insurance, and other expenses. There is one way in which to decide the most intelligent election between the corporate and the limited liability company form. Take the business forecast and run two scenarios: limited liability company versus corporation. Compare the after-tax wealth of the shareholders assuming a sale of their shares in Year 5 at a multiple of ten times earnings. Look at the difference and decide.

Source: VC Experts, Inc.

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