TABLE OF CONTENTS

Choice of Entity

For A California Closely Held Enterprise

Overview

Sole Proprietorships

General Partnerships

Limited Partnerships

Limited Liability Partnerships

Limited Liability Companies

C Corporations

S Corporations

Security Considerations

Conclusion

 

DISCLOSURE STATEMENT

This material is intended to provide you with a current and accurate summary of the subjects covered.  However, the subject contemplated requires an independent analysis of your individual circumstances. Always seek the assistance of your Tax Planning Professional or Transactional Attorney when making Estate Planning decisions. 

 

OVERVIEW

Selecting the appropriate business entity is the first of many steps when attempting to either form a new business or change the structure of a currently operating business enterprise.  The choice of an entity must be made through careful weighing and balancing of all the numerous interrelated tax and nontax factors involved in the formation and conduct of a business venture.  It cannot be overemphasized that this choice must be made on a case-by-case basis and must be tailored to the specific tax, legal, and financial objectives and expectations of the principals involved in the venture. Both short-term and long-term objectives must be determined. Even more importantly, the choice of the proper business entity is not merely a decision to be made at the inception of a venture. It is an ongoing decision that requires review and reconsideration at least yearly in the light of changing tax laws and the changing circumstances of the business and its principals. 

The goal of this pamphlet is to assist clients in determining the best entity structure for their business by comparing the most common types of entities available to California businesses.  Presently, the most popular choices for entity formation are the Sole Proprietorship, General Partnership, Limited Partnership (“LP”), Limited Liability Partnership (“LLP”), Limited Liability Company (“LLC”), C Corporation and S Corporation.  The general characteristics of a closely held enterprise are as follows:

1.  There are few shareholders;

2.  The shareholders all know each other;

3.  All or most of the shareholders are active in the operation of the business;

4. There is no ready market for the shareholder’s shares; and

5. Who holds the other shares is important to each shareholder.

The closely held enterprise is to be distinguished from the large publicly held corporation or limited partnership that requires an extensive number of investors to fulfill its large capital needs.  If your business will require a significant amount of capital to start, operate or maintain, e.g., more than just a small business loan, you may want to consider a public or private offering of securities.  These offerings must comply with several federal and state securities laws, and is therefore beyond the scope of this pamphlet. 

The choice of entity has important tax consequences and establishes the rights, preferences, privileges, restrictions, and liabilities of the principals or promoters. Although entity selection is rarely an irrevocable decision, the process can yield significant rewards or, conversely, subject the business to unnecessary burdens if not completed with due care. For example, incorporating a sole proprietorship or partnership is not normally an expensive or difficult process, but dissolving a corporation can have significant tax and nontax costs. The failure to select an entity that yields tax benefits to the owners may result in the loss of significant tax benefits altogether. Therefore, careful planning is a must. 

Both tax and non-tax considerations must be explored when selecting the form of business entity.  Tax factors include: 

1.  Tax rate differentials between corporations and individuals and other pass-through entities;

2. Double taxation of corporate earnings distributed to shareholders;

3. The pass-through of gains, losses, credits, and deductions for certain noncorporate taxpayers and S corporations;

4. The treatment upon the withdrawal of an investment or liquidation of the venture; and

5. The application of certain penalty taxes and other taxes applying particularly to corporations.

In addition to tax considerations, the non-tax aspects must be weighed to ensure that the entity chosen satisfies the needs and objectives of the principals.  Non-tax factors include: 

1. Limitation of liability;

2. Transferability of interests;

3. Continuity of existence;

4. Management and control;

5. Capacity to raise capital and finance the enterprise; and

6. Costs and expenses associated with the various choices of entity structure.

The advantages and disadvantages of each type of business entity cannot be fully determined without detailed consideration of the above-mentioned factors. 

NEW FEDERAL ENTITY CLASSIFICATION RULES

Effective beginning January 1, 1997, federal entity classification regulations now allow “eligible entities” to elect their tax classification for federal tax purposes as either an association (taxable as a corporation) or a partnership (pass-through taxation).  Entities with only one owner may elect to be classified as a corporation, or may elect to be disregarded as an entity separate from the owner.  Any business that is not required by federal law to be treated as a corporation for federal tax purposes is an “eligible entity”. 

The promulgation of these new federal regulations has given California businesses the ability to structure an entity in the most suitable manner without triggering a classification as a corporation, thereby incurring double taxation.  Previously, regardless of the choice of entity for state filing purposes, a business enterprise was classified as a corporation for federal tax purposes if it possessed the four characteristics of a corporation:  Continuity of life, centralization of management, limited liability for debts of the enterprise, and free transferability of interests.  Now an eligible entity can possess these desired characteristics while still receiving pass-through taxation status by making an affirmative election of classification on Form 8832. 

TAX TREATMENT OF CORPORATIONS

The corporate tax rate is 15 percent of taxable income up to $50,000; 25 percent of taxable income between $50,000 and $75,000; 34 percent of taxable income between $75,000 and $10,000,000; and 35 percent of taxable income in excess of $10,000,000.  Also, if taxable income is between $100,000 and $335,000, a 39 percent tax rate applies.  If taxable income is between $15,000,000 and $18,333,333, a 38 percent tax rate applies. 

Corporations are not eligible for a special tax rate for capital gains, unlike individuals.  It currently stands at a flat 35 percent of the net capital gain.  If an individual or pass-through entity is anticipating sizable net capital gains, a decision to incorporate should be postponed until the gain has been recognized. 

Incorporation carries with it the problem of double taxation.  First, a corporation is taxed on its net taxable income.  Then, when corporate earnings are distributed to the shareholders as dividends, the dividend is taxed to the individual shareholder as ordinary income.  Therefore, despite the advantageous corporate tax rates, unless all but a small portion of the profit of a corporation will be paid out to the principals as reasonable compensation, it is unlikely that C corporations will offer significant tax advantages to closely held businesses. 

The repeal of the General Utilities Doctrine has made the C corporation less appealing than before.  Previously, a corporation recognized no gain or loss on certain liquidating distributions of its assets to shareholders, on certain nonliquidating distributions relating to qualified stock, or on certain liquidating sales of its assets.  Tax was not imposed until the shareholder level, meaning no double taxation.  The repeal of the General Utilities Doctrine eliminated this potential for relief from double taxation and significantly increases the tax cost of liquidating a C corporation. 

A number of penalty taxes may be imposed on a closely held corporation.  The potential application of these taxes must be taken into account when determining whether or not to choose the corporate form of entity:

1.        An accumulated earnings tax may be imposed on a closely held corporation that is formed or used for the purposes of avoiding income tax with respect to its shareholders by accumulating earnings and profits instead of dividing and distributing them to its shareholders.  A safe harbor minimum accumulated earnings credit of $250,000 protects many closely held corporations from the tax.  The accumulated earnings tax rate is a flat 39.6 percent.

2.        A penalty tax is imposed on personal holding companies to prevent corporations from being used to retain earnings from passive sources at the lower corporate rate of taxation than the tax rates of the controlling shareholders.  The personal holding company tax equals 39.6 percent of the undistributed personal holding company income for the tax year. 

3.        The collapsible corporation rules were designed to prevent tax avoidance by the conversion of a corporation’s ordinary income into long-term capital gain to a shareholder by means of the sale or exchange of the stock of the corporation or the complete or partial liquidation or other capital distribution before a substantial part of the income from the property has been realized by the corporation.  Any gain to the shareholders from such a transaction or distribution that otherwise would be entitled to long-term capital gain treatment is recharacterized as ordinary income. 

TAX TREATMENT OF PASS THROUGH ENTITIES

A pass through entity is an entity that is not taxable on its own, but which provides a pass through of tax attributes, such as profits, losses, and credits, to its owners.  Proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability corporations, and S corporations all have elements of and are generally characterized as pass through entities. 

Section 1 of the Internal Revenue Code provides the amount of income tax imposed on individuals.  The rates differ depending upon whether an individual is filing as the head of a household, married and filing jointly, married but filing separately, or unmarried.  Listing the actual rates would not be feasible as adjustments are made to the tax tables each year so that inflation will not result in tax increases.  Always certain, however, is that the maximum individual tax rates are 36 and 39.6 percent. 

Recent amendments to the code have made the maximum individual rate applicable to capital gains generally around 20 percent.  For tax years beginning in 2001 and later years, the 20 percent maximum rate will be reduced to 18 percent.  The difference in capital gains treatment between corporations and individuals is one of many recent changes by Congress that has made the corporate choice of entity less appealing than in the past.

 

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SOLE PROPRIETORSHIPS

A sole proprietorship is a business entity that involves only one principal.  Business may commence with a minimum of expense, as little is required other than selecting the name under which to do business, obtaining appropriate business licenses, obtaining a tax identification number, and filing a fictitious business name statement, if required.  Beyond the preparation and filing of applicable tax returns, record keeping is the minimum necessary to adequately account for the operations of the business. 

In a proprietorship, all capital requirements of the business must be supplied by the individual principal involved in the business, either through self-funding or through loans from third parties.  Therefore, a significant disadvantage is the inability to shield one’s personal nonbusiness assets from the liabilities generated by the business.  Furthermore, if a sole proprietor is married, all the community property is liable for contract obligations incurred by the business during the marriage.  Prudent business people will purchase insurance to minimize the exposure from unforeseen circumstances, but business and nonbusiness assets will still be exposed.  Clients with significant net worth outside the business should explore the corporate form in order to protect existing assets from potential unforeseen financial burdens generated by the business. 

Continuity of existence is not a notable attribute of sole proprietorships.  A proprietorship exists only as long as the individual proprietor continues to transact business under that business name.  If a proprietor envisions a business that will continue beyond their death or incapacity, either an agreement must be reached with another individual to carry on the business, or a different form of entity must be selected. 

A proprietorship also has limited marketability.  Because there is only one principal, there is no built-in purchaser of the proprietor’s interest like there is with a partnership.  Should the business have to be sold, the purchaser is likely to be a third party obtained through advertising or the use of a business broker.  If the need to dispose of the business is a result of disability or death, a sale of the proprietorship at liquidation value may be required if a willing buyer cannot be found.  A sale at liquidation value will almost always result in a significantly lower sales price because there is no mechanism in place to take care of the contingency and there is no ready successor willing or able to take over the management and associated liability of the business.  Adequate life and disability insurance coverage is advised to provide the liquidity that otherwise might not exist. 

In a sole proprietorship, all management and control rests in the proprietor.  A proprietor may delegate certain responsibilities to employees or agents, but the ultimate burden of management is squarely on the proprietor.

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GENERAL PARTNERSHIPS

A partnership is an association of two or more persons to carry on as co-owners a business for profit, whether or not the persons intend to form a partnership.  A general partnership allows for the participation of a number of principals, therefore permitting the distribution of work and sharing of risks among the principals.  Although the Uniform Partnership Act of 1994 provides a statutory framework for operating a partnership, the general partnership agreement, if one exists, is the primary source for determining the rights and obligations of the parties.  Most of the statutory rights and duties of partners to one another are expressly made subject to any agreement between them. 

General partnerships provide no protection to the principals from losses generated by the business.  General partners have the right to bind the partnership to contracts with third parties, although this right may be limited in certain situations.  Each partner’s assets are fully exposed to third-party claims that arise from the operations of the partnership.  All general partners may also be held liable for the partnership’s payroll taxes, including any penalty for nonpayment, regardless of which partners are responsible among themselves for remitting the taxes.  Therefore, one must be confident in and comfortable with the other general partners.  Disparity of net worth, experience, or business acumen among the principals may indicate that general partnership is not appropriate in a given case. 

For partnerships formed before 1997, the Uniform Partnership Act provides that a general partnership may be dissolved for myriad reasons, including the death or bankruptcy of a partner, withdrawal or admission by a partner, or the express will of any partner if no definite term or particular undertaking is specified.  For partnerships formed after 1996, the 1994 Uniform Partnership Act controls.  The newer version does not call for dissolution when a single partner dies, but instead requires the express will of at least half of the partners to dissolve and wind up the partnership business, thereby allowing for longer continuity of existence.  As always, the partnership agreement can provide for a continuity of existence as agreed upon by all partners. 

Absent an agreement to the contrary, a partner cannot sell a general partnership interest without the consent of all other partners.  A partner is not a co-owner of partnership property, and has no interest in partnership property that can be transferred.  A partner may, however, transfer his or her share of the profits and losses of the partnership, as well as the partner’s right to receive distributions.  The remaining general partners of a general partnership traditionally are the most likely potential purchasers of a general partner's interest when an unanticipated occurrence forces a liquidation of that partner's interest. If the remaining general partners are unable or unwilling to purchase the interest of a withdrawing partner, the partnership may be forced to liquidate, much in the same manner as a proprietorship. 

A general partnership allows the responsibility for management, as well as the control of the decision making, to be spread among the partners.  A general partnership allows the partners an infinite number of choices in dividing up the management responsibilities and allocating the ownership percentages. The choices are limited only by the imagination of the practitioner drafting the partnership agreement.  Note, however, that the concept of centralized management may be difficult for a general partnership to accomplish because each general partner has the ability to bind the partnership in dealing with third parties.

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LIMITED PARTNERSHIPS

A limited partnership is a partnership formed by two or more persons that has one or more general partners and one or more limited partners (or their equivalents under another name).  The limited partnership provides a vehicle through which certain principals (the limited partners) may avoid subjecting their assets outside the limited partnership to the claims of the limited partnership's creditors.  Only those assets contributed to the partnership by a limited partner, or as to which the limited partner has an obligation to make subsequent contributions, are subject to claims of third-party creditors of the partnership.  This makes the limited partnership a superior vehicle for the attraction of equity capital. 

A limited partnership must have at least one general partner and one limited partner.  There may be different classes of general partners and limited partners.  If there are, the partnership agreement must define the rights, powers, and duties of those classes relative to other classes of general and limited partners, respectively. The different classes may be given the right to vote separately or with all or any class or the general partners or any class of general partners on any matter. 

If a limited partnership is not formed in accordance with applicable statutes, or if a limited partner is named as a general partner in the certificate or participates in the control of the business, the limited partner may lose the limitations on liability afforded by the limited partnership. General partners in a limited partnership generally have unlimited liability for obligations incurred by the partnership.   

It is not uncommon to require that limited partners execute guarantees in certain business transactions. The guarantees subject the limited partner to liabilities in excess of those imposed by the obligation to make capital contributions.  In addition, if a limited partner participates in the control of the business without being named as a general partner, that partner is liable as a general partner only to persons who transact business with the partnership with (1) actual knowledge of that partner's participation in control and (2) a reasonable belief, based on that partner's conduct, that the partner is a general partner at the time of the transaction.  A limited partner is not deemed to be participating in control merely because the limited partner acts on matters related to the partnership business that are specified in a written partnership agreement to be subject to the approval or disapproval of the limited partners, or because the limited partner exercises any right or power under the California Revised Limited Partnership Act. 

Continuity of existence is not a characteristic generally associated with limited partnerships.  Although limited partnership interests are generally transferable, a limited partnership will be dissolved and its affairs wound up upon the earlier of the following: 

1. The occurrence of an event specified in the partnership agreement;

2. The written consent of the general partners and a majority in interest of the limited partners (unless the agreement otherwise provides);

3. The general partner ceases to be a general partner (for example, because of withdrawal, incompetence, or termination of corporate status), unless (a) the partnership agreement allows the partnership to be continued by other remaining general partners and there are other remaining general partners who agree to continue the partnership; or (b) a majority in interest of the limited partners or the greater interest provided in the partnership agreement agree in writing to continue the business of the limited partnership and, within six months after the last remaining general partner has ceased to be a general partner, to admit one or more general  partners; or

4. The entry of a decree of judicial dissolution.

 The transferability of interests of partners in a limited partnership has distinctively different characteristics depending on whether a general or limited partnership interest is being transferred. A partnership agreement may provide that a general partner may not assign or encumber a partnership interest in a limited partnership.  In addition, the transferability of general partnership interests is subject to significant restriction through (1) the requirement that all general partners consent in writing to the admission of a new general partner, and (2) the statutory right of limited partners to vote on the admission of a general partner.   In addition, a general partner who assigns all of his or her interest in a partnership to a third party may be removed by a majority in interest of the limited partners. The transfer of a limited partner's interest does not dissolve a limited partnership, and the interests of limited partners tend to be freely transferable.  Indeed, a limited partnership interest is assignable in whole or in part.  A transfer by way of merger is also possible when two or more limited partnerships merge into one limited partnership, subject to dissenting limited partners' rights.  A limited partnership may also merge with a general partnership into a limited partnership or general partnership, provided that the merger is specifically permitted in the general partnership agreement.  Mergers with other business entities are also authorized.  Limited partnership interests,  however, do not represent an attractive commodity to third-party purchasers, and limited partners may be faced with a sale of their interests at a substantial discount if forced to liquidate an investment in a limited partnership.

In a limited partnership, management and control rests primarily in the general partners; as with general partnerships, management responsibilities among general partners in a limited partnership may be divided in a variety of ways in the limited partnership agreement.  Limited partners are allowed to vote on a limited number of issues and engage in various activities with the limited partnership without jeopardizing their status as limited partners.

A limited partnership is required to file appropriate certificates of limited partnership in a timely manner in order to provide the protection of limited liability to the limited partners.  The protections from liability available to a limited partner are not fully available until the certificate of limited partnership has been properly filed.

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LIMITED LIABILITY PARTNERSHIPS

A limited liability partnership is a partnership formed by two or more persons that has one or more general partners and one or more limited partners (or their equivalents under another name).  However, only partnerships engaged in the practice of public accountancy or the practice of law may be structured as a Limited Liability Partnership (“LLP”).  No other businesses may consider the LLP option.  Legal and accounting businesses must weigh the advantages and disadvantages of an LLP compared to other entities.  Among the advantages of an LLP are the following:

1.        Ceasing to qualify as a small business corporation; 

2.        Receiving passive investment income in an amount exceeding 25 percent of its gross receipts for three consecutive taxable years and having Subchapter C earnings and profits at the end of each of those years; or 

3.        Revocation of the S corporation election with the consent of shareholders holding more than one half of the corporation's stock.