28 Oct Choosing a Corporate Entity
Choosing A Corporate Entity
Choosing a corporate entity should be one of the first decisions you’ll make when starting up your new business. It may seem easy to skip this step, and instead forge ahead as a sole proprietor, but this rarely makes sense. An entity protects your personal assets from your company’s creditors, and your company’s assets from your personal creditors. Moreover, creating an entity allows you to establish an independent credit history for your new business and to protect your new business’s property (including intellectual property).
There are a handful of entities that exist, most of which are variations of partnerships or corporations; the other type is the LLC. There are corporate and tax advantages and disadvantages to each. These days the vast majority of new businesses choose to go with either a corporation or an LLC. I’ll mostly discuss those, but first I will touch on partnerships. (If, instead of reading further, you’d prefer to see a simple chart showing the relative advantages and disadvantages of C corps, S corps and LLCs, click here: Choosing an entity.)
Partnerships come in three forms: general, limited (LP) and limited liability (LLP). General partnerships are the easiest to form; two or more people simply carry on a business together and share profits. There are no corporate formalities required, such as regular meetings or elections, so partners can more or less manage the business how they see fit, within the boundaries of Oregon’s Revised Partnership Act in ORS Chapter 67. While they may be easy to manage, a disadvantage of general partnerships is the lack of liability protection. General partners are not protected from each other’s liabilities or the liabilities of the partnership itself.
From a tax perspective, most general partnerships choose to be taxed by the IRS as partnerships. (To step back for a moment, the IRS allows businesses to choose how they wish to be taxed.) Partnerships and LLCs can choose to be taxed as partnerships, S’s or C’s, but most choose to be taxed as partnerships. As such, they enjoy pass-through taxation, which means that the partnership itself is not taxed and profits and losses pass through to the partners.
One drawback, however, is that partnership tax law is extremely complex, so your accountant will be busy. I won’t go much further into tax law in this article, but it is important to keep in mind the distinction between how a state views a company as an entity (a general partnership, LP, LLP, corporation or LLC) and how the IRS views a company under a tax regime (under the partnership, S or C regimes). This difference is all-too-often missed or misunderstood, and is one of the critical reasons why entrepreneurs who don’t have trusted lawyers and tax advisors from the outset later have nasty surprises.
LP’s are rarely used outside of certain industries, such as real estate development projects where passive investors are involved. They are easy to form: one need only file a certificate of limited partnership with the State of Oregon, and, like general partnerships, they are easy to manage since there are no ongoing documentation requirements. Of course, in most cases, partners would still be well-served to draft out a limited partnership agreement so that everyone has a clear understanding of how the business will be run.
It is likely that LP’s aren’t used often because of their unique control and liability rules. In LP’s there are two groups of partners: limited and general. The limited partners have no management rights, but they enjoy liability protection. In one respect, they are essentially passive investors. On the other hand, general partners have all of the management rights, but also have unlimited liability. While some businesses may find this appealing, LP’s are not very favored because they are hard to wrap around most business models.
LLP’s also are rarely used outside of certain industries, but this is due to the strict guidelines of ORS Chapter 67, which restricts their use to professional partnerships and their affiliates. Basically, this means that only traditional professions such as accountants, architects, lawyers, dentists, and so on (you can see a whole list at ORS Chapter 67, if you’d like) are permitted to be LLP’s. Like LP’s, there is a registration requirement with the State of Oregon. LLP’s are managed more like a general partnership since all partners are allowed to participate. One significant benefit is that all partners have limited liability protection. Having said that, not all states recognize LLP’s; in those that don’t, they are treated like general partnerships.
The first thing one notices about corporations is their defined and rigid (sometimes cumbersome) management structure. This means more paperwork, which can be both good and bad since you’ll be required to keep lengthy records, but someone will have to take the time to make and maintain those records. To create a corporation, articles of incorporation must be filed with the State. By-laws should then be drafted, and shares of stock should be issued.
Where partners in a partnership can wear all hats, so to speak, corporations typically have a strict separation between the roles and duties of shareholders, directors and officers. The by-laws will need to thoroughly address how they all interact. Generally shareholders elect the Board, which in turn appoints the officers who run the day-to-day operations. When the company begins to operate, minutes of meetings should be recorded, and resolutions of significant decisions should be made. For small companies, a corporate structure may seem burdensome, but corporations are excellent for companies seeking to grow quickly, especially through complex financing or raising capital. Investors tend to know and understand how corporations work, and consequently are more comfortable investing in them.
Corporations are taxed either as a C or an S corporation, but can choose the latter only if the corporation has 100 or fewer shareholders, all of whom are individuals, certain tax-exempt organizations, qualifying trusts or estates, and none of whom can be non-resident aliens. Under the S tax code, income and losses pass directly through the corporation to the shareholders, so there is no corporate tax (an obvious advantage). But one significant limitation is that only one class of stock may be issued.
C corporations, unlike S’s, are subject to double-taxation, and cannot pass losses through to their shareholders. There are advantages to C’s, however, especially for their shareholders and investors. This is a big reason why corporations that plan on growing large, or already are large, are C’s. Corporations may be owned by an unlimited type of investors, may issue different classes of stock with various rights, offer tax advantage to venture capital funds, offer favorable capital gains treatment to certain investors, and employee salaries and other reasonable compensation, along with employee fringe benefits, are usually fully deductible against the corporation’s income. The C’s of this world are not the mom-and-pop corner shops (unless mom and pop have bad advisors).
LLCs are the go-to entity these days for many small businesses. During the last decade, there’s been an explosion in new LLC’s in Oregon. But that doesn’t mean they’re right for every business. Advantages include flexibility in ownership and management combined with limited liability protection, and the benefit of pass-through taxation.
LLCs come in two types, manager-managed or member-managed (members are owners), which basically means that you can have a few people run the company while others are more like passive owners (in the case of manager-managed LLCs), or you can have everyone play a part in management and ownership. In either case, few ongoing formalities are required. For example, there is no need to appoint a Board of Directors or officers, and the main agreement (the Operating Agreement) can be put together with as little as a handshake, although no one would advise that.
However the company is managed, the members and/or managers enjoy liability protection from the company’s debts and obligations, and the company enjoys liability protection from its members’ debts and obligations. LLCs also enjoy the benefit of pass-through taxation, if they choose to be taxed as a partnership or S.
Although LLCs are quite popular, they do have disadvantages. Because they are the newest type of entity, no consistent body of law exists to predict how courts will interpret LLC statutes. LLC’s have limited growth potential: they cannot go public (although they can be converted into a corporation); they are not suitable for businesses financed by venture capital; and many investors and owners find the concept of membership interests difficult to understand, and instead prefer something more familiar, like shares of stock in a corporation.
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Author: Andrew Harris
Learn More About Choosing a Corporate Entity
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