CHOICE OF ENTITY: AN OVERVIEW. Steven G. Thomas, JD, LL.M. Lavelle & Finn, LLP

Transcription

1 CHOICE OF ENTITY: AN OVERVIEW by Steven G. Thomas, JD, LL.M. Lavelle & Finn, LLP 1

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3 BUSINESS ORGANIZATIONS: Tax and Legal Aspects Compared Choice of Entity: An Overview November 4, 2015 Steven G. Thomas, JD, LL.M. 3

4 Choice of Entity Considerations Prior to establishing a new business, an entrepreneur is faced with the crucial task of choosing the appropriate business vehicle. There are several issues of organizational structure which should be considered by the business owner, both tax and non tax related. In selecting the appropriate business structure, one must take into account several factors, including the need for flexibility, tax advantages of different types of entities and the way that each business vehicle exposes an owner to liability. Formation I. Procedural/Formation Requirements A. Considerations: 1. Ease of formation 2. Costs of organization and doing business 3. Simplicity v. formality of operations 4. State of formation B. Requirements of Different Types of Entities: 1. Sole Proprietorship: a) No formal organization required. b) Operated under name of individual owner. c) Least Expensive formation costs. d) Can file a "doing business as" (DBA) name, if doing business under an assumed name, a sole proprietor must file with the County Clerk in each County in which the business is transacted [NY GBL 130(1)]. 2. General Partnership: a) Similar to a sole proprietorship, but has more than one owner. b) Doesn't require a formal agreement, informal agreement arises from sharing profits and losses of a business. c) Must file a certificate with clerk of each county in which partnership transacts business, or with the Secretary of State, setting forth name, address and nature of business [NY GBL 130 (1)). 4

5 d) Partner does not need to be an individual (i.e. can be a Corporation [NY BCL 202(a)(15)]). e) Duration: the death of any partner usually causes dissolution [NY Partnership Law 62(4)], although a partnership agreement can provide for continuation after the death of a partner. 3. Limited Partnership: a) Requires certificate of formation to be filed with Department of State [NY Partnership Law , ]. b) Requires a written partnership agreement [NY Partnership Law ], which must be signed by all general partners. c) Name of the entity must contain "LP" or "Limited Partnership" [NY Partnership Law (a)(1)]. d) A partner need not be an individual (A corporation may be a limited partner [NY BCL 202(a)(15)]. e) Requires at least one general partner [NY Partnership Law (h)]. f) Publication Requirement: A limited partnership must publish a notice containing the substance of the certificate of limited partnership, once a week for six consecutive weeks, in two newspapers in the county in which the original certificate is filed [NY Partnership Law (c)(i)]. 4. Limited Liability Company (LLC): a) Requires Articles of Organization to be filed with the Department of State [NY LLCL 203(a)] (See Attachment A). (1) An LLC is formed at the time of filing, or at another time stated in the articles of organization, but not to exceed 60 days from the filing of initial articles [NY LLCL 203(d)]. (2) An organizer may be an individual or another entity [NY LLCL 102(w); NY LLCL 203(a)]. (3) The name of the organization must include LLC or "Limited Liability Company" [NY LLCL 204(a)]. 5

6 (4) Articles of Organization must contain the company name, the county of the principal office, and the events necessitating dissolution. Additionally, it must designate the Secretary of State as an agent for the service of process [NY LLCL 203(e)]. b) Publication Requirement: An LLC must publish a notice containing the substance of the articles of organization, once a week for six consecutive weeks, in two newspapers in the county in which the LLC is located [NY LLCL 206(a)]. c) No limit on number or character of members, except that there must be at least one member [NY LLCL 203(c)]. Can provide for future classes of members in the articles of organization [NY LLCL 418(a)]. d) Operating Agreement: A written operating agreement is required under NYS law (compare with Delaware, which does not require an operating agreement) [NY LLCL 417(a)]. (1) Must be entered into within 90 days of formation, but may be entered into prior to formation of the LLC [NY LLCL 417(c)]. (2) An operating agreement must be consistent with law and the articles of organization. Generally governs the business of the LLC, the conduct of the affairs, and the rights, powers, preferences, limitations or responsibilities of its members, managers, employees or agents. (i) (ii) Provisions in an operating agreement can override statutory default provisions Provisions that should be in an Operating Agreement: (a) Name of LLC and names of members; Location of principal office; (b) Duration of LLC; (c) Rights and responsibilities of members; 6

7 (d) Management Structure (including procedures for change of managers); (e) Accounting protocols; (f) Voting procedures and agreements (g) Capital Contributions (h) Admission of members (i) Indemnification; (j) Provisions for change of membershipdissolution, winding up, consolidation, death or disability of member; (k) Transfer rights, etc. 5. Corporations: a) Requires Certificate of Incorporation to be filed with the Department of State [NY BCL 104]. b) Must file a Certificate of Incorporation (Certificate) detailing the corporate name, corporate purpose or purposes, place of office, duration (only if not perpetual), aggregate number of shares authorized to be issued (including a description of classes and series of shares, if any), and name and address of the registered agent, if any, for service of process [NY BCL 402] (See Attachment B). (1) The Certificate may include any other provision that is consistent with law [NY BCL 402(c)]. c) Certificate must designate the Secretary of State as agent for service of process and should include the address to which the Secretary of State shall address any such process. d) Must state a lawful business purpose [NY BCL 201(a)]. e) Same requirements for C and S Corporations, (i.e. state filings/fees; S Corporation differences come from federal tax law). f) If an S Corporation (discussed hereunder "Taxation"), must file with both New York State (Form CT 6, Attachment C) and with 7

8 the IRS (Form 2553, Attachment D). g) The Organizational Instruments of the corporation (the Certificate of Incorporation and the By laws) govern the corporate existence, the operations and management of the corporation and the relationships between the owners and employees of the corporation. (1) Initial By laws: Upon formation of a corporation, initial by laws must be adopted by the incorporators at the organization meeting [NY BCL 601(a)]. Such by laws may include any provision pertaining to the business of the corporation, the rights and responsibilities of shareholders, directors or officers, and any matter related to the operations of the business, so long as the by laws do not conflict with the Certificate of Incorporation or law [NY BCL 601(b)]. h) Organizational Meeting: Generally, an organizational meeting is held by the incorporators to select an initial board of directors. Operational Issues II. Control/Operational Issues A. Considerations: 1. Who will be the owners? 2. Statutory restrictions on types of owners in certain entities 3. Who will make Management and control considerations a) Some entities require more formalities in setting up management structure 4. Will you want Different classes of ownership a) One or more classes of stock b) Voting and non voting interests c) Flexibility in allocating income and losses B. Differences between Entities: 1. Sole Proprietorship Complete Control over the company. Can sell business, although a partial sale will result in a partnership. 8

9 2. General Partnership All partners share in management unless otherwise provided in partnership agreement. 3. Limited Partnership General Partner controls and Limited Partners have no say in management. 4. Limited Liability Company a) Management by statutory default is vested in the members, but the articles of organization can place management responsibilities in a certain class of members or delegate management to a manager [NY LLCL 401(a), 408(a)]. (1) If management is vested in members by statutory default, all members are agents of the LLC [NY LLCL 412(a)]. (2) Managers (including member managers) must perform their duties in good faith. The duty of care standard is that of an ordinary prudent person [NY LLCL 409(a)]. (3) A manager doesn't have to be a member [NY LLCL 410(a)]. (4) Voting Rights are generally tied to members' shares of profits. (5) Meetings: Annual meeting of the members required [NY LLCL 403]. Note that the minimum quorum by statute is 1/3 of members in interest (cannot lower by terms of the operating agreement [NY LLCL 404]). (a) Statutory notice requirements of meetings [see NY LLCL 405, 406]. (6) New members may be admitted to an LLC, however, such admittance must comply with the operating agreement. If the operating agreement is silent on the issue, then a majority vote of the interests is required to admit the new member. (7) Neither a member, manager nor agent is liable for the debts, obligations or liabilities of the LLC. 9

10 b) Operating Agreement (1) Statutorily Required [NY LLCL 417(a)]. (2) Profits and losses may be allocated as mandated by the agreement. If there is no such allocation, profits and losses are distributed in accordance with the value of the contributions of each member [NY LLCL 504]. (3) Although a member manager will be shielded from liability if his or her actions are performed in good faith [NY LLCL 409(c)], the operating agreement may not protect a manager against intentional bad faith acts or misconduct [NY LLCL 417(a)(i)]. c) Distributions to Members: (1) Do not have to be pro rata (unless operating agreement stipulates otherwise). (2) Cannot be made if liabilities of the company exceed assets [NY LLCL 508(a)]. (3) Interest is personal property, thus a member has no interest in actual assets of LLC [NY LLCL 601]. (4) A member has no right to distribution other than cash (not in other assets) [NY LLCL 505]. 5. Corporations: a) Management and control of a corporation is stratified: (1) Shareholders elect a board of directors to oversee the management and operations of the corporation. (2) The board of directors then elects officers to handle dayto day operations. (3) For smaller corporations, management is typically exercised by the owners in various capacities. May have voting and nonvoting shareholders to isolate management and control to a certain group. b) The Shareholder's Agreement governs the relationships between the shareholders. Notably, no such agreement is statutorily required. 10

11 c) Bylaws: Bylaws are the rules and regulations of the corporation and govern its internal affairs, including matters relating to its shareholders, directors and officers [NY BCL 601(b)]. They are not public and thus do not need to be filed with or approved by the Secretary of State. They can be altered by a shareholder vote. (1) Typically by laws address the time and manner of holding shareholders' meetings; those authorized to call special shareholder meetings; requirements for quorum; election, qualifications, duties, terms and removal of officers and directors; place and time of meetings of board of directors; the number of directors; dividends and distributions; and any other matter relating to the management of the entity [NY BCL ]. C. Continuity/Business Succession 1. Considerations: a) Estate and business succession planning. b) What happens to the entity on death of a member can the interests be transferred easily? 2. Continuity of Different Entities: a) Sole Proprietorship: (1) It terminates on death of owner but can be sold prior to death. b) General Partnership: (1) Terminates on death of any partner unless otherwise provided in partnership agreement [NY Partnership Law 62(4)]. (2) Transfer of partnership interest requires consent of other partners unless otherwise stated [NY Partnership Law 40(7)]. c) Limited Partnership: (1) Continuity depends largely on the partnership agreement, but there must always be at least one general 11

12 partner and one limited partner. (2) In NY, unless otherwise provided by the partnership agreement, a limited partner cannot withdraw from the partnership prior to dissolution [NY Partnership Law (a)]. (3) Good opportunities for estate planning, a partner can gift limited partnership shares but keep control of entity. d) Limited Liability Company: (1) In general, a membership interest can be assigned, but assignee needs the consent of a majority of the nonassigning members to become a member [NY LLCL 604(a)]. (2) Good for estate planning especially because there can be varying classes of interest. (3) Death or Disability of a Member: (a) The representative of the member's estate has the same rights as the member for purposes of settling estate [NY LLCL 608]. e) Corporations: (1) The life of a corporation is unlimited. Shares are generally freely transferable (although transferability can be restricted by a shareholder agreement). Taxation Ill. Tax Issues A. Considerations: 1. How will entity be taxed a) "Double tax" issue? 2. Taxation of the owners a) "Pass through" taxation? B. Taxation of Various Entities: 1. Sole Proprietorship: Income of business is reported on tax return of owner (i.e., Schedule C). 12

13 2. General Partnership: a) Must file a tax return for the partnership, but partnership income passes through to partners (and the partners are taxed on their share regardless of whether income is actually distributed). Losses can be deducted up to partner's basis. b) Must pay self employment tax on income from a trade or business. 3. Limited Partnership: a) Income passes through to partners (similar to General Partnership). 4. Limited Liability Company: a) An LLC can be taxed as partnership or corporation (must elect to be taxed as a corporation [Treas. Reg ]). If the LLC is taxed as a partnership: (1) Income is taxed directly to the members. (2) Services rendered by a member to an LLC may be structured so that they are not taxed (if the ownership interest is merely a profits interest). (3) A member can deduct losses up to level of basis in the entity. (4) Any income derived by the member from the LLC is subject to employment taxes. (5) Upon liquidation, member is not taxed on amounts up to the member's basis. 5. Corporations: a) C Corporation: (1) Double tax Situation: Entity is taxed on the net income and shareholders are taxed on Corporation distributions [IRC 11, 301). (2) A shareholder will be taxed on services performed for the corporation in exchange for ownership interests. Such services will be taxed on their fair market value. 13

14 (3) Tax advantage of corporation over LLC's: (a) The graduated corporate tax rates are lower than those of individual rates. (b) There is no self employment tax on profits drawn by shareholder. (c) A shareholder employee may enjoy greater fringe benefits. b) S Corporation: (1) An election under IRC 1362 (See Attachment C) and NY Tax Law 660 (See Attachment D) must be timely filed for the entity to be treated as an S corporation. The following requirements must be met in order to qualify for the election: (a) Maximum of 100 shareholders. (b) Only U.S. citizens, resident aliens and certain trusts are eligible shareholders. (c) Single class of stock. (d) Can be formed by one or more natural persons 18 years or older. (2) Pass through taxation applies so long as a valid S Corporation election is made. (a) Losses are deductible to the extent of the shareholder's basis. (b) As with a ( Corporation, an individual who performs services for the entity in exchange for an ownership interest will be subject to tax on the fair market value of such services. (c) Medicare Tax on passive income If a shareholder is not active in the business, there may be up to a 3.8% surtax depending upon the shareholders' tax bracket. (d) shareholder employee is only subject to self 14

15 employment tax on "reasonable wages." Any profits derived from the corporation beyond "reasonable wages" are not subject to employment tax. Jurisdictional lssues I. Jurisdiction: A. Important to decide in which STATE to form your company. Every state has its own set of laws regarding how entities are governed. Some are more favorable than others depending on your particular circumstances. For example: 1. NY Rule Protecting 20% Shareholders In New York, BCL 1104 a gives the holders of 20% or more of the outstanding shares of a corporation the right, when the other shareholders or directors engage in oppressive conduct, to petition the court for dissolution. Delaware does not provide similar protection, leaving minority shareholders to rely on case law regarding oppression and breach of fiduciary duty. 2. Corporate Liability for Wages: a) In New York, the ten largest shareholders of a corporation are liable for wage claims [NY BCL 630]. 3. Business Purpose: a) New York Limited Liability Company Law 201requires a lawful business purpose to form a Limited Liability Company in New York, for example, owning and operating business assets. A lawful business purpose is also required to form a Corporation in New York, as required by New York Business Corporation Law 201. Other activities like maintaining an investment portfolio or owning residential property may not constitute a valid business purpose in New York. b) To form a Limited Liability Company in Delaware, of the Delaware Limited Liability Act states that the entity only needs a lawful purpose. Additionally, one only needs lawful purpose to form a Corporation in Delaware pursuant to Delaware General Corporations Law 101. Therefore, holding an investment 15

16 portfolio and owning residential property will constitute a valid entity purpose in Delaware. B. Consider the rights of personal creditors which are governed by state law. 1. Charging orders. A charging order is a creditor's remedy by which the creditor can attach a partner's or member's right to distributions. A charging order is used by a personal creditor of the owner of the entity (not a creditor of the entity itself). Note that a creditor of a shareholder cannot obtain a charging order against a corporation. a) In Delaware, charging orders are the exclusive remedy for creditors of the member/partner [DE LLCA (d)]. It prevents the creditor from attaching the member's or partner's membership/or partnership interest, or from forcing dissolution of the entity. b) Unlike the Delaware statute, the New York statute does not clearly indicate that a charging order is an exclusive remedy for the creditor of an LLC member [NY LLCL 607]. However, consider NY LLCL 603, which governs assignments of membership interests. Unless otherwise stated in the operating agreement, "the only effect of an assignment... is to entitle the assignee to receive... distributions" [NY LLCL 603(a) (3}]. (1) With regard to partnerships, New York is explicit that the charging order is not the exclusive remedy of a creditor of a partner [NY Partnership 111]. 2. Piercing the Corporate Veil: a) Under Delaware law, the corporate veil may be pierced "in the interest of justice, when such matters as fraud, contravention of law or contract, public wrong, or where equitable consideration among members of the corporation require it, are involved." [See Pauley Petroleum Inc. v. Continental Oil Co., 43 Del. Ch. 516, 521, 239 A. 2d 629, 633 (1968}]. b) In contrast, New York courts disregard a party's corporate veil more "reluctantly". New York law requires a part seeking to 16

17 pierce the corporate veil to show that the owners, through their domination, abused the privilege of doing business in the corporate form to commit a wrong or fraud. 3. Taking Ownership: a) In a corporation, a creditor may attach the shares of a debtor's stock to gain all the rights that the debtor had in the corporation, including rights to sell the shares, voting rights, the right to view books and records, and rights to bring derivative actions against errant corporate officers and directors. b) If the corporation is an "S" corporation, and the creditor is not an individual, then the creditor's attachment of the stock may cause the "S" election to be terminated, which would possibly result in unwanted tax consequences to the remaining shareholders. c) A similar change in ownership with a Partnership or LLC may disrupt the operations of the entity and force non debtor partners into an involuntary partnership with the creditor. C. Formation Requirements may also be more costly in one state over another: 1. States available for formation are usually where the business of the company will be conducted, where the assets of the company will be held, and then several states such as Delaware and Nevada that have advanced corporation laws and whose courts tend to respect the sanctity of the corporate entity against those who would set it aside. 2. Small businesses benefit most from incorporating or forming their LLC in the state where the business is physically located or operating, by avoiding additional costs and paperwork associated with forming in one state and then having to qualify their corporation or LLC to do business as a foreign entity in another state. 3. Additional costs to file in a foreign state: a) State fee required to file foreign qualifications; b) Registered agent service fees; c) The company will have to pay an annual fee and possibly franchise taxes in both states. 17

18 4. Additional paperwork to file in a foreign state: a) Foreign qualification filing with the state; b) Will have to file tax returns in both states; c) Will have to file annual reports in both states. 18

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