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When an entrepreneur decides to realize his or her dream of starting a company, one of the first questions that they typically ask their legal counsel is which type of legal entity to select for their business. In most cases, the answer to this question is a Delaware “C” corporation, particularly if the entrepreneur plans to raise venture capital to fund the business. This article will discuss the most common types of legal entities and explain why this conclusion is usually reached.
The most common types of legal entities through which a business can operate are corporations (both “C” and “S” corporations), general partnerships, limited partnerships, and limited liability companies (“LLCs”). The designation of a corporation as a “C” or an “S” corporation refers to the subchapter of the Internal Revenue Code under which the corporation is formed. The two most significant factors that affect the choice of entity are limitation of liability for the owners of the entity and the tax treatment of the earnings of the business at the entity level and the owner level.
The owners of the entity, whether they are founders, investors, or employees, generally desire to insulate themselves from personal liability for the obligations of the entity. All of the entities mentioned above except general partnerships provide some degree of limited liability for their owners. Under state partnership law, all of the partners of a general partnership are personally liable for the obligations of the general partnership. Limited partnerships provide limited liability for the limited partners, but not for the general partners. As a result, general partnerships and limited partnerships are not acceptable entities for venture-backed businesses.
Generally, the owners of corporations (both “C” and “S” corporations) and LLCs will not have personal liability for the obligations of the entity itself. There are certain judicially created and statutory exceptions to this general rule. For example, if the entity is not properly formed and operated and the legal formalities of the entity are not followed, a court may pierce the corporate veil and hold the owners liable for the obligations of the entity. Also, the owners of the entity may have personal liability in certain cases that relate to environmental and products liability.
“C” corporations are subject to double taxation. The corporation itself must pay federal and state income tax on its profits. Then, after these profits are distributed as dividends to the corporation’s stockholders, each stockholder must pay income taxes on his or her share of those dividends. Since the corporation cannot claim a deduction for the distribution of dividends, there is no way to lessen the impact of this double tax.
Generally, limited partnerships, general partnerships, “S” corporations, and LLCs are all treated as pass-through entities for federal and state income tax purposes. As a result, none of these entities are subject to federal or state income tax at the entity level. Under the Internal Revenue Code or the North Carolina tax laws, there is no partnership income tax, “S” corporation income tax, or LLC income tax. Rather, the taxable income or loss of these entities is passed through to the owners. This pass-through effect potentially could provide numerous benefits to investors including: (a) the ability to pass through to investors tax deductions and losses that are typically generated by early stage companies; (b) the ability of investors to increase their tax basis in their investment through retained earnings as the business becomes profitable; and (c) the distribution of earnings to investors without incurring a tax on those earnings at the entity level. However, if a pass-through entity is generating net income on which its owners must pay taxes, the entity must be able to make cash distributions to the owners so that they have will have funds to pay their tax liabilities.
Notwithstanding the significant tax benefits of these pass-through entities, most venture-backed entities are organized as “C” corporations. The reason is that most venture funds cannot invest in pass-through entities under the terms of their investment documents. Most venture funds receive a significant amount of their funding from tax-exempt organizations such as pension funds. Pension funds and similar organizations are exempt from taxation on dividends and capital gains that they receive, but not on pass-through income. As a result, most venture funds are prohibited from investing in pass-through entities.
In addition to being a pass-through entity for tax purposes, “S” corporations are subject to several other limitations that make them unattractive entities for venture-backed companies. Among these restrictions are that: (a) “S” corporations can generally have only individuals as stockholders; (b) “S” corporations can only have a single class of stock; and (c) “S” corporations can only have 75 stockholders.
Once the decision has been made that the “C” corporation is the entity of choice for the new company, the next question is in which state to incorporate. Each state has its own corporate code. While several national bar organizations have developed a model corporate code that many states have adopted to some extent, there are significant differences in the corporate codes of each state. Among the factors that should be considered in selecting the state of incorporation are: (a) the depth and predictability of the state’s corporate law and court system; (b) the nature and extent of the protection that the state’s corporate law affords to officers and directors of the corporation; (c) the flexibility and ease of use of the state’s corporate code; (d) the state’s incorporation fees and annual franchise taxes; and (e) the efficiency and service of the state’s corporation agency. Most corporate attorneys agree that Delaware comes out ahead of all the other states in an analysis of each of the foregoing factors. In addition, most corporate attorneys are very familiar with Delaware corporate law. Therefore, if the investor is represented by out of state counsel, that attorney will probably already be familiar with Delaware corporate law, thus avoiding the necessity of educating the attorney on the nuances of the corporate law of another state. This can help facilitate the closing of a financing and save transaction costs.
As a result of all of these factors, the Delaware “C” corporation generally is the entity of choice for start-up companies.
This article was published in the June 2001 issue of the Triangle TechJournal.