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October, 2008
 
     
 

 

Choice of Entities-Corporations

 

One of the threshold questions any entrepreneur should ask him or herself before starting a new business or strategically planning for the expansion of an existing business is:  "How should I operate the business?"  In the fields of law and taxation, this inquiry is referred to as the "choice of entity" decision.  The consequences of this seemingly simple decision are legion.  In the next several issues of the Biz Newsletter, we'll give a brief overview of the "choices."  We will consider corporations, partnerships, limited liability companies and partnerships, trusts, associations and sole proprietorships (including agencies).  First up are corporations.

 

Classifications

 

The most popular form of business organization is the corporation.  Although corporations come in a variety of forms, they are generically defined in law as an organization formed with governmental approval to act as an legal artificial person to carry on business or other activities, which can sue or be sued, and can raise funds with which to conduct its business or activities.  Most countries throughout the world have legally artificial "persons" which are equivalent to corporations, although they may be called by "local" names.  There are numerous ways to classify corporations, but here are some commonly used in the U.S.:

  •  Domestic or foreign (which may refer to a corporation formed in another country or another state or jurisdiction);
  • Private or closely-held as opposed to publicly traded;
  • Profit or nonprofit; and
  • Subchapter C or Subchapter S

Common Corporate Characteristics

 

No matter the classification or the name by which a "corporation" is called in a particular jurisdiction, it will generally have the following characteristics:

  • Limited liability which limits loss of its owners to their investment in the corporation;
  • Centralized management and control by its corporate officers and/or board of directors;
  • Unlimited duration upon formation; and
  • Free transferability of ownership (although some restrictions may be placed upon this area by law or by agreement).

 

Even though corporations are artificial "persons" under the law, they are afforded some of the same rights as natural persons.  These include:

 

  • Right to due process and equal protection under the 5th and 14th Amendments of the U.S. Constitution, as well as the various state constitutions;
  • Freedom of speech is generally conferred upon them with the prominent exception being that of political lobbying for certain nonprofit corporations; and
  • Right to counsel under the 6th Amendment of the U.S. Constitution, but they do not have a right to appointed counsel if a corporation cannot afford one in a criminal proceeding (yes, corporations can be criminal defendants) and they do not enjoy a 5th Amendment privilege against self incrimination in a criminal proceeding.

Possible Disadvantages

Some of the disadvantages of the corporate form of operation include:

  •  Additional cost to form and maintain properly;
  •  Necessity for separate tax return from owners; and
  •  Possible double taxation if the corporation is for "profit" and is not a Subchapter S corporation (see below).

Although corporations do afford limited liability generally to their owners (and directors and officers through indemnity agreements), that protection is not absolute.  There are a number of legal ways to attack this limited liability (and the officers and directors) under well-established corporate law in the U.S.  Some of the typical attacks include:

  •  Piercing the corporate veil (which can be done in a variety of ways);
  • Common law fraud in promoting the sale of it securities or stock;
  •  Distributions in violation of laws regulating insolvencies and fraudulent transfers (those in deference to creditors of the corporation);
  •  Violation of various securities law requirements;
  •  Self dealing by officers and board members;
  •  Breaches of the duty of care by board members;
  • Sale of "watered down" stock; and
  •  Various other legal and tax attacks (both civil and criminal in nature and scope).

Foreign Corporations

 

In California, as with most states, any corporation not formed in California is considered a foreign corporation.  Foreign corporation, both those formed in another state and those formed in another country, can do business in California once they have been registered.  It is a violation of tax law for a foreign corporation to do business in California without registration and the failure to do so can have devastation legal and tax results.  For example, a foreign corporation that is not registered in California has no standing before the courts of California in many instances.  Thus, it cannot defend lawsuits, as such.  

 

Aside from those corporations formed in "sister" states of the union, there are a number of "offshore" corporations typically used for a variety of legal and tax purposes.  Among them are International Business Corporations ("IBCs"), which are entities that have been granted a charter by a foreign government to conduct a commercial enterprise.

 

Some advantages to using an IBC to move assets offshore are:

 

  • Asset protection to protect real property and savings against future legal claims arising from divorce proceedings, bankruptcy, aggressive creditors and other varieties of litigation;
  • Estate planning as part of an overall strategy to remove assets from large appreciating estates;
  • Privacy & confidentiality to help shield business affairs and assets from detection by potential claimants, ex-spouses, creditors, business competitors and others; and
  • Reduction of tax liability as part of an overall tax strategy to minimize tax liabilities.

An IBC can help accomplish a variety of legal and tax goals: 

  • Open and hold bank accounts in the name of the IBC;
  • Hold and transfer funds globally;
  • Engage or operate in international business, trade and other related transactions globally;
  • Receive income; and
  • Help save money through local jurisdiction exemption from taxation, although this does not automatically mean an IBC is exempt from U.S. taxes.

Private or Public

 

Private companies are often "closely held" or family run businesses; at least initially.  Even if family run at one point in time, the corporation may be the subject of acquisition by larger competitors or market players, as well as employees or entrepreneurs looking for valuable acquisitions.  Moreover, succession planning is needed in order to transfer family run corporations effectively and efficiently from one generation to another.  Various other approaches may be employed with these corporations, e.g. electing to be a small business corporation or a closely held corporation under federal and/or state tax and corporate laws.  These scenarios can be discussed at the formation stages in most instances.

 

Publicly traded corporations are traded on one of the stock exchanges, either in the U.S. or abroad.  There is a noticeable flow of cross-border securities transactions involving both the inflow and outflow of corporate securities to and from the U.S. from and to other jurisdictions.  Notwithstanding this growth, for most U.S. companies, the goal of going public is a culmination of business success and planning.  The process of going public is generically called making an IPO or initial public offering.  It is called a "public offering" because the corporationís stock is offered to the public via any one of the national exchanges or "over the counter." Over the counter or "OTC" sales are outside of the exchanges.  Securities firms called broker-dealers; or brokers who buy stocks for their own account and/or for resale consummate these offerings.  They may also simply put willing buyers together with offerees of securities and make a profit on the spread between the bid and asking price for the securities; although this is not normally the way IPO deals are structured.

 

While going public is almost strictly a securities law and accounting exercise, it should be noted that some offerings are small in comparison to what one might think and are afforded a simplified form of registration.  This is referred to as a Regulation A offering.  There are also certain types of corporate offerings that are exempt from the registration process required for IPOs.  These include Regulation D offerings and private placements.  Not only is the process of going public under the Securities and Exchange Act of 1933 arduous, but subsequent thereto, a plethora of financial reporting requirements are imposed by the Securities and Exchange Act of 1934, the Sarbenas-Oxley Act, the Public Companies Accounting Oversight Board (PCAOB) and the Committee of Sponsoring Organizations of the Treadway Commission (COSO); e.g. 10-Qs, 10-Ks, 8-Qs, Report on Internal Control, etc.  In the wake of the recent $700 billion bailout of the financial sector, there are bound to be many more reporting requirements imposed on publicly traded corporations.

 

To Make a Profit or Not?

 

One of the principal considerations that  affects the decision  to form a  corporation is whether to engage in profit making activities as its primary goal, or to conduct activities that are focused on providing nonprofit services.   There  are  a  variety  of  classifications  of  nonprofit  corporations,  which  vary  by state.    In California, for example, the prominent forms are public benefit and mutual benefit nonprofit  orporations.  But there  are also religious corporations  and a variety of lesser-known  nonprofit corporations, e.g.  title holding  corporations, c redit unions, etc.   And  it is  not  just  a  matter  of  taxation,  as some states, e.g. Nevada do not have a corporate income tax per se. Nevertheless,consideration must be given to whether or not a nonprofit corporate status should be sought in order to meet the delineated goals  of the planned organization.

 

Taxation

 

A  Subchapter  S  corporation  is  a  corporation  that  meets  the requirements for, and has made a proper election to be taxed under, Subchapter S of the Internal Revenue Code. Although its taxation is a creature of the tax code, it is not a corporation that is organized under the Internal Revenue Code. This seems to be a  popular  misconception  among  entrepreneurs.   Most states have adopted tax laws that recognize these corporations as well.

 

The primary  perceived benefit to electing "S Corp" status is one layer of tax.  A corporation like Yahoo is taxed under "Subchapter C" of the Internal Revenue Code. Yahoo pays taxes on its net profits and then its stockholders pay taxes when the profits are paid out to them as dividends. In contrast, a S Corp's net profit or  net loss  is deemed distributed to  the stockholders, who have to include it on their individual tax returns whether or not they actually receive cash.

 

Careful tax analysis must be made to determine  the suitability of this  corporate form.   Certain qualifications must be met and with the leveling  of corporate  and individual income tax rates,  all situations do not yield desirable results upon election.  The tax strategist  must look at the "exit" strategy.    For example, if the company may be sold or taken public in a few years, then the S Corp election may not be desirable. If the exit strategy is a tax-free, stock-for-stock acquisition of your company by a public company, then it might not make sense to have the stockholders pay a larger current tax on profits. Similarly, for most high-tech growth companies  involved in  pre-acquisition research  and product development,  there may not be any net profit during the development stage, so being an S Corporation will  not create a current tax payment situation.

 

So how  does a corporation  receive the benefits of S status?  First, an S Corp must at all times qualify. It can have no  more than  75  stockholders who in general must all be human beings. A few special types of trusts  are  permitted  as  stockholders,  but  there cannot  be  any  corporate  stockholders,   partnership stockholders, etc. Because of this, most S Corps lose their S status when venture capital firms invest. No stockholder can be a "nonresident alien", e.g. a S Corp cannot have as a stockholder a Malaysian citizen living in Kuala Lumpur.  For all practical purposes,  only foreigners living in the United States and having green  cards  will  meet  the "resident alien" test.   The  corporation  must  have  only one class of stock (although two or more classes are allowed if the only difference between the classes is  in voting rights).

 

This is just a sampling of the factors to be considered when forming a corporation.  Competent legal advice should be sought before forming a corporation and there is no substitute for it.

 

DISCLAIMER: This Newsletter is designed to give the reader an overview of a topic and is not intended to constitute legal advice as to any particular fact situation. In addition, laws and their interpretations change over time and the contents of this Newsletter may not reflect these changes. The reader is advised to consult competent legal counsel as to his or her particular situation.