Choosing the Best Form of a Business Entity

by Kit F. Pettit, Esq.

With all of the types of business entities available to choose from when starting a new business, how do you know which business entity is best? There are LLC’s, LP’s, S-Corps and C-Corps, and each type of entity has its own advantages and disadvantages depending on a number of considerations. Some of the advantages and disadvantages are tax matters, asset protection, liability protection and transferability. Some of the considerations include the entity’s size, the type of business activity, desired governance structure and other business investment matters.

Typically, tax treatment is one of the most important factors in choosing the form of business entity. Among other things, one of the basics tax matters an entrepreneur should know when deciding which entity may best suit his or her business plan is that C-corporations are subject to double-taxation while S-corporations are generally not subject to the two layers of taxation. A new business owners should also be aware that limited liability companies and partnerships are flow through entities and the earnings of these types of entities are not subject to federal income tax, however, Pennsylvania treats all limited liability companies as corporations for capital stock taxes. There are numerous tax advantages and disadvantages for each type of entity and a skilled legal practitioner along with advice from an accountant can help an entrepreneur through this maze.

Once the entrepreneur is aware of the tax considerations, personal liability protection is often the next most important factor to consider. The various entities can have different liability shields. Careful planning and consideration should be given and knowledge of the statutory liability limitations is most important. For example, 15 Pa.C.S.A. § 1526 sets forth the statutory rules with respect to the personal liability of shareholders of a business corporation while 15 Pa.C.S.A. § 8922 provides the rules for personal liability of members and managers in partnerships and limited liability companies. Business trusts are governed by a different statute. 15 Pa.C.S.A. § 9506.

The governance structure and standards of conduct of the shareholders, partners or members is also a very important consideration when organizing and forming a new entity. The governance structure of each type of entity differs and there are business, legal and other reasons why an individual or group of individuals may prefer one management structure over another. In Pennsylvania, corporations have established governance principles and structural formalities that are for the most part defined by statute and case law. 15 Pa.C.S.A. § 1701 et al. Partnerships are primarily governed by contract between the partners, i.e., a partnership agreement, however, there are certain rights and duties of partners governed by statute. 15 Pa.C.S.A. §8331 et al. As for limited liability companies, they have significant flexibility with respect to governance of the company. For example, a Pennsylvania limited liability company can be “member-managed” which follows the general partnership rules, or it can be “manager-managed” which governance mechanism is most similar to that of a corporation. 15 Pa.C.S.A. § 8941.

The above matters highlight some basic and important considerations when starting a new business. Corporate formation and organization is more than an online “check-the-box” process. It takes knowledge and careful planning based on information provided by the client. For example, does a majority-member of a limited liability company really want unanimous consent provisions in the company’s operating agreement that would require the consent of a 5% member for certain company actions? Would you incorporate as an S-corporation if you anticipate distributions to some shareholders and not others? After all of the considerations have been discussed and the form of entity selection is made, an entrepreneur should also know that each type of entity has its own formation and organization requirements and respective formalities that should be properly observed and followed once incorporated or organized. Observation and practice of these important formalities such as annual meetings of members and shareholders is a part of the liability protection mechanism and should not be ignored or forgotten once your business is up and operating.

Written by Bernstein- Burkley, P.C. on August 9, 2011

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