Basic Summary Of Characteristics Of Various Types Of Business Entities

A. Business Factors

General Partnerships

Limited Partnerships

Corporations

Limited Liability Companies

1. Ease or Difficulty of Formation; Transaction Costs

No filing required to form the entity.

Partners should, but need not, enter into a partnership agreement. The cost and complexity of the agreement depends on the structure and business of the partnership. Drafting the agreement may be more time-consuming and costly than drafting simple articles and bylaws for a corporation.

A limited partnership is formed by filing with the Secretary of State a Certificate of Limited Partnership (Form LP-1) executed by all the general partners (filing fee $70).

Although oral agreements are permitted, the agreement should be in writing. The cost and complexity of the agreement will depend on the structure and business of the partnership. Drafting the agreement may be more time-consuming and costly than drafting simple articles and bylaws for a corporation.

Articles of incorporation must be filed with the Secretary of State (filing fee $100).
Statement of Domestic Stock Corporation must be filed with the Secretary of State within 90 days after filing the articles.

The parties need not negotiate a detailed agreement governing the structure and operation of the corporation, but can instead rely on the General Corporation Law However, if the parties desire to restrict the transferability or voting rights of stock, or provide for different classes of stock, a detailed agreement or specially drafted articles of incorporation may be required.

After formation, directors must be elected, officers appointed, bylaws prepared and adopted, and shares of stock issued, all of which (plus other organizational matters) should be reflected in organizational minutes.

An LLC is formed by filing articles of organization (Form LLC-1) with the Secretary of State (filing fee $70). Within 90 days after filing the articles, the LLC must file a Statement of Information with the Secretary of State.

All members must enter into an operating agreement. Although oral agreements are permitted, the agreement should be in writing. The cost and complexity of the agreement will depend on the nature of the LLC and its business. Drafting the agreement may be more time-consuming and costly than drafting simple articles and bylaws for a corporation.

2. Management and Control

Unless the partnership agreement provides otherwise, all partners have equal rights in the management of the partnership. The partners may, by agreement, designate specific partners to manage the business, or restrict the authority of certain partners to take specified actions. Partnerships are quite flexible; a great variety of control and management structures are available by agreement.

Limited partnerships are managed by the general partners. If limited partners participate in the control of the business, they risk losing their limited liability. The partnership agreement may eliminate the right of the limited partners to remove the gen­eral partner. Limited partnerships may be structured with more centralized manage­ment and control than general partnerships or corporations.

A corporation is man­aged by or under the direction of the board of directors. Directors generally determine corporate policy and authorize corporate ac­tions outside the ordi­nary course of busi­ness, and officers man­age the day-to-day af­fairs of the corporation. Shareholders (except in the case of statutory close corporations) have no right to participate in the day-to-day management of the cor­poration. A corporation may formally vest man­agement in the share­holders by electing to be a statutory close corporation.
Corporate structure can be highly centralized, especially with a large number of shareholders. The management structure can be altered by devices such as voting and nonvoting classes of stock, voting trusts, committees of the board, shareholder agreements, and super-majority voting requirements for specified actions.

If the articles of organization state that the LLC is to be managed by managers, the LLC is managed by managers (who need not be members); otherwise, the LLC is managed by its members. If an LLC is managed by managers, then members do not, as members, participate in the management of the LLC.

An LLC provides great management flexibility. Management can be as decentralized and informal as the management of a general partnership. Or, a corporate style management structure may be adopted, with officers and managers that act as a board of directors (caveat: managers, unlike directors, have agency power to bind the LLC). Or, the LLC may adopt a centralized structure analogous to a limited partnership, with a manager acting like a general partner and with the members having no right to remove the manager.

3. Agency Authority of Owners and Management

Each partner is an agent of the partner­ship. The act of any partner for apparently carrying on in the usual way the business of the partnership binds the partnership.
The partnership agreement may restrict the authority of a particular partner to bind the partnership; however, a restriction on authority will not be effective against third parties who have no knowledge of the restriction.

General partners are agents of the limited partnership. Limited partners do not have apparent agency authority to bind the partnership.

Officers are agents of the corporation. Neither shareholders nor directors have agency authority to bind the corporation.

In a member-managed LLC, every member is an agent of the LLC, and the act of any member for apparently carrying on in the usual way the business of the LLC binds the LLC. In a manager-managed LLC, (1) every manager is an agent of the LLC, and the act of any manager for apparently carrying on in the usual way the business of the LLC binds the LLC, and (2) members are not agents of, and cannot bind, the LLC.

The articles of organization or the operating agreement may limit the authority of members (in a member-managed LLC) or man­agers (in a manager-managed LLC) to bind the LLC. However, such limitations will not be effective against third parties without actual knowledge of the restrictions.

4. Liability of Owners for Business Obligations

Partners are jointly and severally liable for the wrongful acts or omis­sions of any partner acting in the ordinary course of partnership business or with author­ity of the partners, and are jointly liable for all other obligations of the partnership.

The general partner is liable for partnership obligations to the same extent as partners of a general partnership.
Limited partners are not liable for partnership obligations and risk only the loss of their agreed capital contribution. Limited partners may become liable as general partners if they participate in the management of the partnership business.

Shareholders are not liable for the obligations of a corporation. How­ever, shareholders may be liable (1) to the extent they personally guaranty corporate debts; (2) to the extent they receive improper distributions; (3) if a court "pierces the corporate veil" of a corporation to impose personal liability on the shareholders; or (4) if a controlling shareholder breaches a duty to the other shareholders or the corporation.

Members of an LLC are not liable for the obligations of the LLC. However, a member may be liable (1) to the extent he or she personally guaranteed debts of the LLC; (2) for the member's participation in tortious conduct; (3) with respect to distributions from an LLC made in violation of the LLC Act; and (4) if a court "pierces the company veil" of an LLC to im­pose personal liability on the member.
The criteria used to determine whether to "pierce the LLC veil" are the same criteria used to determine whether to pierce the corporate veil, except that the fail­ure to hold meetings of members or managers or to observe formalities pertaining to meetings will not be considered a factor if the LLC is not required to hold meetings of members or managers.

5. Transferability of Interests

Interests are not easily transferred. A partner may assign his economic interest in the partnership to a third party, but this transfers only the right to share in distributions and profit and loss allocations, and does not transfer voting rights or the right to participate in management.

A limited partner may transfer his economic interest without the consent of the other partners, but this transfers only the right to share in distributions, profits, and losses, and does not transfer voting rights. Unless the partnership agreement pro­vides otherwise, the assignee of an economic interest cannot be admitted as a substitute limited partner without the consent of the general partners and a majority in interest of the limited partners.

The transfer of a general partner's interest is subject to the same rules as transfers of interests in general partnerships. Limited partners must approve the substitution of a general partner.

Shares of corporate stock are (if there is a market) more easily transferred than partnership or LLC interests. There are generally no statutory limits on the right of a shareholder to transfer his stock, and the consent of other shareholders to the transfer is not required. However, in closely held corporations, the transfer or other disposition of shares is often restricted by a shareholders' agreement or by provisions in the articles or bylaws.

A member may transfer his or her economic interest without the other members' consent, but this transfers only the right to share in distributions, profits, and losses and does not transfer voting and management rights. Unless the operating agreement provides otherwise, the assignee of an economic interest cannot be admitted as a substitute member with­out the consent of a majority in interest of other members.

6. Ability to Raise Capital

A general partnership's capital usually comes from the partners' capital contributions and from loans, secured or unsecured, from partners or third parties. General partnerships are generally not attractive to passive investors, because of the risk of personal liability for partnership debts and the lack of free transferability of partnership interests.

A limited partnership's sources of capital include those available to a general partnership, plus the capital contributions of limited part­ners. Because of limited liability and pass-through tax treatment, limited partnership interests are attractive to certain passive investors, especially in connection with real estate ventures and tax-advantaged investments.

However, because limited partners cannot participate in management without the risk of incurring general partner liability, limited partnerships are generally unattractive to venture capital.

A corporation is capitalized through equity contributions by its shareholders, loans from shareholders, and loans from third parties, unsecured and secured. Because of limited liability and the relatively free transferability of corporate shares, and because the consequences of investing in corporate stock may be better understood than the consequences of investing in partnerships or (especially) LLCs, corporations may be more attractive to risk capital.

An LLC is capitalized through capital contributions by its members, loans from mem­ers, and loans from third parties, unsecured and secured Because of the organizational and structural flexibility of LLCs, the ability to actively engage in management without risk of liability, and the ability to make special allocations and deduct losses, LLCs may become attractive to venture capital. LLC membership interests should also be attractive to certain passive investors, for the same reasons that limited partnership interests are attractive.

7. Are Interests in the Entity Deemed Securi­ties?

General partnership interests are not usually deemed securities.

Limited partnership interests are usually deemed securities.

Shares of corporate stock are almost always deemed securities

LLC interests will be securities for purposes of California law, unless all members actually actively engage in the management of the LLC. LLC interests may or may not be securities for purposes of federal law, depending on the facts and circumstances.

8. Continuity of Business

Unless otherwise provided in the partnership agreement, a general partnership may be dissolved by the express will of at least half the partners to dissolve and wind up the partnership business.

Unless otherwise provided in the partnership agreement, the death, bankruptcy, withdrawal, removal, or incompetence of a general partner will dissolve a limited partnership unless: (1) there is a remaining general partner or partners who elect to continue the business, or (2) if there is no remaining general partner, a majority in interest of the remaining limited partners agree to continue the business of the partnership and elect one or more successor general partners.

A corporation has an independent existence and is not terminated by the withdrawal, death, or other event affecting its shareholders, directors, or officers.

Unless otherwise provided in the articles of organization or a written operating agreement, an LLC will dissolve on the written agreement of all members to dissolve.

9. Number of owners required

Two

Two

One

One

10. May licensed professionals use the entity in California?

Licensed professionals may not form partnerships with non-licensed professionals.

No, but lawyers, accountants, and architects are permitted to use registered limited liability partnerships.

Yes (professional corporation)

No

B. Tax Factors

C Corporations

S Corporations

Partnerships

Limited Liability Companies

1. Pass-through tax treatment (i.e., do entity and its owners avoid "double taxation" on the earnings of the entity?)

No

Yes

Yes

Yes (single-member
LLC disregarded)

2. S Corporation Restrictions:

a. May the entity have more than 75 owners?

Yes

No

Yes

Yes

b. May the entity have owners other than individuals, estates, and certain trusts (e.g., corporate or partnership owners)?

Yes

No

Yes

Yes

c. May the entity have nonresident alien owners?

Yes

No

Yes

Yes

d. May the entity have more than one
class of stock or other ownership interest?

Yes

No (however, differences in voting rights are permitted)

Yes

Yes (N/A to single member LLCs)

e. May the entity be a member of an affiliated group (e.g., may the entity own subsidiaries)?

Yes

No (wholly owned S corporation not treated as separate corporation; S corporation may not file consolidated return with C corporation subsidiaries)

Yes

Yes (N/A to single member LLCs)

3. Are Contributions to Capital Taxed:

a. To the entity?

No

No

No

No

b. To the contributor?

i) Property

Unless tax-free under IRC §351, a contributor will be taxed on the contribution of appreciated assets to a corporation.

Same as C corporation.

Contribution of appreciated assets to a partnership may generally be made on a tax-free basis.

Same as partnership (property contributed to single-member LLC treated as owned by member)

ii) Services

Contribution of services for corporate stock is taxable under IRC §83; tax may be deferred if stock is subject to restrictions.

Same as C corporation.

Contribution of services in exchange for a profits interest in a partnership is generally not taxable; contribution of services in exchange for an interest in the capital of a partnership may be taxed.

Same as partnership (services contributed to single-member LLC treated as services for member)

4. Method of Accounting

C corporations must generally use the accrual method, unless gross receipts are less than $5 million, except qualified personal service corporations.

An S corporation may use the cash method, unless it is a "tax shelter."

A partnership may use the cash method, unless (i) it has a C corporation as a partner and gross receipts greater than $5 million, or (ii) it is a "tax shelter."

An LLC may use the cash method, unless it is a "tax shelter" (single-member LLC uses same accounting method as member).

5. Taxable Year

Fiscal year of the corporation's choosing, regardless of the taxable year of the corporation's owners (unless a personal service corporation).

Generally, the calendar year.

A partnership's taxable year must correspond to the taxable year of its majority or principal partners; if the majority or principal partners do not all have the same taxable year, the partnership must generally use the calendar year.

Same as partnership (single-member LLC uses same taxable year as member)

6. Double Tax on Liquidation?

Yes

Yes

No

No

7. Partnership Tax Features:

a. May the entity make special allocations and pass-through tax losses?

No

No

Yes

Yes (N/A to single-member LLCs)

b. May the "inside" tax basis of the entity's assets be stepped up on the death of an owner or on the transfer of an owner­ship interest?

No

No

Yes

Yes (N/A to single-member LLCs)

c. Is an owner's basis in its interest in the entity increased by the owner's share of the entity's debt?

N/A

N/A

Yes

Yes (debt of single-member LLC treated as obligation of member)

8. California Tax Treatment

Subject to California franchise tax. Must pay minimum tax of $800 per year (no minimum tax first two taxable years).

Pass-through entity. Subject to tax of 1.5% on net income. Must pay minimum tax of $800 per year (no minimum tax first two taxable years).

Pass-through entity. Limited partnerships must pay minimum tax of $800 per year; general partnerships are not so required.

Pass-through entity. Must pay minimum tax of $800 per year. Must also pay an annual fee based on gross revenues.

9. Employment Tax Issues

Corporation liable for employment taxes on corporate officers; fringe benefits deductible.

Corporation liable for employment taxes on corporate officers; fringe benefits deductible but taxable as income to 2-percent owners.

General partners and limited partners participating more than 500 hours per year subject to self-employment tax on partnership income.

Managers treated as general partners; non-manager members treated as limited partners.