Family Business Law Basics: Choosing Your Entity

Hall of Fame NBA player Tim Duncan is aptly nicknamed "the Big Fundamental," a reference to his incredible proficiency at the game's foundational skills. In the same way that Duncan's focus on the fundamentals led him to five championships and a host of individual accolades, mastering the fundamental legal considerations of a family business can set it up for success both now and for generations to come.

This article is the first in our "Family Business Law Basics" series, which will provide an overview of how to do just that. These concepts are important no matter whether your family business is a dream in the making, or one you have been operating for decades.

Here we begin by focusing on selecting the legal entity type of your business. The four basic entity types are: sole proprietorship, partnership, limited liability company (LLC), and corporation.

While many states have additional types of entities created for specific purposes, and may have slight deviations in place concerning the four described, these four entities make up the vast majority off all businesses in the United States. We will briefly examine each entity type based on the following characteristics: taxation, liability protection, formalities required, access to capital, and ease of succession.

Definition of Terms

Taxation

Whether a business has to pay its own taxes or all of its profits and losses are taxed to the business owners directly is a primary consideration when thinking about entity type selection. When a business has "pass-through" tax treatment, the entity itself does not pay taxes on any of its revenue; for tax purposes, it is disregarded as even existing.

Instead, the owners of the business pay taxes on the business's profits as if they earned them directly. For example, suppose that Business 1 is a pass-through entity, which realized $300,000 in profit in year 1 and distributed $100,000 to each of its two owners (for a total of $200,000) in that same year. Business 1 itself, as a distinct legal entity, would not pay taxes on any of the $300,000 of profit. Rather, each of the owners would report their $150,000 portion of that $300,000 on their individual tax returns—the size and timing of the distributions would be generally irrelevant for tax purposes.

On the other hand, a non-pass-through entity pays taxes at the entity level for its profits. This means that the entity itself pays taxes on the profit it recognizes. The owners of the entity are also responsible to pay taxes on any amount they personally receive as dividends or distributions. This taxation at both the entity and owner level is known as "double taxation." Sticking with the example above, this means that Business 1 would have to pay taxes on the $300,000 of revenue and the owners would have to pay taxes on their $100,000 distributions.

Generally speaking, pass-through tax treatment is preferred since each dollar is taxed once rather than twice.

Liability Protection

As a general rule, if an entity provides liability protection for its owners, then the business's creditors can only pursue the assets of the business entity itself to satisfy its debts, and the personal assets of the entity's owners are shielded. Conversely, if a business type does not provide liability protection, the business's creditors can pursue the personal assets of the owners to satisfy the debts of the business.

Formalities Required

The formalities that a business entity must perform are the procedural and administrative tasks that the law requires the entity to complete in order to be formed and remain in good standing. Examples include the type and frequency of leadership meetings that must take place, the sophistication of the governing documents the entity must draw up, and the like.

Formalities do have a cost in terms of time to comply as well as fees that must be paid to advisors or the state. Further, the failure to comply with certain formalities can result in penalties for the entity, or even the revocation of its ability to do business.

Access to Capital

Businesses need money in order to make money. Different entities have different options for raising capital. The most important distinction is that some entities can sell equity in their company to raise capital, while others cannot and must rely solely on loans/debt, or the personal assets of their owners.

Succession

Succession refers to the passing on of the ownership and management responsibilities of the business to the next generation in a manner meant to enable a smooth transition. Usually, this means the ability to pass on ownership and management rights and responsibilities over time, rather than all at once. This is often a crucial consideration for family businesses, which tend to have a very strong interest in the longevity of the company.

Overview of Entities

Sole Proprietorship

A sole proprietorship is created when an individual commences a business without undertaking the necessary formalities for the creation of another type of entity. Sole proprietorships have one owner (by definition), pass-through tax-treatment, no liability protection, few ongoing formalities, cannot sell stock or other equity, and are not capable of being passed on to the next generation in the same form in which they are currently operated.

Partnerships

There are three types of partnerships: general partnerships, limited partnerships, and limited liability partnerships. A partnership is defined as the association of two or more people who carry on a business for profit as co-owners.

• General Partnership: A general partnership is essentially a sole proprietorship when more than one person is involved—when multiple individuals commence a business together without undertaking the necessary formalities for the creation of another type of entity.
  
  General partnerships have pass through tax treatment, no liability protection, few ongoing formalities, and can generally only raise capital by borrowing. Moreover, they have limited options for succession because the next generation cannot take ownership of the business without becoming subject to personal liability and having full rights and responsibilities of management.
• Limited Partnership: Limited partnerships have two classes of partners: general partners and limited partners. The classes differ in the liability protection they possess and their ability to manage the company. General partners generally do not have liability protection while limited partners do. Conversely, limited partners are generally unable to have an active role in the management of the company.
  
  Limited partnerships receive pass-through tax treatment and have few formalities. Their interests can be sold in exchange for capital, meaning limited partnerships can make use of both debt and equity capital raising strategies. Succession is complicated for limited partnerships—in order to bring the next generation into ownership, they must either be a limited partner and not be able to participate in management or become a general partner and be subject to unlimited liability.
• Limited Liability Partnership (LLP): LLPs are creations of state laws, and as a result, the specific provisions governing them can vary. However, as a general matter in an LLP, all partners both enjoy liability protection and may be involved in the management of the company. They also have pass-through tax treatment and, in addition to borrowing, can raise capital by selling partnership interests.
  
  Upon first glance, the combination of liability protection and pass-through tax treatment makes LLPs an attractive choice in states that have them. However, LLPs are usually created for specific purposes by states (e.g., law firms and other professional organizations) and as a result usually have more formalities than the LLC, which benefits from those same characteristics.

Limited Liability Company (LLC)

All owners of an LLC enjoy liability protection. In addition, LLCs are generally pass-through entities. As mentioned above, in addition to the rare combination of liability protection and pass-through tax treatment, LLCs require minimal formalities. This trifecta is unique to LLCs and makes them a very attractive choice for family businesses.

The benefits of the LLC do not end there. Interests in an LLC are appealing to investors due to the liability protection that accompanies them. This means that capital can be raised through both the sale of equity and by borrowing.

Moreover, LLCs provide great flexibility when it comes to succession planning. Subsequent generations can be brought into ownership over time with the full benefit of liability protection and can be involved in management to the extent deemed appropriate for their skills.

Corporation

Corporations are another popular entity choice for family businesses. There are many types of corporations—including C corporations, S corporations, non-profit corporations, and benefit corporations. This article will focus on the C corporation, as the most popular type of corporation.

Corporations provide liability protection and multiple classes of stock are easily created and sold to investors, which gives corporations flexibility in how they raise capital. Further, corporations are able to take advantage of the same succession planning benefits as LLCs. However, corporations are not pass-through entities and are thus subject to double taxation.

Conclusion

The descriptions provided above are very general, and the specific rules and regulations covering any entity type vary from state to state. There are also many exceptions to the general rules described. Choosing the entity type for your company is a big decision—one that hinges on the specifics of your business. Be sure to have a clear vision for your company and to consult with qualified legal counsel before selecting or changing your entity type.