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Martin & Reynor, P.C.

Choice of Business Entity Handbook
by
Gregory M. Johnson, CPA, Esquire

Martin & Raynor, P.C.
1228 Cedars Court
Charlottesville, Virginia 22903-4801
Telephone: (434) 817-3100
Fax: (434) 817-3110
 

Chapter 1 - Introduction
Chapter 2 - Choose Your Team
Chapter 3 - Put the Team to Work
Chapter 4 - Types of Entities and Their Characteristics
Chapter 5 - Conclusion

Appendix A - Characteristics of Business Entities
Appendix B - Links to Other Website

Chapter 1
Introduction

One of the most important decisions facing any business owner is choosing the most appropriate legal form of doing business. The options, which can seem overwhelming, include proprietorships and general partnerships, which do not provide the owners with limited liability protection, and limited partnerships, limited liability general partnerships, limited liability limited partnerships, C corporations, S corporations, limited liability companies and business trusts, which provide the owners with limited liability protection to varying degrees (collectively referred to herein as “limited liability entities”). Each type of form or entity has distinct tax and non-tax advantages and disadvantages. For example, while businesses that operate as proprietorships and general partnerships may be easier to start, proprietorships and general partnerships do not provide the owners of the business with any protection from the liabilities and obligations of the business.  

A careful analysis of each owner’s, as well as the business’s, specific tax and non-tax goals and objectives must be performed taking into consideration the specific type of business or businesses to be conducted by the entity. 

Entity selection is an issue which must be addressed by business owners both at inception and at many stages during the life of the business.  The type of entity which is appropriate at inception may not be appropriate later in the life of the business.  For example, tax laws may change making another type of entity preferable over the type of entity originally selected by the owners.  Assuming the conversion to the more preferable type of entity can be accomplished economically and efficiently, tax or otherwise, the business owners would want to seriously consider making the conversion.  The current trend for state law purposes is to allow flexible conversion to just about any type of entity from just about any type of entity.  However, the same is not true for tax purposes so careful consideration should be given to the tax considerations of any such conversion.  

Therefore, it is important to remember that the business owners should periodically review with their advisors the entity selected to determine whether a change is necessary.  For example, many start-up businesses with a single owner and no employees will begin operations as a sole proprietorship and eventually convert to an entity providing limited liability protection to the owners when the business has become successful and has added employees and possibly new owners.

Please also note that it is generally relatively easy for state law purposes to convert from one type of business entity to another, yet, for tax purposes, some conversions may be simple and tax free, such as from a partnership to a corporation, but other types of conversions may be more complicated and costly, from a tax standpoint, such as from a C corporation to a partnership.  

In this handbook I will attempt to outline, in detail, the process one should go through in deciding which entity is most appropriate at any given point in time.

Chapter 2
Choose Your Team

Whenever faced with the issue of choice of entity, business owners must know who to consult to make the best decision possible.  Due to the fact that this decision will have business, legal and tax consequences to both the business and its owners, the team should consist of the officers and directors of the business, the business owners, business consultants, as well as the CPA’s and attorneys representing the business and each of its owners.

The business owners’ team, which should consist of experienced advisors who are regularly involved in advising business clients can help lead the business owner through the maze of options. The team of advisors can help the business owner develop and implement the most effective and cost efficient strategy. This collaborative approach will result in tax savings and peace of mind for the business owners, so that the business owners will be assured that any exposure to risk and liability (tax or otherwise) associated with a bad choice of entity decision has been minimized, allowing the business owners to focus on the important operational issues facing their business.

In choosing the dream team, the business owner should select professionals experienced in the business area.  For example, a business owner would generally not want his or her divorce attorney advising the business owner on sophisticated business issues nor would the business owner want a business attorney advising him or her on divorce issues.  Information necessary to put together this dream team is generally available from the internet and yellow pages, as well as from friends and other trusted advisors, such as your CPA.   For example, most CPA firms and law firms have their own websites from which the business owner can obtain a wealth of information about the firms which may be best suited for that particular business.  

Depending on whether you want one-stop shopping and a higher degree of sophistication, which would tend to lead you towards the larger more sophisticated and established firms, or whether cost and simplicity is a key factor, which would tend to lead you toward the smaller firms or even sole proprietorships,  the type of firm you ultimately select could have a significant impact on the success or failure of your business.

Ideally, all of the players on the team will meet or otherwise collaborate to arrive at an informed decision taking into consideration all relevant information obtained from the business and its owners.  Otherwise, the decision may be based on insufficient information, which could be catastrophic for the business.

Chapter 3
Put the Team to Work

In reaching its decision, the business owners’ team (“team”) will need to analyze the factors risk, tax and other business factors mentioned below, first to determine whether a limited liability entity is appropriate and, if so, which type of limited liability entity discussed in Chapter 4 is most appropriate. 

Risk Factors:

Tax Factors:

Other Business Factors:

Chapter 4
Types of Entities and Their Characteristics

In this chapter, I will discuss the various types of entities out of which the owners of a business may operate.  Appendix A attached hereto contains a table outlining the characteristics of each type of entity.

  1. Sole Proprietorship.  Many small businesses with a single owner begin as a sole proprietorship because it is the simplest and cheapest way to begin operating a business.  However, please see Chapter 3 for additional discussion of when and why it may not be advisable to operate a business as a sole proprietorship or general partnership.  In any event, following are some of the characteristics of a sole proprietorship. 
    1. Ownership.   The sole proprietorship is not an entity separate from its owner, who is also known as a sole proprietor.  As a result, the sole proprietor owns outright all of the assets of the business, but, as I will discuss below, the sole proprietor is also personally obligated for all of the liabilities of the business.  Unfortunately, when the owner dies, in most instances the business dies with the owner.  While the estate of the owner may be able to sell the assets of the business at some distressed value, generally the business cannot continue intact because, as I will discuss below, management is not in place that would enable the business to continue without interruption pending the sale of the business as a going concern.  With some advance planning, it may be possible to provide for the continuation of the business after the owner’s death. 
    2. Management.  Generally the sole proprietorship is managed by the sole proprietor who may, however, employ others to manage the business for him.  When dealing with third parties, much confusion may arise as to the manager’s actual authority to engage in transactions on behalf of the sole proprietor, unless specific written authority is given to the manager for each transaction.  An officer of a corporation, for example, is generally clothed with certain authority simply by virtue of the officer’s title, making it easier for the owners of a corporation to effectively use others to manage the business for them.  Unless the sole proprietor engages in some type of succession planning, the sole proprietor’s business will die with the sole proprietor due to a lack management
    3. Taxation.  For tax purposes, the business income of the sole proprietorship is reported on the sole proprietor’s individual income tax return on a Schedule C and a separate tax return for the business is not required, resulting in simplicity and savings to the sole proprietor.   For copies of this and other IRS forms, please visit the IRS’s website at www.irs.gov/formspubs/index.html

      Tax Trap.  Please note that the taxable income of the sole proprietor, in addition to being subject to income taxes, is subject to self-employment taxes, which are the self-employed person’s equivalent to the Social Security and Medicare taxes, one-half of which are withheld from an employee’s compensation and one-half of which are paid by the employer.  The effective rate of the self-employment tax is approximately twelve to thirteen percent of the self-employment income of the sole proprietor.  The sole proprietor should therefore plan for the quarterly payment of this self-employment tax and the income tax to the IRS to avoid any penalty and unexpected surprises when April 15 of the following year rolls around.

      Tax Trap.   Please also note that the IRS loves to audit sole proprietorships, one theory being that the sole proprietor is generally less sophisticated than a corporate taxpayer, and, consequently, is less likely to maintain accurate books and records.   

      Tax Planning Opportunity.  By operating out of an S corporation as opposed to a sole proprietorship, the owner of the business, if the owner is also actively involved in the business, may experience tax savings of up to several thousand dollars by operating out of the S corporation due to the fact that the taxable income of the S corporation is not subject to self-employment taxes.   The tax savings alone may therefore make the S corporation preferable over the sole proprietorship.   See the discussion of S corporations below for more information about this planning opportunity.

    4. Governing Documents.  Unlike limited liability entities, there are no governing documents for the sole proprietorship which dictate how the business is to be operated, managed or owned.  This lack of governing documents can, in some cases, result in confusion over who actually owns the assets of the business.
    5. Liability of Sole Proprietor.  The sole proprietor is personally responsible for ALL of the debts and other contractual and tort obligations of the business.   For this reason alone, all sole proprietors, even those just starting their businesses, should seriously consider forming some type of legal entity out of which to operate their business.  At the very least, if the business is anticipated to have any of the following characteristics, the owner should seriously consider operating out of an entity which will limit the owner’s exposure to liabilities and obligations of the business:
      1. The business will hire employees or independent contractors;
      2. The business will incur significant debts and obligations which the owner will not be expected to personally guaranty;
      3. The business will be conducted from a location which will be accessed by the general public (e.g. restaurant);
      4. The business will sell products, which if defective or used improperly, could cause significant physical harm or damage to property (e.g. guns); and
      5. The business will provide services which could cause significant physical harm or damage to property (e.g. demolition business).

      The liability protection alone from operating out of an entity which provides limited liability protection for the owner under any of these scenarios mentioned above would generally far outweigh the cost of forming and maintaining the entity. 

      Long Term Liability Trap.  Should a creditor of a business obtain a judgment in court against the owner of the business, that creditor would have a very long period of time in which to attempt to collect that judgment (20 years in Virginia).  Consequently, business owners, who think they may have little to lose in the way of assets or outside income at the time they are operating as a sole proprietorship, could be exposing future income, assets, inheritances, and gifts to the liabilities of their businesses for a very long period of time. 

  2. Partnerships.  There are four types of partnerships, general partnerships, limited partnerships, registered limited liability partnerships and registered limited liability limited partnerships.
    1. Ownership.   While the assets inside the partnership are owned by the partnership, the entity itself is owned by its partners, which are comparable to members of an LLC and shareholders in a corporation.   Partners’ ownership interest in the partnership is generally referred to as “partnership interests” and is stated as a percentage.  If the need arises, different rights can be established to give some partners preferential treatment with respect to distributions while giving other partners more favorable tax treatment.  Under Virginia law, the partnership must have at least two partners.
    2. Management.  Generally, the partnership is managed by its general partners or by a managing partner in the manner set forth in the Partnership Governing Documents (as defined below).  In general partnerships and limited liability partnerships, each general partner generally has the authority to bind the partnership, unless the Partnership Governing Documents provide otherwise.  The authority or any limitation on the authority of a partner to enter into transactions on behalf of the partnership should be set forth on a statement of partnership authority filed with the SCC.   Limited partners should not be involved in the management of the partnership.  With limited partnerships and limited liability limited partnerships, there are two classes of partners, general and limited, with only the general partners having the authority to bind the partnership in the manner set forth in the Partnership Governing Documents. 
    3. Taxation.  For tax purposes, the partnership will be required to file a Form 1065 for each calendar year by April 15 of the following year, unless it requests a four-month extension.   The partnership should provide each partner with a K-1 form necessary for the partner to report the partner’s share of the business income of the partnership on a Schedule E to be attached to the partner’s income tax returns, if the partner is an individual and not an entity.   Other income of the partnership, such as interest, dividends, and rents, should be reported on the appropriate schedules of the partner’s tax returns.  Please note that each partner’s share of the taxable business income of the partnership is subject to self-employment tax, which tax might be avoided to some extent with the use of an S corporation.
    4. Partnership Governing Documents.  The rules governing the management and operation of the partnership are contained in the Virginia statutes (Virginia Code Annotated Sections 50-73.1, et seq., for limited partnerships and Virginia Code Annotated Sections 50-73.79, et seq., for general partnerships), and the partnership agreement (collectively “Partnership Governing Documents”).  The partnership agreement can be a very lengthy document as it usually deals with a myriad of issues from the ownership and management structure, to accounting issues, the sale of partnership interests, to the dissolution of the partnership.  It is advisable that, at the very least, you seek legal counsel to assist you in the preparation of the partnership agreement, if at all possible.
    5. Liability of Partners.   Personal liability of the partners for the obligations of the partnership varies depending upon the type of partnership. Each partner in a general partnership and each general partner in a limited partnership has unlimited joint and several liability for partnership obligations.  Limited partners in a limited partnership (so long as they do not participate in the management of the partnership), all partners in a limited liability partnership, and all partners in a limited liability limited partnership, general and limited, have limited liability for partnership obligations.
  3. Limited Liability Company (“LLC”).  A relatively new entity in Virginia, (the LLC statutes were enacted by the Virginia General Assembly in 1991), the LLC is an entity in which the owners, generally referred to as “members”, have limited personal liability for LLC obligations.  An LLC has a tremendous amount of flexibility in how its ownership and management are structured as well as how it is taxed.
    1. Ownership.   While the assets inside of the LLC are owned by the LLC, the entity itself is owned by its members, which are comparable to shareholders in a corporation and partners in a partnership.  However, if the members wish, they can refer to themselves as shareholders, but, for liability purposes, they should not refer to themselves as partners.  The members may be involved in the management of the LLC either as members in a member-managed LLC or as managers in a manager-managed LLC.  Members’ ownership interest in the LLC is generally referred to as “membership interests” but can also be referred to as “shares of stock”.  If the need arises, different classes of membership can be established.  Under Virginia law, the LLC can have as few as one member.
    2. Management.  Generally the LLC is managed by either managers or by the members.  However, if the members wish, the LLC can look exactly like a corporation and have a board of directors and officers, such as a president, vice president, secretary, and treasurer.  If the LLC is manager-managed, the members elect the managers in the manner set forth in the LLC Governing Documents (as that term is defined below).   Under Virginia law, the same person can serve as the sole member and manager of the LLC.
    3. Taxation.  For tax purposes, the LLC is disregarded if there is only one member, (“single-member LLC”), and it is treated as a partnership if there is more than one member, (“multi-member LLC”).  However, the LLC can, if it wishes, elect to be treated as a corporation, including an S corporation.  If it is a sole proprietorship for tax purposes, the LLC need not file any income tax returns.  Instead, the business income (losses) of the LLC should be reported on a Schedule C to be attached to the member’s federal and state income tax returns, if the member is an individual and not an entity.  If it is a partnership for tax purposes, the LLC should report its income on a Form 1065 and should provide each member with a K-1 form necessary for the member to report the member’s share of the business income of the LLC on a Schedule E to be attached to the member’s income tax returns, if the member is an individual and not an entity.   Other income of the LLC, such as interest, dividends, and rents, should be reported on the appropriate schedules of the member’s tax returns. If the LLC is either a partnership or a sole proprietorship for tax purposes, each partner’s share  (or the sole proprietor’s share, if it is a sole proprietorship), of the taxable business income of the partnership (or the sole proprietor’s share, if it is a sole proprietorship), is subject to self-employment tax, which tax might be avoided to some extent with the use of an S corporation.
    4. LLC Governing Documents.  The rules governing the management and operation of a Virginia LLC are contained in the Virginia statutes, (Virginia Code Annotated Sections 13.1-1000, et seq.), the articles of organization and the operating agreement (collectively “LLC Governing Documents”).  The articles of organization, which can be a simple one page document found at the SCC website located at http://www.scc.virginia.gov/division/clk/index.htm , are filed with the SCC along with a $100 filing fee.   The operating agreement can be a very lengthy document as it usually deals with a myriad of issues from the ownership and management structure to accounting issues to the dissolution of the LLC.  It is advisable that, at the very least, you seek legal counsel to assist you in the preparation of the operating agreement, if at all possible.
    5. Liability of Members.  Generally, the members are not liable for the obligations of the LLC.  However, the members may be asked by the LLC’s bankers, landlords, suppliers and others to personally guarantee obligations of the LLC owed to them, in which case the members would be liable for the specific obligation that the members have guaranteed.  In addition, members may be personally liable for certain taxes, such as payroll taxes withheld from the employees’ paychecks, sales taxes and meals taxes, if the members have check writing authority.  There are circumstances where the LLC veil of limited liability may be “pierced” and the members held liable for other obligations of the LLC.  Care should be taken by the members and managers in the operation of the LLC to ensure that its limited liability veil will not be pierced.  Steps to be taken include (A) maintaining separate books, records and bank accounts for the LLC; (B) using the complete legal name of the LLC, including the abbreviation “LLC” or “LC”, as applicable, on everything that will be seen by those dealing in any way with the LLC, including its employees, creditors, suppliers, landlords, and customers; (C) when signing all documents on behalf of the LLC,  conspicuously noting the legal name of the LLC above your signature and beside or under your name the capacity in which you are signing, whether it be member or manager; and (D) when the LLC is dealing in any way with the members or managers, individually, or with an entity in which the members or managers have an ownership interest, the terms of any such dealing should be arms-length and commercially reasonable. 
      CAUTION: Due to the fact that LLC’s are relatively new entities in Virginia, the body of law to be followed by the courts in determining when to pierce the limited liability veil of the LLC is not nearly as well developed as for corporations, and, consequently, some uncertainty currently exists as to when a creditor will be permitted to pierce the LLC’s veil.
    6. Bankruptcy Remote Issues.   On the flip side, situations arise where it is also critical for the assets within the LLC to be protected from the liabilities or bankruptcy of each member of the LLC.  For example, a bank making a loan to an LLC may require that an LLC be what is called a bankruptcy remote entity so that if any member of the LLC should become a debtor in a bankruptcy, the assets inside of the LLC would not be subject to the control of the trustee or debtor in possession.  This issue is generally only faced by single member LLC’s and can be resolved by adding what is known as a special purpose member to the LLC, which member would have the right to vote on certain major decisions, such as the sale of LLC assets, but would not have an economic interest in the LLC.  If an LLC is concerned about bankruptcy remote issues, it may want to be formed as a Delaware LLC, as Delaware is considered by many attorneys to provide the most protection possible to the LLC with respect to bankruptcy remote issues.
    7. Unique Uses for LLC’s. 
      1. Like-Kind Exchanges.  Single-member LLC’s are ideal for holding title to real estate to be sold, (“Relinquished Property”), or acquired, (“Replacement Property”), in a like-kind exchange under Section 1031 of the Internal Revenue Code.  Because the single-member LLC is a disregarded entity for tax purposes, the exchange is deemed to be made by the member of the LLC and not the LLC itself, which is especially crucial if either the Relinquished Property or the Replacement Property was or is to be titled in the name of the member and not the LLC for any reason.
      2. Avoiding Transfer Taxes.  LLC’s which hold title to real estate can avoid local and state transfer taxes on the sale of the real estate in many states by structuring the sale as a sale of the membership interests in the LLC, which are considered personal property and not subject to the transfer taxes arising from the sale of real estate, as opposed to structuring the sale as a sale of the real estate itself.
      3. Anonymity.  Should the persons managing the business wish to remain anonymous, the LLC would be preferable due to the fact that it need not report to the SCC the names and addresses of its officers and directors as is required of corporations. 
      4. Consolidated Entities.  If an individual or a group of individuals owns or wishes to own several different businesses or several different parcels of real estate, then each business or each parcel of real estate could be placed in its own LLC, (“subsidiary LLC”), all of which subsidiary LLC’s would be owned by yet another LLC, (“parent LLC”).  The parent LLC would then be owned by the individual or group of individuals.  Because each subsidiary LLC has only a single member (the parent LLC), only the parent LLC, and not the subsidiary LLC’s,  would be required to file income returns to report the income of the subsidiary and parent LLC’s.
      5. Different Classes of Ownership.  If for whatever reason the owners of the entity wish to provide for separate classes of ownership, then the LLC may be preferable to the S corporation, as the S corporation cannot have separate classes of stock.  For example, if the owners wanted to give one class of owners preferential treatment with respect to dividends, which would be equivalent to preferred stock in a corporation, then the operating agreement of the LLC could provide for this preferred treatment, and the LLC could still qualify as a partnership, for tax purposes, while a corporation could not qualify as an S corporation if it has more than one class of stock.
      6. Foreign Owners.  If any of the owners of the entity are not citizens of the United States and do not reside in the United States, the entity could not qualify as an S corporation and, consequently, the LLC may be the preferable form.
      7. Intellectual Property is a Principal Asset of Business.  In many instances, the LLC will be the entity of choice when the business has patents, trademarks, copyrights or trade secrets which it will attempt to commercialize through joint ventures or licensing due to the fact that as part of the commercialization process, different owners may be granted different rights with respect to distributions of profits or otherwise, which would result in a second class of ownership, which is allowed for partnerships but is not allowed for purposes of qualifying as an S corporation. 
      8. Real Estate.  If a business has any real estate holdings, the LLC is generally the entity of choice for taking title to the real estate because partnerships can move that real estate around without adverse tax consequences much easier than say an S corporation.  The LLC would then lease the real estate to the operating entity under commercially reasonable terms
    8. Formation in Other States.  Given the global nature of many businesses today as well as the transient nature of many business owners and executives, when forming an LLC, one may want to consider forming the LLC in other states such as Delaware or Nevada, for tax and other business reasons.  Delaware law and courts, for example, are considered possibly the most business friendly and knowledgeable, respectively, of all the states.  Consequently, an LLC and its assets may be afforded greater protection in Delaware than in other states for the reasons stated above and for other reasons as well.  While forming an LLC in one state and operating it in other states may result in additional complexity and costs (the entity will have to maintain its LLC status in the state of formation and will have to qualify to do business in all of the states in which it does business), the costs and additional complexity are often far outweighed by the additional benefits afforded to the LLC.
  4. Corporations.  A much more mature entity in Virginia, and elsewhere, the corporation is also an entity in which the owners, generally referred to as “shareholders”, have limited personal liability for the corporation’s obligations.  A corporation, however, as compared to the LLC, does not have quite as much flexibility in how its ownership and management are structured and how it is taxed. 
    1. Ownership.   While the assets inside the corporation are owned by the corporation, the entity itself is owned by it shareholders, which are comparable to members of an LLC and partners in a partnership.   The shareholders may be involved in the management of the corporation either as shareholders, if all of the shareholders agree, in writing, to eliminate the board of directors, or as directors or officers.  Shareholders’ ownership interest in the corporation is generally referred to as shares of stock.  If the need arises, different classes of stock can be established to give shareholders of one class preferential treatment with respect to dividends and other distributions while giving another class more favorable voting rights.  Under Virginia law, the corporation can have as few as one shareholder.
    2. Management.  Generally the corporation is managed by a board of directors which is elected by the shareholders in the manner set forth in the Corporation Governing Documents, (as defined below), unless all of the shareholders agree, in writing, to eliminate the board of directors.  The board of directors then elects officers, such as a president, vice president, secretary, and treasurer, to manage the day-to-day operations of the corporation.   Under Virginia law, the same person can serve as the sole shareholder, director and officer of the corporation.
    3. Taxation.  For tax purposes, the Corporation will be treated as a separate tax-paying entity, (“C corporation”), unless it elects to be treated as an S corporation by filing Form 2553 with the IRS.  If the corporation elects to be treated as an S corporation, for each calendar year, it will be required to file a Form 1120S by March 15 of the following year, unless it requests a six-month extension.   The S corporation should provide each shareholder with a K-1 form necessary for the shareholder to report the shareholder’s share of the business income of the corporation on a Schedule E to be attached to the shareholder’s income tax returns, if the shareholder is an individual and not an entity.   Other income of the S corporation, such as interest, dividends, and rents, should be reported on the appropriate schedules of the shareholder’s tax returns.  Given that a C corporation is subject to two levels of tax, one at the corporate level, and the second at the shareholder level when distributions are made to the shareholders, in a form other than compensation and loans,  most small corporations operate as S corporations
      Tax Planning Opportunity.  S corporation shareholders can in some cases save thousands of dollars of employment taxes by paying themselves the smallest reasonable salary possible, while either distributing the remaining income to themselves as dividends or retaining that income in the corporation for other corporate purposes.  Care should be taken to ensure that the salary paid to the shareholder is reasonable, otherwise, upon audit, the IRS could reclassify some of the payments as compensation, subject to federal social security and Medicare taxes.   This planning opportunity is well suited for businesses which have employees other than an owner/employee assisting in the operation of the business.  For example, a grocery store is owned by an S corporation, with one shareholder, A, who is also the manager of the store.  Before a salary is paid to the manager, the taxable income of the store is $50,000.  Assuming that a reasonable salary of $25,000 is then paid to the manager, subject to withholding and payment of Social Security and Medicare taxes, the remaining $25,000, while being subject to the income tax, is not subject to any Social Security, Medicare or self-employment taxes.  With an effective self-employment tax rate of 13%, the tax savings in this example would be 13% of $25,000 or $3,250.  As with the other tax traps and tax planning opportunities discussed in this handbook, please consult with your tax advisors regularly to make sure you stay out of the traps and take advantage of the planning opportunities available to you.
    4. Corporation Governing Documents.  The rules governing the management and operation of the corporation are contained in the Virginia statutes (Virginia Code Annotated Sections 13.1-601, et seq.), the articles of incorporation, bylaws, and shareholder agreements (collectively “Corporation Governing Documents”).  The articles of incorporation, which can be a simple one page document found at the SCC website, are filed with the SCC along with a $75 filing fee.   The bylaws and shareholder agreements can be very lengthy documents as they usually deal with a myriad of issues from the ownership and management structure, to accounting issues, to sale of stock, to the dissolution of the corporation.  It is advisable that, at the very least, you seek legal counsel to assist you in the preparation of the bylaws and shareholder agreements, if at all possible.
    5. Liability of Shareholders.  Generally, the shareholders are not liable for the obligations of the corporation.  However, the shareholders may be asked by the corporation’s bankers, landlords, suppliers and others to personally guarantee obligations of the corporation owed to them, in which case the shareholders would be liable for the specific obligation that the shareholders have guaranteed.  In addition, shareholders may be personally liable for certain taxes, such as payroll taxes withheld from the employees’ paychecks, sales taxes and meals taxes, if the shareholders have check writing authority.  There are circumstances where the corporation’s veil of limited liability may be “pierced” and the shareholders held liable for other obligations of the corporation.  Care should be taken by the shareholders, directors and officers in the operation of the corporation to ensure that its limited liability veil will not be pierced.  Steps to be taken include (A) maintaining separate books, records and bank accounts for the corporation; (B) using the complete legal name of the corporation, including the abbreviations “Inc.” or “Corp.”, as applicable, on everything that will be seen by those dealing in any way with the corporation, including its employees, creditors, suppliers, landlords, and customers; (C) when signing all documents on behalf of the corporation,  conspicuously noting the legal name of the corporation above your signature and beside or under your name the capacity in which you are signing, whether it be officer or director; and (D) when the corporation is dealing in any way with the shareholders, directors or officers, individually, or with an entity in which the shareholders, officers or directors have an ownership interest, the terms of any such dealing should be arms-length and commercially reasonable.
    6. Formation in Other States.  Given the global nature of many businesses today as well as the transient nature of many business owners and executives, when forming a corporation, one may want to consider forming the corporation in other states such as Delaware or Nevada, for tax and other business reasons.  Delaware law and courts, for example, are considered possibly the most business friendly and knowledgeable, respectively, of all the states.  Consequently, a corporation and its assets may be afforded greater protection in Delaware than in other states for the reasons stated above and for other reasons as well.  While forming a corporation in one state and operating it in other states may result in additional complexity and costs (the entity will have to maintain its corporate status in the state of formation and will have to qualify to do business in all of the states in which it does business), the costs and additional complexity are often far outweighed by the additional benefits afforded to the corporation.   For more information on forming a Delaware entity, please visit the Delaware Secretary of State’s website at http://www.state.de.us/sos/.
  5. Business Trusts.  Business trusts, a new entity in Virginia, can now be established as a result of a statute enacted in 2002.   Business trusts include unincorporated businesses, trusts or associations that are:
    1. governed by what is generally known as a trust agreement under which:
      1. property is or will be held, managed, administered, controlled, invested, reinvested, or operated by a trustee for the benefit of persons as are or may become entitled to a beneficial interest in the trust property; or
      2. business or professional activities for profit are carried on or will be carried on by one or more trustees for the benefit of persons as are or may become entitled to a beneficial interest in the trust property; and
    2. file articles of trust with the SCC.
      Businesses currently following under the categories of associations, clubs, foundations, funds, institutes, societies, unions and syndicates are likely candidates for selecting business trusts from which to operate.   For example, Real Estate Investment Trusts established under Sections 856 through 859 of the Internal Revenue Code of 1986, as amended, (“Code”), and Real Estate Mortgage Investment Conduit under Section 860D of the Code can qualify as a business trust.  Business trusts may also be well suited for being used for estate planning purposes where the owner of a business would like for the business to be managed, after the owner’s death, by an independent trustee for the benefit of his spouse or other heirs or intended beneficiaries .
    3. Ownership.   While the assets inside the business trust are owned by the business trust, the entity itself is owned by its beneficial owners, which are comparable to shareholders of a corporation, to members of an LLC and partners in a partnership.   The beneficial owners may be involved in the management of the business trust if permitted by the Business Trust Governing Documents (as defined below) of the business trust.  The ownership interest of a beneficial owner in the business trust is generally referred to as beneficial interest.  If the need arises, different classes of beneficial interests can be established to give beneficial owners of one class preferential treatment with respect to dividends and other distributions while giving another class more favorable voting rights.  Under Virginia law, the business trust can have as few as one beneficial owner.
    4. Management.  Generally the business trust is managed by the trustee designated in the Business Trust Governing Documents.  The trustee, may, in turn, choose and supervise officers and employees of the business trust, unless otherwise restricted by the Business Trust Governing Documents.
    5. Taxation.  For tax purposes, the business trust will most likely be treated as a corporation, which is a separate taxpaying entity, unless it elects to be treated as an S corporation by filing Form 2553 with the IRS.  If the business trust elects to be treated as an S corporation, for each calendar year, it will be required to file a Form 1120S by March 15 of the following year, unless it requests a six-month extension.   As an S corporation, the business trust should provide each beneficial owner with a K-1 form necessary for the beneficial owner to report the beneficial owner’s share of the business income of the business trust on a Schedule E to be attached to the beneficial owner’s income tax returns, if the beneficial owner is an individual and not an entity.   Other income of the S corporation, such as interest, dividends, and rents, should be reported on the appropriate schedules of the beneficial owner’s tax returns. 
    6. Business Trust Governing Documents.  The rules governing the management and operation of the business trusts are contained in the Virginia statutes (Virginia Code Annotated Sections 13.1-1200, et seq.), the articles of trust, bylaws, and trust agreements (collectively “Business Trust Governing Documents”).  The articles of trust, which can be a simple one page document found at the SCC website, are filed with the SCC along with a $100 filing fee.   The bylaws and trust agreements can be very lengthy documents as they usually deal with a myriad of issues from the ownership and management structure, to accounting issues, to sale of beneficial interests, to the dissolution of the business trust.  It is advisable that, at the very least, you seek legal counsel to assist you in the preparation of the bylaws and trust agreements, if at all possible.
    7. Liability of Beneficial Owners.  Generally, the beneficial owners are not liable for the obligations of the business trust.  However, the beneficial owners may be asked by the business trust’s bankers, landlords, suppliers and others to personally guarantee obligations of the business trust owed to them, in which case the beneficial owners would be liable for the specific obligation that the beneficial owners have guaranteed.  In addition, beneficial owners may be personally liable for certain taxes, such as payroll taxes withheld from the employees’ paychecks, sales taxes and meals taxes, if the beneficial owners have check writing authority.  There are circumstances where the business trust’s veil of limited liability may be “pierced” and the beneficial owners held liable for other obligations of the business trust.  Care should be taken by the beneficial owners, officers and trustees in the operation of the business trust to ensure that its limited liability veil will not be pierced.  Steps to be taken include (A) maintaining separate books, records and bank accounts for the business trust; (B) using the complete legal name of the business trust on everything that will be seen by those dealing in any way with the business trust, including its employees, creditors, suppliers, landlords, and customers; (C) when signing all documents on behalf of the business trust,  conspicuously noting the legal name of the business trust above your signature and beside or under your name the capacity in which your are signing, whether it be officer or trustee; and (D) when the business trust is dealing in any way with the beneficial owners, officers, or trustees, individually, or with an entity in which the beneficial owners, officers or trustees have an ownership interest, the terms of any such dealing should be arms-length and commercially reasonable.
    8. Formation in Other States.  Given the global nature of many businesses today as well as the transient nature of many business owners and executives, when forming a business trust, one may want to consider forming the business trust in other states such as Delaware or Nevada, for tax and other business reasons.  Delaware law and courts, for example, are considered possibly the most business friendly and knowledgeable, respectively, of all the states.  Consequently, a business trust and its assets may be afforded greater protection in Delaware than in other states for the reasons stated above and for other reasons as well.  While forming a business trust in one state and operating it in other states may result in additional complexity and costs (the entity will have to maintain its business trust status in the state of formation and will have to qualify to do business in all of the states in which it does business), the costs and additional complexity are often far outweighed by the additional benefits afforded to the business trust.

Chapter 5
Conclusion

With proper planning, the entity chosen will assist the business owners in accomplishing their short and long-term goals and objectives.  However, as the business grows and evolves and changes take place, such as when non-owner employees are first hired, when new locations are added, when an owner’s ownership interest changes for any reason, when separate lines of business are established, when the business first becomes profitable, when the tax and other laws governing the business change, the business owners must re-evaluate the entity chosen to determine whether that entity continues to meet their needs or whether another type of entity would then be more suitable.    

Appendix A
Characteristics of Business Entities

  Sole Proprietorship Partnership Corporation Business Trust & Limited Liability Company
C S
Cost to Form

low

moderate/high

high

high

high

Limited liability

no

 depends

yes

yes

yes

Multiple owners allowed no

yes

yes

yes (100)

yes

Able to perpetuate

no

moderate/ difficult

yes

yes

yes
Equity financing

no

yes

yes

yes

yes
IRS scrutiny

high

moderate

moderate

moderate moderate

 
Legal formalities:

 

 

 

 

            To form

low

moderate/ high

high

high

high

To operate

low

moderate/ high

high

high

moderate/ high
Tax benefits/burdens for owner/employees:

Health ins. ded.

yes

yes

yes

yes

yes

Grp. term ins.

no

yes

no

no

no

MER

no

yes

no

no

no
Retirement pl.

yes

yes

yes

yes

yes

Self emp. tax

yes

depends

no

no

depends
Double tax.

no

no

yes

no

no
Useful in Estate Planning

no

low

moderate

moderate

high

Appendix Links to Other Websites

IRS: www.irs.gov
Virginia Department of Taxation: www.tax.virginia.gov
Virginia State Corporation Commission: www.scc.virginia.gov
County of Albemarle, Virginia: www.albemarle.org
City of Charlottesville, Virginia: www.charlottesville.org
Delaware Secretary of State: www.secretary-of-state.org/Delaware.htm
Nevada Secretary of State: www.sos.state.nv.us/