1 BUSINESS ORGANIZATION: THE RIGHT STRUCTURE FOR THE RIGHT IDEA Presented by: Benjamin W. Bates Jonathan Stagg Stoel Rives LLP October 30, 2010

2 SUMMARY OF COMMON TYPES OF BUSINESS ORGANIZATIONS Organizations Formed under State Law. –Corporation –Limited Liability Company –Limited Partnership –Note: Each of these entities generally have the benefit of limited liability and are formed by filing a certificate with the applicable state.

3 SUMMARY OF COMMON TYPES OF BUSINESS ORGANIZATIONS (Continued) Organizations Created by Private Agreement or Action –Sole Proprietorship – merely a person with an assumed business name. –General Partnership – an agreement by two or more persons to act as partners on an ongoing basis. Action of each partner binds partnership. Withdrawal of partner causes termination. No partners can join without consent of all other partners.

4 SUMMARY OF COMMON TYPES OF BUSINESS ORGANIZATIONS (Continued) –Joint Venture – an agreement by two or more persons or entities to act as partners on a single project or series of projects; may or may not be governed by a written agreement. –Note: In modern business practice, there is rarely any reason to use any of these three forms of organizing a business, primarily because of the absence of limited liability.

5 FACTORS THAT INFLUENCE CHOICE OF BUSINESS FORM Tax consequences (e.g., certain entities, such as C corporations, are generally less tax efficient than other entities, such as limited liability companies) Limited liability Ease of organization

6 FACTORS THAT INFLUENCE CHOICE OF BUSINESS FORM (Continued) Practical concerns and future plans (e.g., despite tax consequences, entities seeking venture capital or seeking to go public often need to be C corporations

7 TAX CONSIDERATIONS USUALLY THE PRIMARY DRIVER C corporation; ordinary income or capital gain Net income$1, Entity-level tax 34%)$ Net cash available for distribution$ Shareholder tax 15%)$99.00 Net cash to equity investor$561.00

8 TAX CONSIDERATIONS USUALLY THE PRIMARY DRIVER (Continued) S corporation and partnership (including multiple member LLC); ordinary income Net income$1, Entity-level tax 0%)$0.00 Net cash available for distribution$1, Shareholder tax (ordinary 35%)$ Net cash to equity investor$650.00

9 TAX CONSIDERATIONS USUALLY THE PRIMARY DRIVER (Continued) S corporation and partnership (including multiple member LLC); capital gain Net income$1, Entity-level tax 0%)$0.00 Net cash available for distribution$1, Shareholder tax (capital 15%)$ Net cash to equity investor$850.00

10 C CORPORATIONS A corporation is automatically taxed as a C corporation, unless it makes an election to be taxed in accordance with subchapter S of the Internal Revenue Code. Advantages of C corporations –Ability to engage in tax-free reorganizations under the Internal Revenue Code. –Ability to easily structure favorable stock compensation, including the granting of stock options.

11 C CORPORATIONS (Continued) –If publicly traded (which is not easily permitted for other forms of organization), corporation can reinvest for growth and then shareholders can sell appreciated stock, on which they pay lower capital gains rates. –Venture capitalists, angel investors and individuals more accustomed to investing in C corporations. –In order to go public, a company almost always needs to be a C corporation.

12 C CORPORATIONS (Continued) Disadvantages of C corporations –DOUBLE TAXATION! Current distributions of operating income generally subject to double tax; first to corporation and then to shareholders as ordinary income dividends. –State statutes require adherence to certain corporate formalities, including annual shareholders’ meetings and boards of directors.

13 C CORPORATIONS (Continued) –For Utah corporation, cannot give control to single individual or entity (unlike LLC or LP) – must have board of directors of at least 3 persons (if at least 3 shareholders). Despite tax disadvantages, a company that expects a venture capital investment, a tax-free reorganization or a public offering in the near future should usually be formed as a C corporation.

14 S CORPORATIONS An S corporation is created when a corporation makes an election with the IRS to be taxed as a partnership under subchapter S of the Internal Revenue Code. –This election generally needs to be made within two months and 15 days from the beginning of the tax year.

15 S CORPORATIONS (Continued) Advantages of S corporations –SINGLE LAYER OF TAXATION! If subchapter S requirements are met, entity is disregarded for tax purposes and all losses and profits flow through to equity owners. –Dividends not subject to self-employment tax; salaries, however, are subject to employment taxes. IRS may recharacterize dividends payments as salary to collect employment taxes.

16 S CORPORATIONS (Continued) –Ability to engage in tax-free reorganizations under the Internal Revenue Code. –Ability to easily structure favorable stock compensation, including the granting of stock options. Disadvantages of S corporations –Because of restrictions applicable to S corporations, professional advice and monitoring needs to occur over the life of the entity.

17 S CORPORATIONS (Continued) –Shareholders limited to U.S. individuals, estates, certain trusts and certain charitable organizations (i.e., no corporations, partnerships, LLCs, retirement accounts, among others). –Cannot have more than 100 shareholders. –Cannot have more than one class of stock; rule prohibits not only formal stock (e.g., preferred) but also “instruments, obligations and arrangements” that are in essence a separate class of stock; voting and non-voting common OK.

18 S CORPORATIONS ( Continued ) –Practical need for shareholders agreement in order to prevent transfers that would endanger S Corporation status and to require payment of dividends to pay tax on pass- through income. –Losses limited to shareholder’s basis, which does not include entity-level debt to third parties. –No tax-free liquidation or distribution of appreciated property (which are available for LLCs and LPs). –Special employee rules for shareholders owning 2% or more of stock; generally treated as partners.

19 S CORPORATIONS (Continued) –State statutes require adherence to certain corporate formalities, including annual shareholders’ meetings and boards of directors. –For Utah corporation, cannot give control to single individual or entity (unlike LLC or LP) – must have board of directors of at least 3 persons (if at least 3 shareholders). –Must distribute at a significant percentage of profits, rather than accumulate for reinvestment, in order to permit members to pay taxes.

20 S CORPORATIONS (Continued) S corporations are most commonly used for closely-held businesses owned by a family or few partners. Because of the restrictions listed above, LLC is generally a better option.

21 LIMITED LIABILITY COMPANIES The limited liability company came into existence in response to a demand for an organization that affords its owners limited liability but is not subject to the double tax regime applicable to C corporations. –First LLC statute enacted in Wyoming in –In 1988, the IRS finally stated that properly organized LLCs would be taxed as partnerships, which quickly led to all states adopting LLC statutes.

22 LIMITED LIABILITY COMPANIES (Continued) LLCs have since become what many consider to be the preferred business choice for many businesses. Advantages of limited liability companies –SINGLE LAYER OF TAXATION! Entity is disregarded for tax purposes and all losses and profits flow through to equity owners, without S corporation limits on number of members, type of owner and classes of stock.

23 LIMITED LIABILITY COMPANIES (Continued) –In contrast to S corporations, most professional advice relating to structuring occurs at inception – less concern about loss of status. –No management formalities required by statute. –Distributions of property usually tax free. –No 80% control requirement to achieve tax free organization (in contrast to corporation). –Flexibility in structure of management. Possible management structures include control by single person or entity, control among partners, or control by board of directors.

24 LIMITED LIABILITY COMPANIES (Continued) –Flexibility in structure of allocation and distribution provisions compared to corporation. –Good vehicle for joint ventures. Disadvantages of limited liability companies –Relatively complicated operational tax provisions. –Creation of operating agreement can be complicated and expensive if structure is complex. –Self-employment taxes for certain controlling LLC members.

25 LIMITED LIABILITY COMPANIES (Continued) –No user-friendly counterpart to stock options (in corporations) for compensation of employees. –Must distribute a significant percentage of profits, rather than accumulate for reinvestment, in order to permit members to pay taxes.

26 LIMITED LIABILITY COMPANIES (Continued) Unless a venture capital investment, a tax-free reorganization or a public offering are reasonably foreseeable, a limited liability company is often the best choice of entity due to the favorable tax treatment and flexibility in management and structure.

27 LIMITED PARTNERSHIPS A limited partnership is a partnership organized under state law with one or more general partners, who have sole management control over the entity, and limited partners, who must not have management responsibilities to preserve limited liability.

28 LIMITED PARTNERSHIPS (Continued) Most commonly used for private equity funds or other investment partnerships because of historical prestige of form and desire to allocate profits to general and limited partners based upon formula rather than capital contribution.

29 LIMITED PARTNERSHIPS (Continued) Advantages of limited partnerships –SINGLE LAYER OF TAXATION! Entity is disregarded for tax purposes and all losses and profits flow through to equity owners, without S corporation limits on number of members, type of owner and classes of stock. –No management formalities required by statute. –Distributions of property usually tax free. –No 80% control requirement to achieve tax free organization (in contrast to corporation).

30 LIMITED PARTNERSHIPS (Continued) –Flexibility in structure of allocation and distribution provisions compared to corporation. Disadvantages of limited partnerships –Although limited partnership agreements are flexible (with essentially no statutory limitations), they are often very complicated because there are few statutory default rules. –Unlike LLCs, management may not be shared among partners (limited partners must be uninvolved).

31 LIMITED PARTNERSHIPS (Continued) –Relatively complicated operational tax provisions. –Self-employment taxes for general partner. –No user-friendly counterpart to stock options (in corporations) for compensation of employees. –Must distribute a significant percentage of profits, rather than accumulate for reinvestment, in order to permit limited partners to pay taxes.

32 LIMITED PARTNERSHIPS (Continued) Due to an increase comfort level with LLCs in recent years, the number of limited partnerships being formed has declined significantly. Limited partnerships are still used relatively frequently for investment funds, but typically LLCs can be used to accomplish the same objectives with less effort.