The following post comes from Wade Cribbs, a 2L at Scalia Law and a Research Assistant at CPIP.
By Wade Cribbs
Last week, Arlington Economic Development’s BizLaunch network co-hosted an online legal clinic event entitled “Mason Law Clinic @BizLaunch: Which Entity is Right for Your Startup?” with Antonin Scalia Law School’s Innovation Law Clinic, which is led by CPIP Executive Director Sean O’Connor. The virtual clinic addressed entrepreneurship and which business entities might best fit a business’s needs and attract investment. The panelists were Kenneth Silverberg, Senior Counsel at Nixon Peabody, and third-year Scalia Law students Mitch Gibson and Rebecka Haynes.
Mr. Gibson opened the discussion by describing the kinds of non-corporate pass-through business entities: sole proprietorships, partnerships, and limited liability companies (LLC). Sole proprietorships are operated by only one person, while partnerships can have as many participants as desired. Neither form of business entity requires registration with the State Corporation Commission; nevertheless, registering a business’s name or obtaining an employer identification number may be necessary. Similarly, partnership agreements are borderline necessary before beginning a partnership so that all parties agree on profit splits, decision making, and how much say each partner has in the venture.
An entrepreneur must register an LLC with the State Corporation Commission. An LLC is made of members and managers. A member of an LLC is anyone who owns a stake in the company—analogous to a shareholder—while a manager can be either a member or an outside person who handles the business decisions. Either members or a manager can run an LLC. To create an LLC, form LLC-1011 must be filed with the State Corporation Commission. If the business is for professional occupations—such as for doctors, lawyers, or architects—form LLC-1103 is needed.
Pass-through taxation is where the business itself is not taxed for the gains and losses. Pass-through taxation occurs at the ownership level, and its most significant advantage is that there is only a single level of taxation. Gains are taxed as the owners’ income and are taxed only once—instead of being taxed when made as profit by the business and then again when distributed to shareholders. Similarly, another advantage is pass-through losses. If the business loses money, the losses can be used to diminish other tax burdens. Liquidity, however, is a disadvantage of pass-through taxation. Liquidity occurs when the business has made a profit that remains within the business. When this happens, the owners are still taxed on the profits without receiving any of them. Another disadvantage is that there is a limit of $10,000 that can be deducted from state or local taxes per member or partner.
Ms. Haynes continued the discussion of pass-through taxation with how it applies to corporations. A corporation utilizes pass-through taxation by electing to be taxed as an S-Corporation, which is a corporation that chooses to be taxed under Subchapter S of the tax code. An S-Corporation is formed by incorporating in the desired state and submitting form 2553, “Election by a Small Business Corporation,” signed by all shareholders. For a business to be an S-Corporation, it must be a domestic corporation, have no more than 100 shareholders, and have only one class of stock. Furthermore, the kind of shareholder is limited to individuals, certain trusts, and estates. Certain financial institutions, insurance companies, and international sales corporations are ineligible to be S-Corporations. An S-Corporation is different from other tax-through businesses in that it allows for tax-free reorganization, provides stock options, and can easily convert to a C-Corporation.
A C-Corporation, on the other hand, is a corporation that does not elect to be taxed under Subchapter S of the tax code and by default is taxed under Subchapter C of the tax code. C-Corporations are closely or publicly held. A closely held corporation has a limited number of shareholders, whereas a publicly held corporation has a large number of shareholders with shares on the market. Some states allow for closely held C-Corporations to dispense with some of the formalities of operating a corporation. C-Corporations are taxed separately from their owners at a flat 21% tax rate. Any further profits distributed to shareholders are then taxed again, resulting in an effective tax rate of 41% on the distributions. The exception to this is that qualified small business stock that has been held for more than five years after its issuance is eligible for 100% exclusion from gain on disposition, not to exceed $10 million for any one shareholder. For a stock to be a qualified small business stock, there are three requirements: it must be issued by a C-Corporation at original issuance; the corporation must be engaged in active business that is not a service business; and the business’s gross assets cannot exceed $50 million. A C-Corporation’s benefits are that it can issue more than one class of stock and have unlimited deduction of state and local taxes.
Prof. Silverberg addressed how the various tax and business structures apply to someone who wants to start, run, and sell a business. Prof. Silverberg did this by examining the sale of a hypothetical landscaping business. Through this hypothetical example, Prof. Silverberg looked at what motivates a purchaser to buy a business and how this affects the taxation of the transaction. The buyer and seller have to agree on the purchase price and how that price is allocated to different assets. Prof. Silverberg then discussed the amount pocketed by the entrepreneur after selling the business under pass-through taxation; he also discussed the sales structure under the different possible business structures and compared it to taxation under a C-Corporation. Looking at the numbers, Prof. Silverberg highlighted the tension between the seller’s desire to sell the business as stock under a C-Corporation and the buyer’s desire to buy assets under a sole proprietorship or the like.