CHOOSING YOUR DELAWARE BUSINESS ENTITY
Some General Business Concerns
While there are always many areas of concern in selecting the proper form of entity, among the forefront are issues of management and control, personal liability, tax treatment, and regulatory compliance. It is the balancing of all such concerns that ultimately determines the best form of business entity for a given venture.
The owners’ desire to have centralized or decentralized management will greatly influence the decision as to the appropriate business structure. In general terms, centralized management means that the owners of the enterprise relinquish control over management to one or a group of persons. Where decentralized management exists, the owners of the enterprise retain management authority.
As a general rule, corporations and limited partnerships provide for centralized management through the board of directors of the corporation or the general partner of the limited partnership. By contrast, general partnerships typically have decentralized management, with all partners participating in management. Limited liability companies and statutory trusts may, depending on the terms of their organizational documents, provide for either centralized or decentralized management.
Depending on the business structure chosen, the owners of a business will have varying degrees of liability for the obligations of their business.
A corporation, limited partnership, limited liability company, or statutory trust generally provides limited liability. Thus, unless obligated through a separate agreement, such as a personal guarantee, a stockholder, limited partner, member, or beneficial owner has no personal liability for the debts and obligations of the entity.
By contrast, both a sole proprietor and a general partner of either a general or limited partnership has unlimited personal liability to third parties. A general partner may obtain some protection by causing the partnership to become a limited liability partnership (or a limited liability limited partnership in the case of a limited partnership). In such case, the general partner will be personally liable only for debts arising from the partner’s own negligence, wrongful acts or misconduct, and that of persons under the general partner’s direct supervision and control.
The tax treatment accorded to a form of entity almost always plays a critical role in deciding whether the form of entity is suited for a particular business venture.
Corporations are taxed as separate entities and pay their own corporate taxes, including income taxes. Profits distributed to stockholders by way of dividends are taxed a second time as income to the stockholder. Small business corporations often qualify for a special tax status, referred to as Subchapter S status. A Subchapter S corporation generally pays no income tax at the corporate level. Rather, all corporate income is attributed to and taxed to the stockholders, whether or not actually distributed to them.
By contrast, a sole proprietorship, because it is not a separate legal entity, is not taxed separately. All profits and losses are attributed to the owner and must be figured into the owner’s overall tax situation.
General partnerships, registered limited liability partnerships and limited partnerships are known as pass through entities for tax purposes. Rather than being taxed at the entity level, profits and losses are passed through to the partners and allocated to them in proportion to their ownership interests. As a consequence, partnership income is taxed as a part of a partner’s income at the tax rate applicable to the partner. In limited partnerships, the ability of a limited partner to deduct losses is usually restricted by special limitations on the deduction of losses.
A limited liability company may be taxed either as a corporation or a partnership, depending on its structure. Similarly, a statutory trust may be structured so that it is taxed either as a corporation, a partnership, or a trust.
Citizens of countries other than the United States are often concerned with the tax consequences of owning an entity such as a limited liability company. A Delaware LLC that (1) carries on no business in the U.S., (2) derives no income from any sources within the U.S. and (3) has not elected to be treated for tax purposes as a corporation does not need to file a U.S. tax return or a Delaware tax return.
Under the current IRS “check-the-box” rules, a Delaware LLC that does not affirmatively elect to be treated for tax purposes as a corporation will be treated for federal tax purposes as a partnership. It will be treated as a partnership for Delaware tax purposes as well.
Under current Treasury Regulations, a partnership that carries on no business in the U.S. and derives no income from any source within the U.S. does not need to file a tax return. Delaware law currently provides that a partnership need file a return only if it has income from sources within the State of Delaware.
If the LLC has only one member, then for federal tax purposes the LLC is disregarded, and the sole member is taxed as a sole proprietor. Current Treasury Regulations provide that a nonresident alien who is not engaged in a U.S. business and who does not derive any income from any source within the U.S. does not have to file a tax return. Similarly, Delaware law currently provides that a nonresident alien having no income from sources within the State of Delaware does not have to file a Delaware return.
By law, certain types of businesses, primarily banking and insurance, may be conducted only in corporate form subject to regulation by state or federal authorities. For many professionals, such as physicians or architects, the type of business entity may be restricted by statute or by professional rules of ethics.
No matter what form of business entity is chosen, some registration will be required, ranging from a fictitious name certificate for the sole proprietorship or general partnership to the appropriate filing with the Secretary of State to create a corporation, registered limited liability partnership, limited partnership, limited liability company, or statutory trust. All necessary business licenses must be obtained, as well as a federal tax identification number. Where multistate business will be conducted, the entity may have to qualify to do business in states other than the state in which the entity is organized. For a limited liability company or statutory trust, this may be a concern if it wishes to do business in a state that does not recognize the particular form of entity.
Most investments in a business involve the offer or sale of a security. Consequently, where more than one person invests in an enterprise, whether by way of a capital contribution or a loan, attention must be given to compliance with both federal and state laws and regulations governing the offer and sale of securities.