Difficult to raise capital without bringing in new partners
Requires 2 or more partners
Any partner can commit the others
Death of partner dissolves partnership
Partnership tax treatment
Limited Partnership
Limited liability for limited partners
Ability to attract passive investors by making new limited partners
Requires 2 or more partners
Requires general partner responsible for all obligations
Limited partners cannot actively participate in management
Adding new partners may require consent
Not attractive for institutional investors
No stock to use for options
Death of partner may affect continuity depending on partnership agreement
Partnership tax treatment
Income to limited partners not subject to self-employment tax
Limited Liability Companied
Flexible structure
Can have different classes of stock, different rights and allocations
Owners can be persons, corporations or other LLCs
Conversion to corporation easy
Familiar structure for foreign investors (GmbH,SARL)
Body of law not well developed
No stock to use for options
Not attractive structure for institutional investors
Many states require 2 members (not DE or NY)
Death of member may affect continuity
Exhibit 3.1 Selection of Entity-Summary
(continued)
ADVANTAGES
DISADVANTAGES
Partnership tax treatment
Can convert to C corporation without adverse tax affects
All income may be subject to self-employment tax
Subchapter S
Security of corporate structure
Can have only 75 shareholders
Corporation
Well defined law on corporations
Can have only 1 class of stock
Death of shareholder does not affect continuity of company
Qualified tax exempt entities can be shareholders
Can have corporations and LLCs as subsidiaries
No foreign investors
Only for qualified small business corporations
Not suitable for institutional investors
Limited employee benefits to large shareholders
Partnership tax treatment
Only salary (not profits) subject
to self-employment tax
Conversion to LLC requires liquidation and adverse tax effects
Issues on conversion to C corporation
Limited flexibility on allocations of income, leases, credits, and deductions
Subchapter C Corporation
Limited liability for shareholders
Maximum flexibility on classes of shares,liquidation preferences, voting rights
Preferred investment choice for institutional investors
Suitable for initial public offering
Stocks options available
No limit on number or type of shareholders
Well-defined law on corporations
More formalities-Board meetings, shareholder meetings, voting issues, etc.
Most favorable structure for employee benefit plans
Double taxation on dividends (but rate reduced to 15%)
Limits on how much of earnings can be retained in closely held companies
Limits on level of salary to avoid dividends of closely held companies
No pass through of net operating losses to personal return
Exhibit 3.1 Continued
often limited to the value of not more than one-third (collectively) of all gains, but actual numbers can vary. The one-third share represents an equal distribution of increased profitability or sales with the other two-thirds being distributed equally-as profit to existing shareholders and as reinvestment in the firm. Shares to family members can also pass from one generation to the next in family firms, depending on stock restrictions. In family firms, before any shares are transferred, the impact of such distribution on nonfamily members should be assessed.
Stock purchased, whether from founders stock, shares of other large shareholders, treasury stock, or stock from departed employees, is sold as it becomes available. Pricing is based on the share valuation in place at the time of sale. Stock purchases may be cash transactions, or they may be financed over a period of years.
The Succession Leader
In some instances, particularly during a succession process, an interim or bridge CEO or managing director may be engaged. This executives contract will almost certainly involve either a share-based reward for overseeing a successful transition or some form of shadow equity (contractually promised sharing in either a change in control or in the establishment of a new ownership/leadership team) scheme. Most firms and CEOs favor some small stock holding coupled with shadow equity. The benefit of this preferred approach is that capital gains taxes are not due on shadow equity until received (at some future point when the change occurs), as opposed to an equity position that is taxed as received. Vesting in a shadow equity plan does not constitute constructive receipt for IRS purposes.
Whether to pay dividends is a C-Corp issue. Many owners consider that the appreciation in a C-Corp firms shares, as demonstrated by the annual valuation update, constitutes fair consideration. Any profits that cant otherwise be legally expensed are typically given to shareholders as bonus dollars. In the S-Corp and LLC forms, profits pass through to the individual shareholder. For those who take the appreciation route, it should be remembered that the shareholders have invested in the companys success. Their shares are the representation of that investment. A fair return should be expected on that investment. The firm should also be careful not to adopt a practice of declaring bonuses that too closely coincide with the salary or shareholder equity percentages of the major shareholders. The IRS sometimes determines that bonus programs that track key executive salaries and stockholdings too closely are really undisclosed dividends. For a quick rule of thumb on industry averages, firm leaders should consider asking their banker for information on their type of firm from their industry research teams. Other benchmarking information
