Choice of Entity Basics and Other Suggestions for Your New U.S. Business

Whether one owns a seasoned U.S. business or a foreign business seeking to do business in the United States for the first time, often there is confusion regarding the types of available corporate entities and which is the best fit for your particular new enterprise. Often, U.S. persons select a limited liability company (LLC) and foreign persons select a corporation without considering the other options or understanding why. This article identifies seven of the most typical U.S. entities, including the LLC and the corporation, and provides some explanation about each. It spends a bit more time comparing the LLC and the corporation. As an aid to foreign entities that may be unfamiliar with the U.S. system, it provides additional recommendations on issues to consider as one enters the U.S. market.

Often the preferred form of entity is based on your organization's particular goals and how your anticipated revenue may be maximized by legitimate tax planning strategies.

1. Proprietorship. This is owned by a single individual. There are no formalities or "corporate governance" issues. Income is reported on Schedule C of the Form 1040—the U.S. Internal Revenue Service (IRS) tax form—and there is no "entity" filing. The major—and significant—drawback is that the proprietor is personally liable for contracts and torts (i.e., harms) of the business.
2. Partnership. This is owned by two or more persons who own a business conducted for profit. Formalities may be required, depending upon the form of the partnership. Partnerships file a copy of Schedule K-1 (Form 1065) with the IRS to report a partner's share of the partnership's income, deductions, credits, etc. Generally, partnerships do not pay tax at the entity level. The exception is if the partnership makes a "check-the-box" election to be treated as a C corporation for tax purposes (#7, below). Unless otherwise agreed, typically all partners are equal owners and have an equal voice in management, and ordinary matters are decided by majority vote. Also, unless otherwise agreed, acts outside the ordinary course of business require a unanimous vote. As in a proprietorship, no formalities are required, although a partnership agreement is recommended. Also as in a proprietorship, the major drawback is that all partners are liable for the contracts and torts of the business. Examples include some smaller professional firms (lawyers, accountants, medical professionals) and smaller businesses (retail, restaurants, etc.).
3. Limited Partnership (LP). This involves one or more general partners who manage the business and have unlimited liability, and one or more limited partners who have no voice in management but enjoy limited liability. Generally, the limited partnership must file a certificate of limited partnership with the state, and each state has different requirements for drafting and filing. General partners are liable for contracts and torts of the business, but limited partners are not liable. The structure may encourage investment into more risky ventures where the management team is experienced and is perceived to have "skin in the game," given the unlimited personal liability. Examples include hedge funds, some real estate deals (hotels, office buildings, shopping centers), tax minimization vehicles (movie or record deals, some oil and gas), and family offices (when used as an estate planning tool).
4. Limited Liability Partnership (LLP). This is a general partnership (#2, above) that has elected limited liability status for its partners. Often this requires a simple filing with the state. An LLP structure protects the partners against personal liability arising from contracts or torts made after the date of filing. Examples include national accounting firms, large law firms (like Venable), and other professional firms.
5. Limited Liability Limited Partnership (LLLP). This is a limited partnership (#3, above) that has elected limited liability status for its general partners. It is not available in all states, but, where permitted, generally this requires a simple filing with the state. Like the LLP (#4, above), the structure protects partners against personal liability arising from contracts made after the date of filing. Examples include existing limited partnerships that desire to protect the general partners from personal liability (for liabilities incurred following the date of conversion) and a family LP.
6. Limited Liability Company (LLC). This is not a "partnership," but, like partnerships, typically LLCs pass through the income to the member and do not pay tax at the entity level. LLCs are the response of states to the rigidity of the U.S. Internal Revenue Code regarding the taxation of corporations. The structure allows owners and investors to enjoy limited liability without the complexities of a corporate taxation structure. Generally, the entity is organized by filing articles of organization or similar with the state. Unlike the corporation (#7, below), which has comprehensive rules codified in statutes regarding corporate governance, generally LLCs create their own management scheme, although the governing statutes do provide certain default rules. The primary tool for doing so is the operating agreement. Owners of the LLC are referred to as members rather than stockholders, as in the corporation context. Often LLCs are governed by managers. The members may serve as managers directly (a "member-managed" LLC) or appoint others to serve as the managers (a "manager-managed" LCC). The default rule is that action may be taken if authorized by those members holding a majority of the LLC's interests in profits.
7. Corporation. This is what one may think of as the traditional corporate form. The owners of a regular corporation are stockholders. The stockholders elect the board of directors, which manages, or oversees the management of, the business and affairs of the entity. The board of directors, in turn, appoints the officers to manage the day-to-day operations of the entity. The general principle is that decisions are made by the board of directors as the elected representatives of the stockholders. The exception is for certain extraordinary acts that require a vote of the stockholders, such as for a merger, a sale of assets, or an amendment of the charter. In contrast to a regular corporation, a "close corporation" may elect to have no board of directors, and typically certain extraordinary acts require the unanimous or two-thirds vote of all stockholders. In terms of taxation, the corporation may elect to be treated as an "S corporation," which protects the corporation from being taxed at the entity level and, like an LLC or partnership, permits the income to pass through to the stockholder for tax reporting. An S corporation, however, is subject to certain restrictions. For example, the entity must have 100 or fewer stockholders, all stockholders generally must be individuals or certain trusts (and not corporate entities), and there may be only one class of stock. Importantly for foreigners, the structure does not permit non-U.S. ownership. By contrast, a "C corporation"—like the LLC (#6, above)—has no limit on the number of stockholders, no limit on the classes of stock, and no limit on the types of stockholders. But, unlike the LLC, the entity is subject to double taxation, meaning that income is taxed at the corporate level at the then-prevailing corporate tax rate and again when dividends (payments) are issued to the stockholders.

Comparing LLCs and Corporations

For a simple comparison of the LLC and corporation options—and the potential adverse impact of double taxation in the C corporation structure—consider that the assets of an entity held for some period of time are acquired for a purchase price of $10 million. Assume also that corporate tax rates are 40% (35% federal and 5% state) and capital gains/dividend tax rates are 30% (20% federal and 10% state). (These estimates may be wildly off current rates but are used here for illustrative purposes only.) Consider the following:

On a hypothetical $10M sale, the LLC structure nets $2.8M more than if the assets are sold by a C corporation. Here's why: On the $10M gross sale, after a corporate tax of $4M, $6M is available to the corporation. Upon a distribution of those proceeds to the beneficial owners, the stockholders, the $6M in proceeds is subject to a second tax of $1.8M, which leaves only $4.2M for the stockholders. For an LLC, by contrast, there is no corporate tax, so the full $10M proceeds are passed directly to the beneficial owners—the members. After the capital gains tax of $3M, the members net $7M.

So if an LLC and a corporation both permit significant flexibility in terms of classes of ownership, given the tax disparities, why would anyone elect a corporation over an LLC?

• First, LLCs are relatively new corporate constructs that have taken hold only in the last 30 or so years. It is possible the entity was formed as a corporation before LLCs were an option or used widely. Converting from a legacy corporation to an LLC incurs taxable income that often is cost-prohibitive, absent a freeze transaction or other corporate solution.
• Second, despite double taxation, the corporation's overall tax rate may be (or was at the time of entity selection) lower than one's personal tax rate, which is where an LLC's income is reported.
• Finally, and perhaps most importantly for non-U.S. taxpayers, the corporation is its own corporate entity and is responsible for paying U.S. taxes. So the corporation acts as a blocker between a non-U.S. taxpayer and the IRS. The LLC requires a foreigner who does not otherwise pay U.S. taxes to do so, which necessitates filing for an individual tax identification number (ITIN). While the foreigner pays taxes only on its U.S. income, many non-U.S. entities unfamiliar with the U.S. approach to taxing global revenue prefer to keep their overall business revenue free from the prying eyes of the IRS. (Note, however, that if an LLC elects to be taxed as a corporation for federal income tax purposes, while the corporate governance differences between the entities are unaffected, for federal income tax purposes the LLC is treated as a corporation and may also act as a blocker.)

What Else to Consider When Establishing a Presence in the United States

Although it is by no means an exhaustive list, besides carefully weighing tax considerations, here some additional issues to consider by subject matter when establishing a commercial presence in the United States.

• Corporate. In addition to the type of entity, consider what standard contracts you may need—non-disclosure agreements, distribution agreements, etc.—and assess whether there is a related-party transaction between your new entity and an affiliated entity. If so, know that transfer pricing rules apply in the United States without a de minimis threshold. This means that such transactions require certain contemporaneous documentation, such as an intercompany services agreement whereby entity A remunerates entity B and pays an arm's-length fee. The risk of not so documenting is that the IRS may challenge and ultimately adjust the amount paid to a U.S. service provider, which may result in additional U.S. taxes and penalties.
• Regulatory. What U.S. regulatory issues may apply to your business? For example, if you are selling a product, would you benefit from a label and claim substantiation or advertising review? If importing, what is the product classification and the country of origin, and how does this impact applicable tariffs? If your business is international, best practice is also to implement standard compliance policies, such as sanctions, anti-bribery, and export control policies.
• Employment and Benefits. If you plan to have a U.S.-based workforce, you should consider standard employment contracts and obtain general employment compliance advice. Similarly, a benefits policy that includes direct-deposit payroll and 401(k) (employee retirement) services options is standard. There are third-party firms to which you may outsource such functions, although if you plan to have more than 20 employees it makes sense to draft an employee handbook.
• Privacy Policy and Online Marketing. With significant new attention to data privacy and other issues, it is industry best practice to implement a privacy policy, although if sales are expected to be below a certain threshold or are solely in the business-to-business context without collecting personal data, this may be an area to address in future. For those anticipating direct business-to-consumer sales or an online presence that collects any consumer-related data, seek guidance on material elements for a privacy policy that is also compliant with the California Consumer Privacy Act (CCPA) and craft protections against class actions, to the extent possible.
• Intellectual Property. Review whether you should protect your intellectual property in the United States and, if so, the best way to do so. If you are creating innovative products, explore U.S. patent protection. If brand protection is a key concern, a robust trademark strategy is an important consideration. If you have trade secrets, implement confidentiality controls to protect your IP asset. And, to the extent your new U.S. entity will be using the IP rights of your existing entities, implement a patent, trademark, or trade secret licensing agreement between the two.

* * * * *

The author wishes to thank Patsy McGowan, Chris Davidson, and Dan Straga for reviewing drafts of this article.