Many clients call our office for immigration assistance and begin by telling us that they wants to do business in the United States. The most popular visa to reach this goal is the E2 Visa. An E-2 visa is a nonimmigrant visa available to an individual investor from a country that has a joint investment, or commerce and navigation treaty with the United States.
One of the first steps is to determine the best type of legal entity for immigrant investors’s conduct of business in the United States.
This post addresses the basic elements of the following five business entities: sole proprietorship, corporation (C corporation and S corporation), partnership (general and limited), limited liability partnership, and limited liability company. Each entity has its own advantages, disadvantages, and tax implications, and it will be important for you to understand the purposes and objectives of the proposed business prior to determining which type is most appropriate. Choosing the right legal entity can help to minimize the owner’s liability for obligations of the business.
A sole proprietorship is a business entity that is not otherwise incorporated or organized as a separate legal entity and therefore has no separate existence from its owner. It essentially refers to an individual doing business in his or her own name (or possibly under a different “assumed” name). A sole proprietorship may be the preferred manner in which to conduct business in the United States if the business owner does not anticipate complex financing or co-owners and wants to keep things simple in terms of business filing and compliance.
The principal advantage of a sole proprietorship is the ease involved in forming such a business. No documents are required to be filed with any government agency, although the sole proprietorship must meet other legal requirements for doing business, if any, such as licensing, permits, and insurance. If the sole proprietorship does business under a name different from that of its owner, a certificate must generally be filed with the state(s) in which the business is being conducted, so that the authorities and the public can determine who is “behind” the business.
The main disadvantage of a sole proprietorship is that the owner is personally liable for all acts of the company, including all debts and liabilities. Such personal liability is unlimited and can put the owner at substantial financial risk. For example, if an employee of a sole proprietorship negligently injures an individual, the sole proprietor can be held liable for all liabilities associated with the injury, and all her personal assets will generally be available to satisfy the claim.
A second disadvantage is the lack of anonymity. Everyone knows, or can readily find out, who owns the business. If anonymity of ownership is important to your client, particular care needs to be taken in determining what type of entity to use and where to establish it.
A sole proprietorship and its owner are treated as one. For example, taxable income earned by the business is deemed to be income of the owner, and expenses of the business are taken as deductions against the owner’s income and must be reported as such on the owner’s federal (and state, if applicable) income tax return. Sole proprietorships are taxed on all net income, which means it is not possible for the business to retain earnings without the owner being taxed on them. If the owner wants to use the income of the business to grow the company (for example, to reinvest the profits back into the business), a different type of legal entity, such as a corporation, should be considered.
CORPORATION (C CORPORATION AND S CORPORATION)
A corporation is a separate legal entity, existing independent of its shareholders, officers, and directors. It is created under and exists pursuant to authority granted by state law. Corporations do not need to be incorporated, or established, in the state where the owners live, but must be incorporated or authorized to do business in the state or states in which the business is conducted. It is very common, for example, for a corporation to be incorporated in the state of Delaware (which has favorable corporate laws) and then separately authorized to do business in another state, such as New York, where the corporation expects to actually engage in business.
One of the main advantages to choosing a corporation for operating a business is that it offers limited liability for its shareholders (i.e., owners). Assuming that the requirements for forming and operating a corporation are satisfied, the corporation’s shareholders will generally not be held personally responsible for the acts or obligations of the corporation solely because of their investment in the corporation. This personal liability protection can be lost, however, if the corporation is deemed to be the “alter ago” of its shareholders or a “mere corporate shell,” or if its set-up or operation are such that the principles regarding “piercing the corporate veil” can be applied. These legal concepts are beyond the scope of this article. However, you should make your clients aware that it is possible for the courts to determine that there is no real differentiation or separate existence between the corporation and the owner, resulting in the shareholder being responsible for all acts and obligations of the corporation if it is not operated properly. Clients should not assume that filing a certificate of incorporation and putting minimal capital into the entity will give them protection.
The terms “C corporation” and “S Corporation” are tax terms. A C corporation is one that is governed by subchapter C of the Internal Revenue Code.
Section 301 et seq. of the Internal Revenue Code of 1986, as amended.
A C corporation is taxed as a separate entity, apart from its owners. The corporation will have to file a corporate tax return and pay taxes on the income it receives. If any dividends are paid to the owners, the owners will have to report and pay taxes on the money received as dividends. Dividends are not deductible to the corporation. This is referred to as double taxation and could be deemed a disadvantage to the C corporation structure. Similarly, if the corporation has net losses, the shareholders do not get the benefit of deducting them on their personal returns.
An S corporation is governed by subchapter S of the Internal Revenue Code.
Section 1361 et seq. of the Internal Revenue Code of 1986, as amended.
It is one of several types of entities typically referred to as a “flow-through” entity. Such entities are not subject to double taxation at the federal level (there may be state tax exceptions, however). S corporations do not pay tax on income earned. Instead, the profits and losses of an S corporation “flow through” to, and are reported on, the shareholder’s income tax returns. This means, among other things, that the shareholder pays taxes on the entity’s taxable profits whether or not they are distributed. An S corporation is formed the same way a C corporation is formed, and it functions under the same structure; the S corporation election is a tax-driven mechanism and is elected by filing Form 2553 (Election by a Small Business Corporation) with the Internal Revenue Service.
In addition to making such an election in a timely manner, there are several requirements for qualifying under S corporation status. They include a limit on the number of shareholders (100 shareholders for tax years beginning after January 1, 2005, and 75 shareholders for tax years beginning prior to January 1, 2005); shareholders may only be U.S. citizens, legal permanent residents, and certain trusts and estates; and only one class of stock is permitted.
These requirements generally make the S corporation unavailable as an alternative for non-U.S. owners.
Of the entities discussed in this article, corporations are generally subject to the most detailed documentation requirements. For example, it is necessary to file a certificate of incorporation in the state of incorporation, to file documents to qualify the entity in other states where it has fixed operations or otherwise transacts business, to have a board and officers, and to comply with annual or other periodic filing requirements. The documentation requirements are routine. It is, however, important that they be complied with on establishment and going forward.
There are two types of partnerships, general and limited.
A general partnership exists when two or more business owners engage in business, even if they do not formalize the partnership relationship in any other manner, such as through a partnership agreement. While it is best to have a formal agreement governing the partnership relationship, it is not required under the law. The law regulating general partnerships in most states is the Uniform Partnership Act, which is a model law that individual states have adopted, often with some modification, resulting in some variation among the different states. The Uniform Partnership Act includes rules on a variety of subjects relevant to partnership and their owners. In many cases, these are default rules that the partners can modify by agreement.
A general partnership exists and functions as a legal entity separate from its partners. It can own or convey legal title to real property in, and can sue or be sued under, the name of the general partnership. The manner in which the general partnership’s profits and losses are allocated (e.g., equally or disproportionately) can and should be addressed in the partnership agreement. Absent such an agreement, the profits and losses are shared equally among all partners. Further, absent an agreement that states otherwise, as co-owners, each partner has an equal right to participate in the management of the business, regardless of actual ownership percentage.
A general partnership is relatively easy to establish. There may be a “name”-type filing in some states, but documentation and filing requirements are fewer than for a corporation. While a written partnership agreement is not mandatory, it is strongly recommended.
The main disadvantage to establishing a general partnership is that each partner has personal liability for all of the partnership debts. Each general partner is jointly and severally liable to third parties for the business obligations of the partnership, regardless of how the partnership agreement allocates losses. Each partner may likewise be held liable for commitments entered into, or, for example, tortious acts committed, by another partner in the course of the partnership’s operations.
With respect to taxation, partnerships are also “flow-through” entities. They are not subject to federal income tax on the income earned by the business, but the individual partners are considered to have earned the income attributable to the partnership. Individual partners therefore pay income tax on the profits attributable to them from the partnership as if such money was personal income (again, whether or not the income was distributed). If the partnership experiences a loss, the individual partners can claim such loss as a deduction on their federal income tax return equal to their respective ownership percentages.
A limited partnership is a specific type of partnership authorized by state laws. It is largely similar to a general partnership, but it also has one or more limited partners in addition to general partners. Generally, the day-to-day business of a limited partnership is managed by the general partners, who remain subject to personal liability for the debts of the partnership. The limited partners most often contribute capital to the business in exchange for a share of the profit, but are not subject to such personal liability. As long as a limited partner is acting in such capacity (note that the protection against personal liability afforded to a limited partner can be lost if the limited partner engages in management of the partnership), the limited partner’s liability is limited to the amount of money it invests (or agrees to invest) in the partnership.
Taxation of limited partnerships is the same as that for general partnerships, such that income earned by the partnership is attributed to the partners according to their individual ownership interests, and profits can be divided among the individual partners as the parties desire. The allocation provisions, which are often very complex, should be set forth in detail in the partnership agreement.
LIMITED LIABILITY PARTNERSHIP
A limited liability partnership has elements of both a partnership and a corporation. In a limited liability partnership, the Uniform Partnership Act (or comparable laws) provides limited liability for partners similar to that of shareholders in a corporation. Additionally, all of the partners of a limited liability partnership are able to participate in the daily management of the business. Limited liability partnerships are generally limited to professionals, such as lawyers, accountants, and architects. In some states, including New York and California, they can only be used for such professional practices.
The advantage to doing business as a limited liability partnership is that the structure provides limited liability protection to its partners (each partner is liable for his or her own conduct and afforded limited liability for the conduct of other partners) and there is no double taxation as with a corporation. The disadvantage is that few businesses may actually qualify for such a structure, particularly if more states restrict limited liability partnerships to professional businesses.
Taxation of limited liability partnerships is essentially the same as that for general and limited partnerships, such that income earned by the partnership is attributed to the partners according to their individual ownership interests, and profits can be allocated among the partners as they agree. A written agreement is again strongly recommended.
LIMITED LIABILITY COMPANY
A limited liability company is a legal entity offering the benefits of both a partnership and a corporation, such that pass-through tax treatment (like a partnership) and general limited liability protection (like a corporation) apply, unless otherwise determined by the owners. A limited liability company can be established by one or more owners, each of whom is called a “member.” Members may choose to manage the limited liability company individually or elect a manager or managers (more or less the equivalent of corporate officers) to operate the business on a daily basis.
A limited liability company is governed by an operating agreement or limited liability company agreement, which is an agreement among the members covering subjects such as the members rights and restrictions regarding the management and control of the company; limits on the transfer of membership interests; whose approval is required for various activities relating to the management of the company (such as veto rights, special voting requirements) and other governance matters; and how profits will be divided among the members. As with partnerships, it is preferable that a written operating agreement or limited liability company agreement be prepared and signed by all members, although state laws provide default provisions that apply in the absence of an agreement. Among other things, the process of preparing a written agreement will encourage the members to address various issues that they may not otherwise consider or want to consider, such as restrictions on transferability, possible sale of the business, and division of profits.
The main advantages associated with a limited liability company are that members and managers are not subject to personal liability for the company’s debts, obligations, or liabilities by virtue of being members or serving as managers, and limited liability companies are very flexible in structure. For example, an operating agreement can easily provide for sharing of profits that differs from the proportionate ownership interests (for example, 75/25 percent sharing of profits but 50/50 percent ownership). It is also possible to have multiple classes of members, with different preferences and shares.
As is the case with a corporation, care must be taken to ensure that the limited liability desired by the owners is obtained and maintained. While there is less legal authority in the area of limited liability companies, you and your client need to consider capital adequacy, operation of the company as a separate legal entity, and similar concepts.
With respect to taxation, limited liability companies enjoy the same flow-through tax treatment that partnerships and S corporations do, which means that even though a limited liability company must file a tax return, it does not pay taxes on its income. Instead, the members of the company report income and pay taxes owed on such income on their individual federal income tax returns. This taxation treatment avoids the double taxation associated with a corporation, but similar to a partnership and an S corporation, the limited liability company may not retain earnings without the members having to pay income taxes on such earnings.
The above information is general, and it is provided to give a basic understanding of the various legal entity choices for individuals or entities wanting to do business in the United States. Each alternative presents different factors in terms of convenience, risk, and other considerations. There are considerable resources available on the legal and practical considerations relevant to the selection of a legal entity. It is also important to involve a tax advisor in any planning.
For more info about the E2 visa and Business options in the US, feel free to email me at any time.
Once you have an understanding of the type of business in which the client expects to engage, the short-term and long-term goals of the business, and the relevant legal issues and applicable requirements, you will be in a better position to suggest a legal entity that will suit the needs of your client and protect the client’s ultimate objectives.