Published on April 5, 2021
by Paul Share
In previous posts, we discussed business types that exist without any filing (sole proprietorships and partnerships) and corporations, the first type of entity to exist under US law that provided investors “limited liability”—the ability to invest in an enterprise without exposing all of one’s assets to liabilities of the enterprise.
But, we noted, corporations have two negatives: the need to comply with corporate law and its formalities, and that corporations are subject to double taxation. In this post, we will briefly describe two entities that can be used as workarounds for at least some of these problems, depending on the circumstances–Sub-Chapter S Corporations and Limited Partnerships.
Sub Chapter S Corporations
Under Sub Chapter S of the Internal Revenue Code, corporations are allowed, at certain times, to file to be treated as Sub Chapter S Corporations. Subchapter S Corporations are treated as a pass-through entity, like partnerships and sole proprietorships.
This means that a corporation doesn’t pay taxes on its taxable income. Rather, the corporation’s taxable income is attributed to its stockholders, pro-rata, based on the number of shares each stockholder owns. The stockholders then each include their share of the corporation’s income in their return and pay taxes on their portion of the income, whether or not the corporation has distributed them. This avoids the double taxation issue. Although, as discussed in a previous post, this feature can be a negative where the business wishes to retain much of its income to reinvest in the business because it can result in stockholders paying tax on income that was never distributed by them.
But this solution does not work for all situations because of several key limitations. First, all shareholders of a Sub S Corporation must be a U.S. Citizen or resident. Secondly, with certain exceptions, shareholders of a Sub S corporation must be natural persons, leaving out many investment funds. And third, a Sub S Corporation may have only one class of shares which is also a problem for corporations looking for investment, since many investors want preferential rights, which corporations can accommodate only by creating and issuing to them a separate class of shares.
Limited Partnerships and Limited Liability Limited Partnerships.
A Limited Partnership is a partnership whose partnership agreement provides for one (or more) General Partners (GP) and one and usually more limited partners. The General Partner typically is given full management rights for the entity and has general liability for the Limited Partnership’s liabilities.
The limited partners, on the other hand, typically have no liability for the Partnerships debts, but few if any management rights. Indeed, prior to the 2001 amendment to the Uniform Limited Partnership Act (which only applies to the extent adopted by applicable state legislatures), the tax rules required limited partners to not have any management rights if they were to have limited liability.
In the US, this form of entity is often used for real estate ventures, film productions, other single project entities and investment funds.
The 2001 Amendment also provided for Limited Liability Limited Partnerships (“LLLPs”). In LLLPs only the partnership itself is typical liable for its debts– not the GP(s) or the limited partners. In both Limited Partnerships and LLLPs, a creditor can theoretically “piece the corporate veil” (as discussed in our post on corporations) to make a limited partner liable for the Limited Partnership’s or LLLPs debt. However since the governing document of Limited Partnerships and LLLPs (the Partnership Agreement) rarely provides for the amount of formality, that corporate laws typically impose, a creditor has a harder to find a basis to pierce the corporate veil.
In the US, this form of entity is often used for real estate ventures, film productions and other single project entities.
As mentioned in a prior post, our discussion of legal and tax matters are, by necessity, overviews of the law, to help you, the entrepreneur, in your discussions with your corporate counsel or tax advisor. They are not meant to substitute for consulting your attorney and/or tax advisor.
Thank you for reading this post: we hope you enjoyed it and got some useful information to help you on your entrepreneurial journey. If you have any questions or would like to continue the conversation with our firm, please call our office at (866) 954-7687 or email to firstname.lastname@example.org to schedule a free consultation regarding your business.
Paul Share began legal practice in 1973, specializing in corporate and securities law. He also has extensive experience in loan agreements, the formation, acquisition and sale of businesses, and the negotiating and drafting of a wide variety of contracts, including employment agreements, shareholder agreements, leasing agreements, and software development and licensing agreements and the representations of start-ups and high-tech companies.