WHY PARTNERSHIPS ARE BETTER THAN CORPORATIONS: PART 1 THE TALE OF TWO TAXES

Welcome to my soapbox. I am a lawyer who has spent a good amount of time converting successful closely-held businesses out of “C” corporation solutions and into partnerships, usually because the owners woke up one day and realized they’ll be staring at a huge tax bill when they sell their business. My advice on this topic to every entrepreneur is: “Understand your choice of entity.”

And to the one-stop-shop start-up lawyers out there: please stop telling every start-up that walks through your door that they must be organized as a corporation before VCs will even begin to look at them. That’s just crazy talk, and you are doing your client a huge disservice by setting them up to pay a big bill to the tax man when they sell their enterprise.

For those readers starting from square one, here’s a quick and dirty course in what lawyers like to refer to as “choice of entity” decisions.  The three mainstream entity choices for organizing a business are (1) limited liability companies (“LLCs), (2) corporations (“Corp.” or “Inc.”), and (3) limited partnerships, (“LP” or “Ltd.”).  These classifications refer only to the state law classification of the entity, i.e., how does the state in which the entity was organized recognize the entity?

The second part of entity classification is the tax classification.  This choice (made by filing a piece of paper with the IRS) determines how the entity will be taxed for federal tax purposes.  Here is the basic breakdown on tax classification:

  1. LLC: a single member LLC is a “disregarded entity” by default, meaning it does not file separately from its owner, and is a sole proprietorship for tax purposes (reports profits/losses on the owner’s Form 1040).  An LLC with two or more members is a federal tax partnership (it files Form 1065) by default.  Any LLC may elect to be taxed as a “C” corporation (files Form 1120) or an “S” corporation (assuming certain other requirements are met) (files Form 1120S). By the way, the “C” and the “S” refer to the subchapter of the Internal Revenue Code that governs these entities (subchapter C, subchapter S, respectively).

 

  1. Corporation: a corporation, regardless of the number of shareholders, is by default a “C” corporation, and may elect, under certain circumstances, to be taxed as an “S” corporation.

 

  1. Partnership: whether a limited partnership or a general partnership, a partnership is by default a federal tax partnership, although it may elect to be taxed as a “C” or “S” corporation.

The major difference between being taxed as a partnership or a corporation comes down to a single versus double layer of tax.  Partnerships (in the tax sense) and “S” corporations themselves do not pay tax—profits and losses flow through to the partners and are reported on their individual tax returns.  “C” corporations, on the other hand, pay an entity-level tax on the corporation’s profits at rates up to roughly 35%, and then any money distributed to the shareholders is taxed at dividend rates of 15%.

On to the discussion on start-ups…

I have seen countless business owners walk through our doors wanting out of their corporation. The story goes something like this:

“I started out as a “C” corporation because I was told that was the only way I could get VC/institutional/angel financing. I never got outside financing because [insert reason here: the economy tanked/it was too expensive/I decided to bootstrap and keep my company/the company didn’t have the right profile]. I recently had an offer from someone to purchase the assets of my business for $15 million, but I realize I’ll have a corporate-level tax bill of about $5 million (!!!) in addition to the $1.5 million I’ll pay when I distribute the cash proceeds to myself as a dividend. What can I do??”

Sorry, but you’re SOL.

What I’ve never seen:

“I’m so happy my lawyer organized my start-up as a c-corporation! Even though we never got outside financing and are about to sell our business and pay tax twice on the sale proceeds, it sure was worth it to be in that “C” corporation just so we could sit at the table with some guys from that VC firm before they passed on us! They sure were swell!”

I agree whole-heartedly that many VCs and other “professional” investor-types will not invest in a company unless it is a “C” corporation– and a Delaware corporation at that (although I love an investor who is willing to take the plunge with a partnership!). Many require that the entity be organized as a true corporation, not just as an LLC electing “C” corporation status. This is driven both by tax issues (some investors don’t like the pass-through taxation element) and state law issues (Delaware has a robust corporate law and an entire court devoted to business litigation). However, not every startup that comes through the doors of a “start-up” lawyer’s firm will make it to a successful fundraising round with investors who care about these issues. Those that don’t may still go on to build a valuable business. Those are the ones who should keep their lawyers up at night, because when they go to sell their business (and those sales are typically asset sales, not stock sales), they’ll watch 35% of their profits on the sale disappear into the hands of Uncle Sam, and then, when they extract the remaining cash from the sale from the corporation as a dividend, that same cash will be taxed again at 15%…and that assumes that dividend rates don’t revert to ordinary income rates in 2013!

If the same business had elected partnership taxation, they would only pay tax on the gain from the sale at their individual income tax rates—which include capital gains rates to the extent the entity was selling capital assets. That’s most likely a savings of a couple million dollars over the “C” corporation scenario.

My beef with the whole start-up process is that entrepreneurs are often poorly advised with regard to choice of entity.  I’m not advocating that the “tax tail” should wag the dog, but it’s worthy of a conversation and a run-down of the pros and cons.

The error in advising a client to be in a corporation from the start lies in the fact that a conversion from partnership (I’m referring to a tax partnership here, so it could be an LLC taxed as a partnership) to corporation is easy and usually tax-free. It can be done on the eve of receiving financing, and should only be done when that financing is a certainty. To go the other way, however, is expensive from a tax perspective. A conversion from a corporation to a partnership is a deemed sale of the corporation’s assets to the partnership, so all of the built-in gain inside the corporation is taxed immediately upon the conversion. To add insult to tax-injury, there was no actual sale, so there’s no cash with which to pay the tax!

There is a way to get out of a “C” corporation without triggering a hefty tax bill, but it is complicated and expensive and you’ll end up paying someone like me a lot of money to do it.

The moral of this story: organizing as a corporation should not be the default route for every start-up.  Just because everybody else is doing it doesn’t mean it is right…isn’t that what our mothers taught us?  Press your lawyer to walk you through the choice of entity decision tree, and work with him or her to make an informed decision on how your start-up should be organized and taxed.

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