The choice for the appropriate legal structure to transact business in the United States (“U.S.”) depends on a combination of factors relevant to a specific activity or sector, as well as on the needs and goals of the investor. The following paper is neither an attempt to define the criteria necessary to make such a decision nor, a fortiori, a substitute for the review of the particular project by an attorney. The aim of this article is to provide potential investors with a pragmatic overview of the American corporate legal and cultural environment, including the means and structures of venture creations.
Setting up successfully in the U.S. often largely depends on a good preparation. A minimum knowledge of the cultural environment is paramount. Experience demonstrates that the various services available in the originating country of the proposed investor, and in the U.S. prove to be very useful.
1. Cultural Environment of the U.S.
The U.S., renowned for its liberal environment, a long tradition of limited interventionism of the federal government, a free access to the market, limited and generally few restricting formalities, a tax burden lower than in most European countries, free repatriation of dividends and capital, is undoubtedly a favorable environment to foreign investments.
Investors must keep in mind the omnipresence of the law in U.S. business life. Furthermore, the involvement of different actors when setting up and managing a legal structure in the U.S., such as attorneys, accountants, tax counsels and bankers, is indispensible. Other actors such as insurance brokers, real estate agencies, recruiting firms, public relations and advertising agencies and other service providers are also commonly involved in the process.
2. Steps To Be Taken Prior To Setting-up in the U.S.
A potential investor in the U.S. should look into the resources of its country of origin, and in the U.S. to determine which organization, if any, could provide assistance in setting up the project. One potential avenue consists in tapping in the networks of international Chambers of Commerce.
3. Identifying and Evaluating Available U.S. Business Structures
The most common forms of legal structures available for a business in the U.S. are:
- the Corporation;
- the Limited Liability Company (“LLC”);
- the General Partnership requiring two or more legal or physical persons as owners, all of whom will be fully liable for the general partnership debts and liabilities;
- the Limited Partnership, consisting of one or more general partners with unlimited liability and one or more limited partners with liability limited to its respective capital contribution; however, the limited partner cannot actively participate in the management of the limited partnership’s business without becoming personally liable without limitation for the limited partnership’s debts and liabilities;
- the Branch. Deprived of the status of separate legal person, it carries the major disadvantage of not isolating the liability of the parent company, which, in case of difficulty, remains entirely liable. Furthermore, American tax authorities (the IRS) may, when collecting taxes from the branch, demand information regarding the foreign corporation in its entirety;
- the Sole Proprietorship, in which an individual personally owns and operates the business.
The choice usually comes down to two types of American legal entities, the Corporation, and the Limited Liability Company.
II. The Corporation
Its simplicity makes it the favorite structure for investors. Corporations are the most common structure for a business seeking to limit the liability of its shareholders for most of the debts and obligations of the entity. They are managed by a board of directors.
Corporations are generally easier and less expensive to form than other types of business entities.
1. The Choice of the State of Incorporation
The geographical location of the corporation is an important issue. A corporation is subject to the laws of the State of its incorporation, and laws vary from State to State. Further, the State of incorporation is not always the one where a company is doing business. A company incorporated in one State may carry out its activities in one or more States and must therefore register and obtain a certificate of doing business, or certificate of authority in each of these States.
Delaware has been, for almost a century, the favorite State of incorporation for businesses. More than half of the “Fortune 500 companies” and 43% of the corporations listed on the New York Stock Exchange are domiciled in Delaware owing to its legal and tax advantages which remain in effect even though these companies carry out their activities in other States.
- On the legal standpoint, Delaware corporate law statutes are very flexible. Companies, whether or not they carry out their activities in Delaware, benefit from an increased legal security as a result of the advanced stage of development of corporate law and case law, which are very attentive to companies’ needs.
- On the tax standpoint, there is no corporate income tax in Delaware, unlike in most States. Corporations are liable to pay only an annual Franchise Tax, which amount, generally low, is calculated in proportion to the authorized stock and the par value of the shares. Delaware authorities do not show any aggressiveness towards “P.O. Box” corporations. The situation quite differs in most other States, which derive a significant share of their income from corporate income tax. Indeed, a company is liable to pay taxes in every State where it conducts business, meaning that the expansion of a company in other States entails a loss for the State of incorporation.
A company incorporated in Delaware and doing business in other States will then have to obtain a certificate of doing business, and pay the appropriate corporate income tax in each of these States. In addition, the entity will be subject to federal income tax, and local taxes where applicable, such as the taxes due to the City of New York.
2.1 Certificate of Incorporation
Corporations are formed through the filing, with the appropriate corporate authorities of a State, of a document entitled Articles of Incorporation or Certificate of Incorporation (“Charter”), depending on the State. Such document includes, without limitation: (i) the corporate name, always to be followed by the word Corporation, Corp., Incorporated or Inc., (ii) the address of the corporation or of its registered agent, (iii) the corporate purpose, often drafted in broad terms so as to enable the corporation to carry out any activity which is not forbidden under the statutes of the State of incorporation, (iv) the number of authorized shares and the par value of the shares, if any, (v) the name(s) and addresse(s) of the incorporator(s), (vi) the duration of the corporation, which may often be perpetual.
One should keep in mind:
- Authorized Stock: In most States there is no minimum stock required. “Authorized stock” means the maximum number of shares, freely set by the incorporators, which the corporation is authorized to issue. The authorized shares are not necessarily issued and paid for in their entirety.
- Par value: The certificate of incorporation sets the par value of the authorized shares. Depending upon the corporation laws of each State, authorized shares may or may not have a par value. The scope of the distinction is not very meaningful: in most States including New York, the rights attached to the shares are identical whether they have a par value or not.
It is customary to give shares a low par value since the issuance price of the shares must be equal or greater than their par value. Generally, the issuance price is much greater (shares which par value is 10 cents may be issued for $10,000 or $50,000 each).
- Address of the Corporation and Registered Agent: Corporate service companies are used by practitioners to facilitate corporate formalities, including timely incorporations. Corporate service companies often act as registered agent for corporations, and thus provide addresses in States in which the entity may not have a physical office in that State. Corporations have the statutory obligation to designate a registered agent in their state of incorporation and in the State(s) in which they are authorized to transact business. As the official representative of a corporation, a registered agent receives and forwards documents and notices emanating from the corporate authorities (e.g. Annual Report, Franchise Tax Notice), and any notice or legal procedure involving the corporate entity.
2.2 Other Formalities of Incorporation
With the exception of the corporate charter which is filed with the office of the Secretary of State, the other documents related to the creation of the corporation remain internal to the corporation: they include the By-Laws and the minutes of the first meeting of, respectively, the board of directors and of shareholders.
The first meeting of the incorporators sets up the board of directors, which, in turn, appoints the officers and approves the subscription offers presented by the first.
3. Operation of the Corporation
- The Board of Directors: In many States, including New York and Delaware, there can be a sole director, who may also be a shareholder. Directors monitor the management of the corporation and owe it, mainly, a duty of care and a duty of loyalty.
- The Duty of Care: imposes on directors the obligation to act in the best interest of the corporation with that degree of diligence, care and skill that an ordinarily prudent businessman would exercise under similar circumstances. Directors therefore have the duty to remain reasonably informed about the business of the corporation. Further, a director who would (i) compete or have a conflict of interest with the corporation or (ii) usurp a corporate opportunity for himself would be in breach of his duty of loyalty.
- The Officers: They are appointed by the Board of Directors. Generally, there is a president, a vice-president, a treasurer, and a secretary. However, these different positions may be held by the same person, as it is the case in New York and Delaware. Officers are the agents of the corporation and are responsible for its daily management, in particular in dealings with third parties. They are also subject to the duty of loyalty and the duty of care.
- Directors and Officers Liability Insurance: Directors and officers liability insurance is not to be confused with professional liability insurance which does not apply to the duties of the executive team. Directors and officers liability insurance protects them from alleged or actual wrongdoings such as breach of duty, misstatements or omissions. The insurance does not, however, cover fines, penalties or financial damages. “D&O” insurance policies may however be very costly for small and medium size corporations.
4. Shareholder Agreements
Shareholder Agreements usually set forth certain basic information about the corporation’s affairs as well as the rights and obligations of shareholders to each other and to the corporation. The agreement is generally executed by the corporation and the shareholders.
Shareholder agreements can be particularly important in small, closely held corporations because the shareholders often desire to restrict each shareholder’s ability to sell their shares to third parties. Such agreements can also be used to provide protection to minority shareholders, and contain provisions relating to the management of the corporation. Such agreements should be closely tailored to the business of the corporation.
5. Dissolution; Transformation
5.1 The dissolution process might be outlined in the by-laws of the corporation. Typically, the shareholders will resolve to dissolve the corporate entity, and a certificate of dissolution is filled with the state. The process requires the filing of paperwork in the state of incorporation, and in each state in which the corporation is qualified to transact business. Also, a corporation must not have any outstanding tax liability in order for the dissolution process to be completed.
5.2 Conversion of corporations. Most states, including Delaware, provide conversion statutes for the statutory conversions of corporations into Limited Liability Companies (“LLC”). New York merger statutes however only allows for conversion-via-merger.
6. Disadvantages of the Corporation
- The first disadvantage of business corporations is dual taxation. The corporation pays income tax on its profits and shareholders are taxed on any dividends they are paid by the corporation. Shareholders cannot deduct any losses of the corporation on their personal returns. Many smaller corporations may qualify as Subchapter S corporations, allowing pass-through/partnership taxation to apply to the S-corporation. This election avoids federal and, often, state income tax at the entity level.
- The second disadvantage is seemingly strict operational formality requirements. For example, the corporation must meet certain statutory requirements before it can act on certain matters and it must hold a meeting of its shareholders every year. Corporate formalities, while seemingly burdensome, can provide a path to good governance that can be neglected when the formalities are not explicitly required.
III. The Limited Liability Company
A Limited Liability Company (“LLC”) unlike corporations, is not a corporate entity, i.e. it is not formed by filing a certificate of incorporation with a state governmental agency. The LLC is an unincorporated hybrid business organization which combines corporation-style limited liability with partnership-style flexibility. It is formed by filing articles of organization or certificate of formation with a state governmental agency. Its hybrid features make it one of the most popular forms of business venture for investors.
The LLC can be managed by all the members, like a general partnership, or by managers, like a limited partnership. The members are required to adopt an operating agreement, which sets forth, among other things, the rights and obligations of the members and how the company will be operated. The profits and losses of an LLC are distributed to its members according to the operating agreement. Typically, an LLC can conduct a broad range of lawful business activities, except a few types such as banks and insurance companies.
An LLC can be made up of one or more owners, referred to as members rather than shareholders, in a corporation, or partners, in a partnership. A member may be an individual, a corporation, a partnership, another LLC or any other legal entity. Most states do not set a limit on the number of members that can be part of an LLC.
Non U.S. citizens can also be members of an LLC.
2. Features of the LLC
2.1. Limited Liability of all Members
The liability of members is limited to their capital contribution, and LLC’s legal obligations do not typically put the LLC owners’ personal assets, such as a home or individual bank account, at risk. Thus, in the event the LLC goes bankrupt, its creditors cannot resort to the members’ personal assets for repayment of the LLC’s financial obligations.
However, members of an LLC, as it is the case with other business entities, may still be personally liable in some limited instances, such as when they personally guarantee a business debt or breach their duties to their LLC.
2.2. Pass-through Income Tax Treatment
Limited liability companies are “pass-through” entities for tax purposes, meaning the entity itself pays no tax. Members declare income and losses on their personal tax returns. An LLC can elect to be taxed like a corporation if desired.
2.2.1. Federal Income Tax
Although, as stated above, an LLC is treated as a legal entity separate from their individual members, LLCs are not necessarily treated as separate entities when it comes to tax.
The federal income tax treatment of an LLC depends on the election it makes and the number of its members. Typically, an LLC will be treated, by the federal tax administration (Internal Revenue Service “IRS”), as a partnership or a sole proprietorship (disregarded entity) for federal income tax purposes unless the LLC files a request with the IRS to be treated as a corporation.
This means that the LLC does not pay federal tax on business income by itself and does not file a tax return with the IRS. The Sole member of an LLC, must report all profits or losses of the LLC on his tax return. Members of co-owned LLCs each pay taxes on their share of the profits (“Distributive share”) or on their personal income tax returns.
An LLC that does not want to accept its default federal tax classification, or that wishes to change its classification, must use Form 8832, Entity Classification Election, to elect how it will be classified for federal tax purposes. Generally, an election specifying an LLC’s classification cannot take effect more than 75 days prior to the date the election is filed, nor can it take effect later than 12 months after the date the election is filed.
However, an LLC remains treated as a separate entity for purposes of employment tax, including self-employment tax, and certain excise taxes.
Most LLC individual owners, who work in or helps manage the business, are required to pay self-employment taxes, on their Distributive share. Owners who are not active in the LLC -- that is, those who have merely invested money but do not provide services or make management decisions for the LLC are generally exempted from paying self-employment taxes on their Distributive share.
2.2.2. State Taxes and Fees
Most states tax LLC profits the same way the IRS does, i.e. the LLC owners pay taxes to the state on their personal returns, while the LLC itself does not pay a state tax.
However, a few states, charge the LLC a tax based on the amount of income the LLC makes, in addition to the income tax its owners pay. Furthermore, some states impose an annual LLC fee that is not income-related.
• New York
An LLC that conducts business in New York City may be subject to the New York City unincorporated business tax and may be subject to an annual filing fee.
Although LLCs formed in the State of Delaware do not file an Annual Report, they are required to pay an annual tax in the amount of $300.00.
• Additional tax considerations for Non-citizens or US residents
Foreign nationals or entities looking to do business in the United States in the form of an LLC should have the following tax considerations in mind:
- If the LLC will not conduct any activity in the United States that will trigger US tax obligations, and none of its members is a US-resident, thus subject to US tax or reporting obligation, then the LLC will not be subject to income tax. However if the LLC will be conducting an activity which will trigger US tax obligations, the Distributive share of the non-US resident member will be subject to 30% withholding tax. Furthermore, a foreign-controlled LLC is also subject to a Branch Profits Tax.
- An LLC that has income derived from New York sources may be required to pay an estimated income tax on behalf of its members who are nonresident individuals or corporations.
- Non-US resident members will have obligations to file U.S. tax returns for the U.S. source income received. Failure to do the withholding makes both the LLC and the persons in the LLC who are responsible for the withholding personally liable for the tax that should have been withheld.
3. LLC Formation
3.1 Choice of Name and Filing of Articles of Organization
After members have chosen a name for the LLC, which must contain the words “Limited Liability Company” or the abbreviation “LLC” or “L.L.C.”, an organizer files the articles of organization or certificate of formation with the Department of State (NY) or the Secretary of State (DE). Any person or business entity may be an organizer. «But organizers need not be members of the LLC formed».
3.2 Operating Agreement
3.2.1. Members of an LLC may enter into an operating agreement to further define the relationship among members, between the members and the company, and with managers, if any. The operating agreement governs the rights and duties of a manager, the activities of the company and the conduct of those activities, and the means and conditions for amending the operating agreement. If the operating agreement is silent on these matters, applicable provisions of the limited liability statute of the applicable jurisdiction, if any, will control such relationships.
Regardless of whether a company has assented to the terms of the operating agreement, it is bound by and may enforce the operating agreement. A person that becomes a member of an LLC is deemed to assent to the operating agreement.
An operating agreement should address all operational, governance and inter-relational issues relevant to the company. Specific areas of focus include:
- Name of the LLC and identification of members and managers, if any;
- Nature and location of the business, and purpose, if desired;
- Intended term of the LLC;
- Characteristics of membership interests and, if more than one type, class or series, the distinctions among them;
- Capital contributions of each member as well as provisions for additional required or discretionary contributions;
- Rights to timing of, and methodology for distributions of profits (both ordinary earnings and liquidity event proceeds) and other property;
- Any special allocations and other tax treatment;
- Management structure, responsibilities, and voting rights among members or managers;
- Procedure for admission of new members;
- Procedure for appointing or electing and terminating managers;
- Procedure for and/or restrictions and limitations on transfers of membership interests;
- Procedure for withdrawal of a member or manager;
- Procedure for requiring a member to leave the LLC;
- Events triggering dissolution and process for winding up the business upon dissolution of the LLC;
- Procedure for amending the operating agreement;
- Indemnities and exculpation provisions.
The operating agreement remains an internal document of the LLC and is not filed with the state governmental agencies.
3.3 New York Requirement: Publication of LLC Formation
New York State requires a copy of the articles of organization or a notice related to the formation of most LLCs to be published in two newspapers for six consecutive weeks. The newspapers must be designated by the county clerk of the county in which the office of the LLC is located.
The newspapers charge a fee for the publication of the notice. The information in the published notice, including the name of the LLC, must match the New York Department of State’s records exactly as set forth in the initial articles of organization.
A Certificate of Publication, with the affidavits of publication of the newspapers annexed thereto, must be submitted to the Department of State, with a filing fee. Failure to publish and file the Certificate of Publication with the Department of State within 120 days will result in the suspension of the LLC’s authority to carry on, conduct or transact business. In practice, investors should keep in mind the existence of the publication costs in New York, whether upon the formation of an LLC or upon its domestication in New York when formed in another state.
There is no publication requirement in Delaware.
3.4 Delaware Requirement: Appointment of a Registered Agent
Delaware law requires that every business entity have and maintain a Registered Agent in the State of Delaware who may be either an individual resident or business entity that is authorized to do business in the State of Delaware. The registered agent must have a physical street address in Delaware. If the business is physically located in Delaware, then the business may act as its own registered agent.
New York does not require the appointment of a registered agent, whether the entity is a corporation or an LLC. However, for practical reasons, it is strongly advised to designate a registered agent in New York.
Certain states’ laws permit (a) LLCs to merge or consolidate with, or into another LLC (or other business entity form), (b) certain business entities to convert into LLCs, and (c) foreign LLCs to become domestic LLCs through the «domestication» process. The laws of the various jurisdictions differ significantly and the consultation with an attorney familiar with the laws relating to the type and original jurisdiction of each entity that is party to a reorganization transaction is well advised. Among the benefits of using a conversion or redomestication statute is that, depending on the laws of the applicable states, the resultant entity may be deemed a continuation of the original entity (and not be deemed to have engaged in a “transfer“ or “change of control“, each with potentially significant ramifications in terms of contractual restrictions on such activities). In addition, in many cases, effecting a conversion or redomestication may be logistically less cumbersome than effecting a merger.
The main disadvantage of the LLC is that the body of case law related to this entity is not as well-developed as that for corporations. Another disadvantage of the LLC, which varies from state to state, is the greater up-front, out-of-pocket organizational costs and requirements necessary for forming this business entity versus other types of legal entities.
The use of an LLC as an investment vehicle does not have a big disadvantage if its members are US-residents or citizens. However, if the LLC is owned exclusively by one or more non-US citizens or residents, or is also made of non-US citizens or residents members, the tax feature may be a major downside.
Lastly, if the LLC intends to do business in multiple states, changes in states law could also present some downside.
IV. General Considerations for Corporations and LLCs
1. Application for an Employer Identification Number (“EIN”) or an Individual Taxpayer Identification Number (“ITIN”) and Registration with State Tax Administration
Applications for EIN or ITIN are made directly through the IRS. Applications for an EIN are rather straightforward and can be done via mail, through the IRS website or over the phone. The last two ways are the fastest since the EIN is obtained in few minutes. Applications for an ITIN is done by filing and mailing form W-7 to the IRS, following the procedure on such form and mailing it to the address provided on the form.
2. Setting-up a Bank Account
Documents required to set up a bank account, may vary depending on the bank chosen. However, banks generally require an EIN or an ITIN and a copy of the articles of organization or the certificate of formation.
Furthermore, U.S. banks generally require that the individual who seeks to open the bank account on behalf of an entity be physically present in front of the bank employee to open an account. The individual must present himself with two identification documents, such as a passport and another national ID document.