KUTAK ROCK LLP
DATE: Updated November 9, 2010(Originally dated September 23, 2008)
RE: Choice of Entity Selection in Arizona
What are the advantages and disadvantages of selecting one entity form over another under Arizonalaw?
Setting Up Your Insurance Agency in Arizona
An insurance agent has many options when organizing an insurance agency business in Arizona. Possible business structures include: (i) sole proprietorship, (ii) general partnership, (iii) registered limited liability partnership, (iv) limited partnership, (v) limited liability company, (vi) regular “C” Corporation, and (vii) “S” Corporation. This article will briefly discuss the legal and practical aspects of each business structure and considerations that an insurance agent or agency owner should address when deciding which type of entity is best for its insurance agency.
II. Factors To Be Considered
When deciding which business structure would be best for an insurance agency, a prospective owner must consider two factors: (i) who will have liability for torts (i.e., professional negligence, deceptive trade practices, defamation, tortious interference with a contract, etc.) and contractual obligations of the business, and (ii) what are the income tax consequences of the entity selection.
Depending on the type of business entity chosen, an equity owner can be vicariously liable for the legal obligations of the business. However, not all possible business structures create an exposure to personal liability for the owner. This will be discussed in more detail below.
Regarding income taxes, different business structures create different tax results. Some entities may result in the taxation of the ultimate owner only, while other entities result in taxation at both the entity level and also with respect to distributions or dividends paid to the owners of the entity. This will also be discussed in more detail below.
Other factors, although less important, to consider when choosing a business structure are: (i) transferability of ownership interests, (ii) ease of management, (iii) formation costs, and (iv) limitations on the number and types of owners. As noted in Section IV below, the transfer of ownership within certain business structures may create additional tax consequences which should also be considered.
In order to best understand liability issues, certain legal principles need to be reviewed.
An owner of a business may be personally liable for debts and other liabilities of the business, depending upon the type of business structure chosen. A sole proprietorship essentially refers to a natural person (individual) doing business in his or her own name and in which there is only one owner. Therefore, the owner will be liable as a matter of law for all tort and contractual liabilities of the business. Any contracts entered into by the owner or by authorized employees of the business give rise to liabilities that can be satisfied, not only out of assets of the business, but also from the non-exempt assets of the owner of the business. The same is true with respect to tort liabilities (or statutory liabilities such as taxes) of the sole proprietorship.
Like sole proprietors, general partners are vicariously liable as a matter of law for the tort and contractual liabilities of their business. A general partnership, a default form of business organizations, is created when two or more people associate to carry on a business for profit as co-owners. Within the ordinary course of business, any contracts entered into and any torts committed by any of the partners or authorized employees give rise to creditor’s claims that may be satisfied, not only out of the property of the partnership, but also out of all of the non-exempt assets of each general partner. Like general partnerships, general partners of a limited liability partnership (“LLP”) or a limited partnership will be personally liable for the partnership’s contractual debts and tort liabilities.
Other business entities, however, do not create vicarious liability exposures for its owners. In a limited liability company (“LLC”), a corporation which has not made an IRS S-election (“C-Corporation”), and a corporation which has made an IRS S-election (“S-Corporation”), the owners are not vicariously liable for the contractual or tort liabilities of the entity. In limited partnerships and LLPs, limited partners are generally shielded from personal liability for the debts and obligations of the partnership if the limited partners do not participate in the control of the partnership. A limited partner may, however, remain personally liable for the partnership’s debts if he permits his name to be used in the name of the partnership in certain circumstances. Moreover, an owner will always be liable for torts which the owner personally commits while acting on behalf of the entity in which he owns an interest. For instance, if the owner negligently collides with another vehicle while driving on company business, the injured person can recover against the negligent owner/driver. In addition, entities are, by law, responsible for negligent acts committed by the entity’s agents within the course of the entity’s business. Therefore, any valid claim may also be recoverable against the entity.
Owners may also contractually assume or guarantee a debt of the entity; frequently, creditors require them to do so. In that case, the creditor can assert any unpaid claims against the owner’s non-exempt personal assets as a result of the owner’s contract with the creditor. The owner may not defend such a claim by asserting that the entity is primarily liable.
In conclusion, the use of certain business forms, such as sole proprietorships and general partnerships, automatically result in vicarious personal liability of the owners of the business. Exposure to personal liability, except that resulting from the owner’s own torts and contracts, may, however, be avoided or restricted to limited partners by choosing another business form, such as a limited partnership, LLP, LLC, C-Corporation or S-Corporation.
The main issue to focus upon when considering income taxation of a business entity is the possibility of “double taxation” of the entity’s revenues. Double-taxation refers to the possibility that revenue earned by the business may be taxed at the entity level and taxed again at the individual level when paid to the business’s owner(s) in the form of distributions or dividends.
Sole proprietorships, general partnerships, LLPs, limited partnerships, LLCs, and S-Corporations are generally not subject to taxation at the entity level. These business entities, except for sole proprietorships, file an information tax return with the IRS, and all income is taxed at the individual level in proportion to each owner’s distribution or interest in the business. With respect to a sole proprietorship, the income of the business is simply reported as the income of the owner/sole proprietor.
A C-Corporation presents the risk of double taxation. However, if a C-Corporation does not pay dividends, it can avoid “double taxation.” If a corporation pays out all or most of its net income to its officers without such payments constituting “excessive compensation” under IRS rules, all or most of the income of the business can be returned to the owners in the form of salaries. In such a case, no dividends are paid, and no second tax is paid on the dividends. However, inactive shareholders cannot be paid substantial salaries, and dividends are the primary way to get income to these shareholders. Consequently, dividends may be double-taxed, first at the business level when received as income, and second, at the individual level when paid to shareholders.
The double-taxation issue also arises in connection with the sale of an insurance agency. Often, buyers of insurance agencies prefer to buy the assets of the insurance agency, rather than the ownership interests in the entity (e.g., shares of stock, partnership interests or membership interests in an LLC). There are two reasons why this is the case. First, in the case of an asset purchase, the buyer generally does not take the assets subject to any of the seller’s liabilities (known or unknown) unless the buyer contractually assumes the obligation to pay such liabilities. Second, the buyer can generally take depreciation and amortization deductions against future earnings for all or most of the purchase price of assets (but not the purchase price of ownership interests).
For all business structures other than a C-Corporation, the sale of the company’s assets is not a detriment to the sellers because there is no double taxation of the gain resulting from the sale of assets. However, for a C-Corporation, the gain from the sale proceeds of the assets will be taxed to the C-Corporation and any distributions in excess of cost of the stock will also be taxed to the shareholder. As a result, disposition of any agency organized as a C-Corporation will generally result either in a discounted sales price (if the stock is sold) or additional taxes (if assets are sold).
V. Choosing a Business Entity Structure
When making the choice of a business structure, one must consider the advantages that certain entities provide and whether those advantages sufficiently justify their use. Because sole proprietorships and general partnerships offer no liability protection, these forms should only be used when there is no concern for personal liability, due to an absence of risk or the existence of adequate insurance.
If liability protection is not an issue, a single business owner may choose to form the insurance agency as a sole proprietorship. The form is simple and inexpensive; in Arizona, no filings with the Secretary of State are required, except registration of a trade name (if utilized). Regarding taxation, the sole proprietorship requires no additional paperwork (income is reported on the owner’s individual tax return), and there is no risk of “double taxation” of income. However, there are other alternatives for a single business owner. A single business owner may create a single member LLC. A single member LLC is disregarded for federal tax purposes (no separate federal tax return is required for the LLC), and the LLC insulates the owner from vicarious contract or tort liability.
If more than one natural person owns the business and has no concern about liability, a general partnership may be the best choice of entity. It also does not present any risk of double taxation. Income of a partnership is not taxed at the partnership level but is allocated to be taxed to the partners in proportion to their partnership interests. Any taxes due are paid by the partners.
If there is concern about liability, one entity to consider is a Limited Liability Partnership (“LLP”). LLPs provide protection from vicarious liability of limited partners, but not general partners, for torts committed by other partners or other representatives of the LLP. However, general partners, a partner who is directly involved in tortious conduct, or a partner who supervised the tortious person, may, depending upon the circumstance, be found to be liable. Unless they have contractually agreed to assume this liability, limited partners of an LLP are not liable for the debts of the LLP. Regarding federal taxation, the tax scheme is exactly the same as that of a general partnership. There is no risk of double taxation because income is allocated to the partners and not taxed at the LLP level. A Statement of Qualification, a $10 fee plus $3 per page, and an annual filing with the Secretary of State are required.
If an LLP is determined to be unsuitable, a C-Corporation, S-Corporation or LLC are other options. All three forms provide protection from vicarious liability to their owners. The tax implications, however, vary. A C-Corporation will be taxed at the entity level, and any dividends will be taxable to the shareholders. A C-Corporation should only be used if the owners are not concerned about double taxation, including taxation on gains resulting from the sale of the assets of the corporation. The acceptance of a C-Corporation as a financing vehicle may outweigh the double-taxation issues. Also, the owners may be sufficiently involved in the business to justify salaries being paid to such persons (which are not so great as to be “excess compensation”) in order to reduce net income of the corporation to a relatively small amount.
If a C-Corporation is determined to be undesirable, the choice lies between an S-Corporation and an LLC. Of those two, an LLC is probably preferable. While both avoid double taxation, there are no restrictions on the number or types of owners of an LLC. Also, there are fewer administrative requirements for an LLC; the LLC is formed upon filing of its Articles of Organization and payment of a $50 filing fee and publishing its Articles of Organization in a newspaper of general circulation in three consecutive publications. By contrast,S-Corporations cannot have certain types of shareholders (e.g., generally corporations and other entities are prohibited), can only have one class of stock, and cannot have more than 75 shareholders.
When deciding which business form should be used to create an insurance agency, one must consider the particular circumstances and concerns of the owner(s). The best choice will depend on an assessment of those factors and how the different elements of a particular business form would help mitigate the owners’ issues and concerns.
KUTAK ROKCK LLP
S. David Childers