To navigate the shoals of the business side of the film industry, you must have a basic understanding of the different types of legal entities. Almost every transaction involves a choice from the smorgasbord of entities, so it is important to know the basic business, legal, and tax distinctions between them.
Sole Proprietorship. A sole proprietorship is a legal nothing; it is merely an individual operating under a fictitious business name. These are often referred to as DBAs because the person is doing business as so-and-so. The good news is that they are cheap and easy to create. The bad news is that because a sole proprietorship is not treated as a separate entity, it gives you no protection from liabilities. They are perfect entities to use if you are acting alone (they can only be owned by one individual) and if you would be responsible for all the liabilities anyway.
General Partnership. A general partnership is deemed to be formed whenever two or more persons combine in a business enterprise to share profits and losses. It does not require any type of filing, and it is not possible to disclaim partnership status by contract (notwithstanding that almost every contract purports to do so). The broad definition of general partnership includes within it the ubiquitous “joint venture” and “co-production”—the names people often give to a film transaction when they do not know what else to call it.
In a general partnership, each partner can contractually bind the partnership vis-à-vis third parties, and each of the partners is personally liable for all the debts of the partnership. For these reasons, it is not common to intentionally form an entity as a general partnership, although it is quite common to inadvertently do so by structuring a transaction as a “joint venture” or “co-production.”
Limited Partnership. Limited partnerships are rarely used in Hollywood, so I will skip a discussion of them.
C Corporation. A C corporation is just a good old-fashioned regular corporation. It is referred to as a C corporation to distinguish it from an S corporation, which is discussed in the subsequent section. The “C” and “S” refer to the Subchapter of the Internal Revenue Code that governs the respective corporations. None of the shareholders of a C corporation has any liability for the debts of the C corporation.
In general, a C corporation is the only entity that can go public. However, if you have grandiose dreams of ultimately going public, you do not need to use a C corporation until that magic day arrives; you can and should use something else until then, and you can simply convert it to a C corporation when you go public.
Far and away, the single most important detriment of a C corporation is that it is not transparent for tax purposes, which results in double taxation; the C corporation is taxed on income it earns, and the shareholders are taxed again when that income is distributed to them. In addition, any losses are locked up in the C corporation and may not be deducted by the shareholders. However, corporations are subject to a very low rate of tax (21%, reducing to as low as 10.5% for foreign income), so they can be attractive if the business will run at a profit and reinvest earnings.
If the income of the C corporation can be bailed out to the shareholders in the form of deductible compensation, the double tax detriment disappears. The primary example is when all the income earned by the C corporation is attributable to loaning out the services of its sole shareholder, and these C corporations are referred to as loan-out corporations. It is quite common for talent (i.e., directors, writers, and actors) to use loan-out corporations to obtain various tax benefits, such as the ability to deduct numerous expenses that would not be deductible if the talent were an employee of the film company.
It also makes sense for a foreign corporation to use a U.S. C corporation to conduct any business activities in the U.S., including through a partnership or limited liability company with a third party. This approach will limit the tax damage (and audits and tax returns) to the U.S. C corporation, as opposed to requiring the foreign corporation to itself file tax returns, which would expose it to direct audit.
S Corporation. Except for their unique tax aspects and restrictions, S corporations are identical to C corporations in every way. The big difference is that the shareholders must affirmatively elect to become an S corporation, in which case the corporation is treated as transparent for tax purposes, and the income and loss of the S corporation is passed through to its shareholders. Thus, S corporations combine advantages of both corporations and partnerships; the shareholders are not liable for the corporate debts, and an S corporation is not subject to double taxation, as a C corporation is. (However, some states impose a small tax on an S corporations’ net income; e.g., California imposes a 1.5% tax.)
There are, however, numerous disadvantages with an S corporation, the most important of which are the following:
• An S corporation cannot have more than 100 shareholders (with members of the same family counted as one shareholder). Thus, an S corporation cannot be publicly traded.
• With minor exceptions, all the shareholders must be individuals who are U.S. citizens or residents. This precludes ownership by any type of entity, such as a partnership, C corporation, or limited liability company.
• An S corporation can have only common shares. It cannot have preferred shares or any other type of preferential equity ownership. This restriction precludes every type of standard equity financing, as an S corporation cannot provide the equity financiers with any kind of preference on distributions.
All in all, it is like playing tennis in a straitjacket, and any foot-fault may result in the disastrous consequence of inadvertently becoming a C corporation, with its attendant double taxation. In general, therefore, it is best to steer far afield from S corporations except for loan-out companies.
Limited Liability Company. The owners limited liability companies (“LLCs”) are not liable for the debts of the entity, as with a corporation, and LLCs are taxed on a transparent basis, identical to partnerships. They thus combine the advantages of both corporations and partnerships, without the restrictions of S corporations. LLCs are thus far and away the preferred type of entity for most film companies other than loan-out companies.
As mentioned above, an LLC is transparent for tax purposes. If it has two or more members, an LLC is characterized as a partnership for tax purposes. If it is owned by a single member, it is disregarded as a separate entity and is treated as part of the owner. This gets tricky: for state law purposes, a single-member LLC is treated as a separate entity, providing limited liability to its owner, while for tax purposes it is completely disregarded and treated as part of the owner. This is an extraordinary result that was not possible prior to the introduction of LLCs.
One negative consequence of LLCs is that, since they are pass-through entities for tax purposes, individual owners are not subject to the same low rate of tax that applies to corporations. In addition, some states charge a premium for using them. For example, in California LLCs are not only required to pay the same $800 annual minimum tax that corporations and limited partnerships are, but they are also required to pay an additional relatively small tax based on their gross income that caps out at about $12,000 of tax at about $5 million of gross income.
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