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.
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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. Every transaction -- from the humblest to the noblest -- 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 "dba's," 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. The best example would be a consulting or other similar service business. Any lenders to the business would undoubtedly require your personal guarantee anyway, and you would be directly liable for any damage you caused, even if you operated through a corporation.

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 many lawyers give to a film transaction when they do not know what else to call it. Since these arrangements will be characterized as partnerships anyway, it makes sense to structure and draft the transactions as partnerships to start with, to make sure that all the relevant issues are dealt with properly (i.e., money in, money out and control).

In a general partnership, each partner has the ability to contractually bind the partnership vis-à-vis third parties, and the partnership is liable for acts taken by any of the partners in furtherance of the partnership's business. Worse yet, each of the partners is personally liable for all the debts of the partnership. For all of 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."

For tax purposes, general partnerships are treated as transparent; the income and loss of the partnership is passed through to the partners, who then deduct the losses (to the extent permissible) and pay taxes on the income.

Limited Partnership

Limited partnerships are like general partnerships, with the following exceptions:

•To create a limited partnership, a filing must be made with the Secretary of State in the state where the partnership is formed.
•A limited partnership has two classes of partners -- the general partners and the limited partners. The general partners have the right to manage and control the affairs of the partnership, and are liable for all the debts of the partnership. The limited partners do not have the right to manage or control the affairs of the partnership (although they typically have the right to vote on specific important matters), but they are not liable for any of the debts of the partnership.

In all other respects, limited partnerships are the same as general partnerships. For example, they are transparent for tax purposes; the income and loss of a limited partnership is passed through to its partners. Because the general partners are liable for the debts of a limited partnership, it is common to use a single corporation as the sole general partner of a limited partnership. This structure combines the limited liability of a corporation (discussed below) with the flexibility and tax transparency of a partnership. Until the advent of limited liability companies (discussed later in this chapter), limited partnerships were the entity of choice for most film financing transactions.

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. Whenever a new client mentions owning a corporation, I always ask whether it is a C or an S corporation, as the answer has tremendous implications on almost any discussion that follows.

A C corporation is formed by filing articles of incorporation with the Secretary of State in the state where the corporation is formed. Ownership of a C corporation is evidenced by shares, and the owners are called shareholders. Unlike a partnership (both general and limited), none of the shareholders of a C corporation has any liability for the debts of the C corporation. For this reason, many lawyers to this day continue to blindly form C corporations, without thinking through the negative tax implications (discussed below), and without considering alternatives.

Far and away, the single most important detriment of a C corporation is that it is not transparent for tax purposes, which results in the extraordinary burden of 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.

The only time that you would not be concerned with double taxation is when you are positive that you can bail out the income of the C corporation to the shareholders in the form of deductible compensation. 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 otherwise non-deductible expenses. As an example, assume that an actor renders services to his wholly-owned loan-out corporation, and the corporation loans out his services to a studio for $10 million. The loan-out corporation then pays the actor $9 million as deductible compensation, and pays another $1million of deductible expenses (which would have been non-deductible if paid directly by the actor). In this manner, the loan-out corporation has no taxable income, and the actor has only $9 million of taxable income.

S Corporation

Except for their unique tax aspects and restrictions, S corporations are identical to C corporations in every way: They are formed under the same corporate law by filing articles of incorporation with the Secretary of State, and they are owned by shareholders who elect directors, etc. 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 corporation's net income; e.g., California imposes a 1.5 percent 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.

Limited Liability Company

Limited liability companies ("LLCs") are manna from heaven. The owners 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. They are absolutely the entity of choice for almost every film company, with the limited exceptions discussed above under the various types of entities.

An LLC is formed by filing articles of organization with the Secretary of State in the state where the LLC is formed. The LLC is either governed directly by its members, or its operating agreement may provide that the members elect managers (who may or may not be members), who in turn run the LLC. As with partnerships, LLCs have complete flexibility; whatever the mind of man can imagine can be written into the operating agreement (such as special allocations of income or control).

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.

The only negative of LLCs is that 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 (the rate of tax varies each year, so you have to check the current rate). This is usually a small price to pay for all the advantages provided by LLCs. If someone in the film industry asks, "What entity should I use . . . , " you can shout, "LLC!" and be right 99 percent of the time without even hearing the rest of the question.

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