What Kind of Business Should You Be? How Do You Choose?
In part one of this article, we learned that there are now six basic choices of business organization: Sole proprietor, general partnership, corporation, subchapter S corporation, limited partnership and limited liability company. If that sound like a lot, here's the good news. Unless you have really compelling reasons to do otherwise, you should only be choosing between a corporation and a limited liability company. Here's why.
First, remember that, just like you can survive in a cave just as well as in a mansion, you can run a business and make (or lose) money equally well with any form of business entity. A business is successful primarily because of the three M's--management, market, and merchandising--and not because it is a partnership or an LLC. Rather, the differences among the various forms of business organization have to do with addressing and compromising among four issues relevant more to the long-term structure of the business than its day-to-day operations. Here are the issues, in what I think is their order of importance:
1. availability of easily tradable units of equity.
2. limited liability
3. taxation, and
4. flexibility of control.
Easy tradability of equity. Not for nothing are virtually all large companies corporations. Companies with many investors must be in a form that allows those investors easily to buy and sell their interests on an established open market. This is called "liquidity," and it generally requires that there be a large pool of buyers and sellers, with access to an intermediary who posts the current market price of the interests and through which trades can take place.
For mostly historical reasons, the established intermediaries and their support systems and networks--the stock markets and NASDAQ--tend to deal almost exclusively in common stock or its derivatives (like options, warrants and the like). The Internet may, in time, change that, as sites are developed that create cyber-marketplaces for partnership interests and LLC units. But for now, most companies seeking venture counseling determine that they need to have common stock, and that consideration trumps all others. If you want your company, now or on the future, to have publicly-trading common stock, then your company must be a corporation. Many start-ups elect to become corporations, thinking, not unwisely, that if things go well they will need to be one, and that if things go poorly, it will not matter.
On the other hand, if you plan to sell the business lock, stock and barrel to another company, then it is not as necessary to be a corporation, and other issues may be more compelling. One very attractive feature of partnerships and LLCs is the flexibility to divide equity amongst the owners in a non-uniform manner. For example, with an LLC you could issue units to those investors who actually put money into the venture that differ from the units of the founding owners, perhaps by giving them most of the tax write-offs of the business. This might make them more likely to invest in a business that is expected to lose money during its development phase. This would not be possible with a corporation or a subchapter S corporation.
Limited Liability. Assuming your company's need for common stock is not that compelling, other choices come into play. The first of these should be the need for limited liability. Limited liability means that the business's legal obligations are not foisted on the individual owners, and it it is probably the legal invention most responsible for the development of our modern commercial world. Limited liability means that the owners generally cannot be held liable for the debts of the business.
For any business of any complexity, limited liability is a must. While it is possible to buy insurance against many business risks, it is a second best solution, involves paying expensive premiums. That is largely unnecessary today when the law offers so many options to form your business without incurring personal exposure for business obligations. Corporations, subchapter S corporations, limited partnerships and limited liability companies all give you limited liability. Sole proprietorships and general partnerships do not, so if you choose to be one of them, you had better have a good reason.
Taxation. The basic business tax issue is whether the income or losses of the business will be taxed to the business, or will "flow through" to be taxed to the owners personally. Of all the forms of business available, only the corporation (but not the subchapter S corporation) is considered a taxpayer in its own right. That means that it pays corporate income taxes on its income, and that its owners do not. Conversely, if the corporation has losses, its owners cannot take advantage of them to reduce the taxes they owe on their personal income, but the corporation can use some or all those losses to offset profits earned in future years. And (not counting salaries paid to owners who are also employees), a corporation can only distribute cash back to its shareholders in the form of dividends.
But here's the rub: the corporation pays dividends with after-tax dollars, but those dividends are still fully taxed to the shareholders who receive them, making the income used to pay dividends twice-taxed. All-in all, then, there are good tax reasons not to be a corporation.
Not that owners of non-corporate entities don't have their problems. Since the tax laws only consider the corporation to be a tax-paying entity, they impose the ultimate taxpaying burden of all other entities not on the business itself, but upon the owners of the business directly. The business entity in effect becomes invisible for taxpaying purposes. Thus, sole proprietors, partners and limited liability company members (as well as shareholders of Subchapter S corporations) are personally responsible for their shares of the business's taxes.
This generally causes no problems so long as the business is losing money, for then the owners get tax deductions that they can use to shelter other income. But they pay the piper when the business turns profitable. Very often, the business cannot distribute all its profits, needing to keep some of its cash profits for working capital, or to pay off debt, or to fund prior year pension plan and tax obligations, or for other purposes not deductible in the current year. Or consider a business that is on the accrual method of accounting, and books revenues in one year but does not receive a cash payment until the next. These all too common events create a peculiarity: The business has more profits than it has cash to distribute to the owners. But the tax laws don't care a whit about distributed cash, only about taxable profits. So you, as the owner to whom the business's income flows for tax purposes, will have the privilege to pay taxes on money that you don't receive. This taxed but un-received income is called "phantom income." (A friend once called it "ghostly lucre," but the name didn't stick.) But there's nothing ethereal about it when you have to write a big tax check out of money that you haven't gotten. The threat of phantom income is probably the most disadvantageous aspect of not being a corporation.
There is no right answer here. It depends on the peculiar circumstances of your business. A business that knows it will generate losses might want to pass those losses on to its investors, as a non-corporate entity. Or it may want to carry those losses forward and use them to reduce its taxes when it does start to make money, as only a corporation can do. A business that plans to distribute all its profits will not want to be a corporation, while a business that want to build a war-chest for research and development or an acquisition program would be foolish to be anything but. Here is where a realistic appraisal of your business goals and good long skull session with your accountant and attorney will pay off. One interesting compromise is to start business life as an LLC and convert to a corporation when you start making money, but be careful because conversion is not so easy in some states as in others.
Flexibility of governance. As a general rule, the ability to make quick management decisions diminishes as one goes from a sole proprietorship to a corporation. A corporation (even a subchapter S corporation) must be run by its board of directors, who work through a team of officers who run the business day-to-day. The officers--president, vice-president, secretary and treasurer, usually--are elected and serve at the pleasure of the board. Anything they do can be overruled by the Board, and the Board alone can make some important decisions. But the Board serves at the pleasure of the shareholders, who must reelect a Board at an annual meeting every year. While all of this is not very onerous in practice if the business is small enough, it can at times cause headaches. By contrast, consider that a sole proprietor can accomplish the combined work of a management staff meeting, a board of directors meeting and an annual or special meeting of shareholders merely by talking to himself now and then. (Entrepreneurs are prone to do that anyway.)
Partnerships, limited partnerships and LLCs are run in accordance with their respective partnership agreements or LLC operating agreements. These can be very flexible in setting up a governance structure, but there are some rules. Limited partners of limited partnerships cannot be involved in management, and if they are they will be deemed general partners and lose their limited liability. LLCs must be managed by a managing member appointed by the members.
And the winner is. . . .
If you think you will need to have easily tradable shares of stock in the near future, then you will have to be a corporation. Any other should probably become a limited liability company if you anticipate losses or if you anticipate distributing substantially all you profits to your owners. If you anticipate earning profits and retaining them for future expansion, then you should become a corporation by the time that happens. The easy answer here, and that chosen instinctively by most entrepreneurs, is to become a corporation and forget about it; but that may not be the best answer, and such a knee-jerk reaction could be cheap in the short term but costly later on. Again, understanding your business goals and realistically assessing the probable future is the key, and your accountant and attorney are your best friends in figuring this one out.
In the next installment, we will walk you through a visit with your lawyer in helping you choose an entity.