What Kind of Business Should You Be? A Day at the Lawyer's
In the first two installments of this article, we saw that the first step in creating a business, whether it is a business to manufacture widgets, develop software, begin a broker-dealer, offer services or any other of the myriad of business ventures, is to decide what form or structure is optimal, both in terms of present needs and future aspirations. Do you remember everything we covered? I didn't think so. Not to worry, for now we will put all that theory into practice.
If you are smart, you have by now at least figured out that your first call after deciding to start a business should be to your attorney. In your first meeting with your attorney she will advise you that the first step to take would be to form an entity that provides you with limited liability so that you may insulate your personal assets from creditors and actions taken against the business. There are three primary choices which offer its owners limited liability, the C corporation, the S corporation and the limited liability company.
Your attorney will next have you focus on the type of business, who the owners are or will be and what your current and future aspirations for the business are. Among those concerns you will be asked to discuss and evaluate the following:
1. limiting yours, and other owners, exposure to liabilities undertaken by the business;
2. the type of management you want and which will be most efficient for your business;
3. having flexibility to transfer ownership interests;
4. the amount of flexibility you require for allocating income and deductions;
5. limiting burdensome reporting and information requirements; and
6. your future financing needs.
Of course in assessing all of the above, you should be, and your corporate attorney will be, aware of the tax implications of the entity you choose.
The key distinction, from a tax perspective among the C corporation, S corporation and limited liability company:
S corporations and limited liability companies are taxable as a partnership and, therefore, are "pass through" entities, while a C corporation is not.
Once you have all available information on the table, your attorney should be able to guide to the appropriate vehicle for your business. Unless you have realistic plans to obtain venture capital or undertake an IPO within a year or two of formation, most attorneys will steer you in the direction of a limited liability company or an S corporation, and most attorneys would strongly advise you to form a limited liability company over an S Corporation. The reason for that is while both the S corporation and the limited liability company avoid double taxation and allow for losses to pass-through to the owners, a limited liability company will typically be preferable to an S corporation at the operating stage.
A limited liability company has no restrictions on structuring allocation and distribution arrangements. On the other hand, an S corporation is restricted not only to the types of shareholders, but also to one class of stock, and, therefore, is highly restricted in creating different interests. What does this mean for you? It means that with a limited liability company you can create numerous classes of interests as a way of distributing income, losses and even managerial responsibility in different ways to different owners or members.
For example: you and your partner, Joe, are to be the primary owners of your business. Your friends Ed and Stan want to be involved and while they can't invest any money, they can invest "sweat equity"? With an S corporation they would have to be the same class of owners as you and Joe, but with a limited liability company you and Joe can be owners of class A interests and Ed and Stan can own class B interests each class with different profit and loss allocations. You can even vest all managerial responsibility in the class A interests so Ed and Stan have no managerial responsibility or very limited managerial liability.
With all that said and done, your attorney will advise you of the two main drawbacks to a limited liability company. The first one is that a pass-through entity may cause its owners to be subject to state tax collection and reporting requirements in the states where the entity conducts business because the owners may be considered to be conducting business in those states by virtue of the pass-through entity's activities. And second is the issue of phantom income. An owner may be taxed on the undistributed income for the limited liability company despite having received no actual money. Both of these issues should be discussed with your accountant, who should be made part of the process of determining which entity is best for you.
After you have had your first meeting with your attorney and she has obtained all the information she needs to advise you, introduce your attorney to your accountant and make sure they are on the same page about which entity is the most appropriate for you.
What if you are thinking about raising immediate capital? Sho uld you use a C or S corporation or a limited liability company?
Well, the first thing your attorney will ask you is: From whom do you plan to raise money? Without going into the securities issues as well as practical aspects of raising money, all of which will be addressed in another article, this is a critical decision. Different financiers prefer different entities.
First round or "Angel Financiers" tend to enjoy the pass through losses that flow from start-up entities, but Venture Capital funds are typically institutions or include foreign investors both of which are ineligible to be shareholders of S corporations, and many funds prohibit investing in pass-thorough entities for a myriad of reasons.
So what to do?
If you know the angel financing will keep your business operating without the need for additional funding for well over one year or you are not sure of the future, a limited liability company may be preferable because it is generally easier to change from a pass-through entity to a C corporation than vice versa and should not trigger a tax consequence. This is where you need to be well advised on the state of formation. As of now, the state of Delaware provides for the easiest conversion from a limited liability company to a C corporation.
What have we learned thus far?
If you are going to start a business with one or two individuals and do not have plans to bring in additional investors or owners of a different class, then you may want to consider an S corporation.
In most other situations, unless Venture funding or an IPO seem imminent it is probably wiser to form a limited liability company. If venture funding or an IPO are imminent, then a C corporation is the most likely choice. How's that for cutting all the complexity down to size?
Of course, every situation is unique, and you should not rely on cookie cutter answers, not even ours. Find and heed the advice of an attorney and accountant in making this all-important first decision for your company.