Choice of Entity: Why You Are Almost Always Wrong

Posted on August 8, 2012

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When you were seven years old, did you know what you wanted to be when you grew up? You probably had a good idea. Are you doing that now? Probably not. Dreams often conflict with reality. It is a similar issue for the start-up, and this is the reason that so many choice of entity selections are, in retrospect, wrong. In order to know what entity you want, you have to know what you want to be as company five or ten years down the road. Because plans change, the original entity decision may not always be the correct one.

While a simple incorporation (LLC) can usually be done online without too many problems, a lawyer’s business acumen can help you determine what choice of entity is best for your company. A LLC might be one of the simplest choices for a business, but that doesn’t mean it is the wisest. Anyone in business wants to opt for the entity that makes the most sense for him or her as the company grows, which it hopefully will. However, because your plans sometimes change, reviewing your choice of entity status every couple of years is a good idea.

Additionally, you should note that the entities presented below are presented in order of development. As a general rule, you want to start with a sole proprietorship and then move down the chain. To move back up the chain, e.g. converting from a C-Corp to an S- Corp, involves complexity and taxes.

Let’s take a quick look at some of the most common business entities:

Sole Proprietorship

A sole proprietorship is a business owned by one person. These are very easy to form because no government documents are involved and no filings are necessary. Sole proprietorships are also inexpensive because there are no legal fees. Since there is no distinction between the business owner and the business, the business owner and the business do not pay separate income taxes (also known as double taxation).

In some cases, the corporate veil offers so little protection that the use of a corporate entity is not worth the cost. A professional, such as a lawyer or a doctor, cannot shield themselves from liability. As a consequence, the cost of a complicated incorporation is not as important as having enough insurance.

Limited Liability Corporation (LLC)

A limited liability corporation is a company regulated under state law, where owners have limited personal liability for the debts and actions of the company. A LLC can also avoid double taxation.

S-Corporation

An S-Corporation is similar to a C-Corporation in that it is also formed under state law as a C-Corporation, but it has an election filed with the IRS. The business and business owners are separate entities, but an S-Corporation is not subject to double taxation like a C-Corporation. S-Corporations are corporations that elect to pass corporate income, losses, deductions and credit through to their shareholders for federal tax purposes. Shareholders of S-Corporations report the flow-through of income and losses on their personal tax returns and are assessed taxes at their individual income tax rates.

C-Corporation

A C-Corporation is the most common type of separate legal entity formed and recognized by state law. There is a legal distinction between the business and the business owners, and the business owners and business are taxed separately.

I like to ask my clients the following questions when determining what kind of entity is best for their company:

  • How many owners will you have in the next year?
  • How many owners do you anticipate having within the next five years?
  • Are there any owners who are not individuals?
  • Are all owners citizens of the United States? (This is important in qualifying for S- Corporation status.
  • As to shareholders, is any person contributing something other than cash in exchange for his shares?
  • Will any owner get a preferred return?
  • What entity does your accountant recommend if you have one? (If your accountant recommends a choice of entity, it’s also important to note whether or not an s-election should be made.
  • How much debt and/or equity will you need to raise in the next five years to accomplish your goals?
  • From 1-5, with 5 being the highest priority and 1 being the lowest, what is your desire to save on taxes?
  • Is the business more likely than not to need or want to issue equity to employees?  If so, does the industry have a preference or dictate the type of equity to be received?  To the extent known, what are the owner thoughts on governance of the company?
  • While different people have different priorities, all for-profit corporations, at some point, need to have a return on their investments (cash and services). How do you plan to get a return on your investment? For example: Go public in five years, create a good salaried lifestyle, have a projected return on dividends, etc.
  • Which statement fits you better? I would rather make a conservative estimate of taxes to avoid an issue with the IRS, or I would rather reasonably compensate myself.
  • Which statement describes the ownership structure best? The ownership structure is well- defined at present, or the ownership structure is to be determined going forward.
  • Which statement fits the company better? This company will provide a means of support for my family for the course of my life; I am working on this company as I figure out which direction I want to go in; I want to do business with another person or business and need to set up a company or I am looking to purchase my own island as soon as possible.
  • Which statement fits the owners better? Simple is better, or if it means additional paperwork, but the structure is more thorough and customized, I’d rather do more paperwork.

With answers to these questions in hand, you’ll not only be better prepared to choose an entity for your company, you’ll also have taken the time to consider what you’d like the future to look like for you and your business. And if you don’t know the answer to most of these questions, it’s probably not time to incorporate, but instead time to reconsider what you’re doing with your company and how to better define its present state and direction.

In the upcoming weeks, I’m going to delve more deeply into the nuances and distinctions between the types of entities available to a company. Specifically, next week I’ll take a closer look at one of the most common entity decisions: LLC vs. S-Corporation. However, as a general matter, I think entrepreneurs waste a lot of time trying to figure out entities. Stop trying; stop reading on the Internet; stop second guessing your professionals. Have your lawyer call your accountant (or vice versa) and tell them to come to an agreement. Two practitioners in this area should be able to either give you a good answer (remember time may change the answer) or give you a crisp explanation of the trade-offs of choosing one entity over the other.

Mike Goodrich
Goodrich Law Firm, LLC

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