Starting a business has become an increasingly complex proposition as regulatory and compliance matters continue to mount for new business owners. There are a variety of considerations for business founders from the outset, including liability protection, tax implications, effective governance, and even possible exit strategies. The structuring decisions you make at the beginning of a new venture could have a real impact on your long-term success.
A little planning can go a long way
Starting a new company is an exciting time in the life of an entrepreneur. A modest amount of planning at the outset can save considerable cost and aggravation later, as a properly structured business entity has advantages over the long-term.
There are a number of issues for founders to consider when forming the business entity. Two of the most important are tax considerations and liability protection. Partnerships and corporations have considerable differences in the way they are taxed and the proper structure for a given venture will depend largely on business goals and the particular ownership circumstances. Additionally, shielding owners from personal liability should be a priority for business owners. There are a number of ways to achieve this goal and business owners must be careful to structure the business properly in order to assure an effective limitation of liability. For both tax and liability issues, it is important to seek professional guidance.
Depending upon the nature of the business, there are a wide range of other issues for the entrepreneur to consider. These range from the somewhat mundane, such as obtaining an employer identification number from the IRS and setting up bank accounts, to the potentially critical, such as an effective strategy for protecting intellectual property rights. If not properly addressed, all of these issues have the potential to become serious headaches for business owners.
At some point during the business growth cycle, most companies also reach a juncture where hiring employees is a consideration. This decision comes with another layer of planning and compliance requirements. Along with employees come obligations for tax withholding, state and federal unemployment insurance premiums, and workers compensation. In addition to complying with requirements of regulatory authorities, the proprietor should also consider internal employee matters such as benefits packages and employee policies memorialized in a formal employee handbook. As with most substantive issues faced by the small business owner, employee matters can be handled in a variety of ways depending on the particular circumstance.
The bottom line for all entrepreneurs starting a business is that a small amount of planning can pay significant dividends down the road. Often it is much more difficult and expensive for a company to remedy structure and compliance issues after a business is fully operational. By spending a modest amount of time and resources at the outset, companies can be optimally positioned to succeed over the long term. We provide clients with practical legal advice, and our goal is to put our clients in the best possible position to excel in the business world.
Corporation or Limited Liability Company?
Whether to form a limited liability company (“LLC”) or a corporation is a question often pondered by new business owners. Corporations and LLCs are not the only form of business structure, and in some cases, including professional services or investment fund vehicles, partnerships—particularly limited liability partnerships—may be ideal. LLCs, corporations, and partnership are all formed pursuant to state law. Within the corporate family, there are C-Corporations (commonly called a “C-Corp” because of the applicable section of the tax code) and S-Corporations (“S-Corps”). Contrary to popular belief, an “S-Corp” is not a distinct legal entity from a C-Corp but rather is a distinct status made through a tax election filing with the IRS.
Tax 101: A Pass-Through and a Blocker
Despite the nomenclature, we are talking tax here, not football. The most important thing to understand about tax basics for business entities is that some entities have pass-through treatment and some do not. Pass-through treatments means that the income of the entity passes through to the individual owners and is paid at their individual rates, rather than another rate at the entity level. A blocker, on the other hand, pays tax at the entity level at an entity-level rate. Important note: as we will see below, while a C-Corp pays tax at the corporate level, individuals still must pay taxes when money flows through to them in the form of salaries or dividends. This is the double-tax feature of C-Corps.
Why a C-Corp?
Most large, publicly traded companies are C-Corps, whereas many start-ups and small businesses tend to be LLCs or S-Corps. There are certain distinct advantages to C-Corps for many more established entities that are not necessarily applicable to smaller, less established companies. For one, institutional investors have a strong preference for C-Corps. Many people think that’s because C-Corp legal rights are more predictable. While there may be some truth to that, in fact, the main reason why some institutional investors prefer C-Corps is because they are NOT pass-through entities. Large, institutional investors often have tax-exempt entities, such as pensions, as their limited partner investors. Without going down a tax rabbit hole, that means these institutional investors typically need to invest in a “blocker entity” that does not have pass-through tax status (meaning a C-Corp). Otherwise, institutional investors’ limited partners could be subject to what is known as UBTI (unrelated taxable business income), which can create major problems. So, indeed if a company has designs on raising institutional funding or going public someday, a C-Corp holding company may indeed be the right choice. In fact, virtually every major corporate family has a C-Corp at the top of the organizational chart with numerous other subsidiaries and affiliates that are often pass-through entities. After the 2017 Tax Act changes, C-Corporations are now taxed at a flat 21% rate (down from 35%). Salaries or dividends are taxed separately at the individual’s personal income tax rate or 20% for qualified dividends, respectively, when distributed to individual owners.
What About LLC or S-Corp?
From the tax perspective, there are a lot of similarities between an LLC taxed as a partnership (the most common tax scenario for an LLC) and an S-Corp. Both are treated as pass-through entities, meaning that the profits and losses pass through the business to the owners of the entity, and there is no federal income tax paid at the entity level. While the primary tax structure of the LLC and the S-Corp is similar, depending on the timing of the decision and the status of the underlying business, the practical tax effect for owners can be different depending on whether an entity is a corporation or an LLC.
There are various other characteristics of the LLC and the S-Corp that have significantly different ramifications for the business owner. For instance, there are ownership and governance restrictions on an S-Corp, including a maximum of 100 shareholders and no separate classes of stock, that limit some of the flexibility in structuring economics and allocating profits, losses, deductions, and credits that can be achieved with an LLC. Unlike S-Corps where profits and losses are allocated to shareholders based on pro rata ownership regardless of the parties’ preferences, an LLC allows flexible allocations that can be drafted into the LLC operating agreement, provided the arrangement has substantial economic effects (another tax concept beyond the scope of this article).
At the same time, there are advantages that the S-Corp structure can have over the LLC. Within certain parameters, the S-Corp may provide owners with payroll tax savings not available to owners of the LLC. Additionally, the corporate structure of the S-Corp can be simpler in certain circumstances, such as when an owner dies or leaves the company.
After changes resulting from the 2017 Tax Cuts and Jobs Act, pass-through entities are entitled to a 20% income deduction for qualified business income (QBI) from a trade or business (but excluding a wide array of service businesses). The deduction is still available for excluded businesses for income up to $157,500 for an individual or $315,000 for a married couple. The deduction is allowable for the lesser of 20% of taxable income plus qualified REIT dividends and publicly traded partnership income or 20% of taxable income minus net capital gains.
The bottom line for business owners is that there is not a simple answer to the corporation versus LLC question. The decision will be fact driven depending upon the particular circumstances of the owners and the business. As with other issues pertaining to a start-up company, the particulars of the business structure are something that legal counsel should be retained to analyze so that the company will be in the best possible position to succeed long-term.