Starting Your Business: Choice of Legal Entity

Consider the Possibilities

When you start a new business there is a wide array of available legal entities from which to choose, including without limitation:

1. Sole Proprietorship
2. Partnership (general or limited)
3. Limited Liability Company (LLC)
4. Corporation (“C” or “S” Corp)

So, How to Choose?

It’s not a “one-size fits all” situation.

Anyone can log on to “Legal Zoom” or similar website or even the website of the Secretary of State and form a Corporation or a Limited Liability Company. If you’re going to be the sole owner, then you don’t even need to file anything to get started, you can be a Sole Proprietorship and report the business on a Schedule “C” on your personal income tax return.

But that’s where the real trouble can start. Choosing the right form of entity for your business depends on a thorough understanding of the facts and circumstances, plans and expectations for your business.

This is one of the most important times to get knowledgeable professional advice – the time before the business starts.

What Facts and Circumstances,
What Plans and Expectations Need to be Considered?

• What kind of business will this be?
  • Personal Service
  • Professional Service
  • Distribution
  • Manufacturing
• What is the sales model?
  • “Bricks and Mortar”
    • Local, One State
    • Multi-State
  • Multi-State
    • Telemarketing
    • Internet
• Will there be more than one owner – will you have a partner?
• What kind of risks and potential liabilities will the business face?
  • Company Debts
  • Professional Service Liability
  • Liability for Acts or Negligence of Others (partners, employees)
  • Product Liability
• Will there be employees?
• Do you think the business will lose money in the first year or two?
• Do you have enough working capital to cover the start-up losses and your own living expenses until the business is profitable?
• Will you bring in investors to contribute working capital to keep the business going during the loss period?

Liability Protection

Flexible Ownership Structure

Observation: The General Partnership and the Limited Liability Company offer the most flexibility both in type of ownership interests and special income tax allocations. There is, however, a big and highly significant difference between the two, namely:

• The Limited Liability Company protects the business owner from many kinds of liability; and is a “pass-through entity”.
• The General Partnership does NOT protect the business owner from liability; but is a “pass-through entity”. (see Income Tax Structure, below)

Income Tax Structure

Is the business income taxable to the business entity?

Do the owners pay income tax again when they receive distributions (money or Property) from the business entity?

Taxable Entity – Double Taxation: When business income is taxable to the business entity and then the owners are taxed again when they receive distributions from the entity.

Pass-Through Entity: When the business income is not taxable to the business entity; instead the business income is taxable directly to the owners. The owners are not taxed when they receive distributions from the entity.

Special Income Tax Allocations

What’s a Special Income Tax Allocation?

When is it important?

Most people don’t think about income tax allocations. In most cases, we assume, and such is that case, that if a business owner, partner of investor owns 20% of the business, that person will also be allocated 20% of the taxable income and tax losses of the business. Yes, that’s true in most cases; but it doesn’t have to be the case for some business entities.

A special allocation occurs when the tax losses are allocated to the owners in a different proportion than their ownership of the business.

Why would you want to make a special allocation?

Here’s a simple example: Let’s say you are the founder and actively running the business. You are operating the business; your partner is an investor who contributed $100,000 for the working capital needed to run the business. The business is owned 50-50 between the two of you.

Now let’s say the business lost $50,000 in the first year of operations. Here’s what happens with each type of two owner business:

1. “C” Corporation:
   1. it’s a taxable entity – double taxation –
   2. the full $50,000 of losses are “trapped” in the business.
2. “S” Corporation:
   1. it’s a pass-through entity;
   2. no special allocations;
   3. You have no “tax basis” in your stock;
   4. your partner has $100,000 of “tax basis” in her stock.
   5. Your partner can write off 50% of the loss – $25,000; but the other $25,000 is yours; since you have no tax basis in your stock, the other $25,000 of loss is “suspended” until you get enough tax basis in your stock to write-off the loss.
3. Partnership:
   1. It’s a flow-through entity;
   2. Let’s say by special allocation the losses are allocated first to those who contributed money to the business.
   3. By special allocation, the full $50,000 loss is allocated to your partner – so she can write-off the full $50,000 loss.
   4. That’s good for her taxes; but remember
   5. If it’s a general partnership, then neither you nor your partner have liability protection; and
   6. If it’s a limited partnership and she is the limited partner and you are the general partner; she has liability protection; but you don’t.
4. Limited Liability Company:
   1. Same facts and tax allocation as with the Partnership in 3, above; however,
   2. Both you and your partner have liability protection because it’s a multi-member LLC (doesn’t matter in which state it’s organized).

Now, it should be apparent to you why this special income tax allocation is important. It provides an important tax benefit to the investor. It cushions the investor’s investment risk because she gets the early benefit of the income tax deduction without any reduction in her ownership interest in the company.

A special allocation of losses may be a strong incentive to investors in a start-up business.

Decision Tree

What Characteristics are Important to You?

Coming Attraction: Where to organize the entity – which State?