One of the hardest decisions business
owners have to make in business
planning is their form of entity.
Choices abound, such as a partnership,
limited liability company (LLC), or sole
proprietorship, and each has advantages
and disadvantages, depending on the type
of business.
Type notwithstanding, owners should not
downplay the significance of choosing the
entity that will best suit their businesses’
needs. For owners, making the right decision means taking the time upfront to identify precise goals and objectives and partnering with the best qualified professional
advisers to help them through the selection
process. Bypassing these important steps
can expose business owners to myriad
risks that can lead to adverse conditions
for them and their companies.
Smart Business spoke with Michael R.
Milazzo, CPA, MBA, a partner with Skoda
Minotti, to learn more about how the selection of an appropriate form of entity can
enhance business owners’ chances of success and improve their possibilities of selling their companies.
What is the connection between goals and
objectives and the selection of an entity?
Form of entity has a large number of
implications for a business. It affects legal
liability, current taxation, the type of tax
forms companies are required to file and
owners’ exit strategies. That’s why it is
important for owners to carefully think
about why a specific entity is best for them,
rather than just pulling a structure out of
the proverbial hat.
If one entity selection doesn’t work out, can
owners change it?
Generally, a company can change its
form of entity at any time. But, depending
on the original form of entity, there could
be significant tax consequences associated
with a change. For example, if a business
opens its doors as a C corporation, which
is a taxpaying entity in itself, and changes
to an LLC, which in most cases is not a tax-paying entity in itself, but a flow-through
entity in which all the income flows through to the individual members on to
their individual tax returns, there will be
differences in how the entity is taxed.
Moreover, there could be significant additional tax incurred by the C corporation
from the change because the tax rules treat
the change as a deemed liquidation of the C
corporation. Nevertheless, companies do
change entities frequently for a variety of
reasons, such as to alleviate administrative
burdens or to accommodate their future
exit strategies.
Does a company’s form of entity make a difference when it is involved in the buying or
selling process?
Definitely. Consider the opposite forces
that are at work in a typical M&A transaction. In most cases, buyers want to purchase assets because they want to limit
their exposure to the target’s liabilities and
be able to write-off the excess purchase
price via amortizable goodwill. On the
other hand, sellers want to sell stock
because they want to generate long-term
capital gains, which are currently subject
to favorable individual tax rates. As a
result, the form of entity has a significant
effect on the buying and selling process.
What it boils down to is that a flow-through form of entity (i.e., partnership,
LLC, or S corporation) is generally better in
the selling process because these entities
are not subject to tax at the entity level.
Therefore, it is possible to structure a
transaction with a flow-through entity that
satisfies the goals of the buyer and seller —
amortizable goodwill for the buyer and
long-term capital gain for the seller. The C
corporation form of entity is not usually a
favorable structure for an asset sale
because the C corporation is subject to
entity level taxes, and the individual shareholders are subject to tax again upon distribution of the funds from the sale.
Owners who recognize the importance of
form of entity early in their formation
process can improve their exit strategies,
which can result in increased after-tax proceeds from a sale.
What risks do entrepreneurs face when they
do not devote the necessary time to selecting
a form of entity in their business planning?
One significant risk is the potential for
personal liability. Owners who offer products or services that can result in personal
liability should be extremely careful in
choosing a form of entity and must involve
their corporate counsel in the decision.
Likewise, owners of entities that are very
profitable and choose C corporation status
simply because it seems like a good choice
at the time can run into problems when
they try to sell. Again, buyers generally
want to purchase assets. That means the C
corporation seller can lose over 50 percent
of the consideration just in taxes if the
business is not structured properly on the
front end. Consequently, the business
owner may find herself in a position where
she wants to sell the company, but finds
that the tax ramifications are too high. That
can happen when owners do not structure
their businesses viably up front.
One of the best ways for business owners
to avoid risks like these is to work closely
with professional advisors when choosing
a form of entity — and get them involved
early in the business planning process.
MICHAEL R. MILAZZO, CPA, MBA, is a partner with Skoda Minotti. Reach him at (440) 449-6800 or [email protected].
