Starting a business often brings a sense of excitement coupled with owners’ desire to move quickly, but careful thought should be given to the tax and non-tax factors affecting the critical decision of how to structure the business.
The right choice of entity protects the owners’ personal property by isolating liability associated with the business operations. Entity choice further affects access to capital, management rights and tax compliance.
“The business form is incredibly important,” says Jonathan C. Wolnik, a tax and corporate attorney at McCarthy, Lebit, Crystal & Liffman Co., LPA. “Failing to start with the right advice from competent advisers can cause significant problems for the business and its owners.”
Smart Business spoke with Wolnik about choice-of-entity considerations.
What are the key factors to consider when choosing a business entity?
It starts with understanding the owners’ goals. Their vision answers questions as to how the company will be capitalized, if it needs to have closely guarded or freely transferrable ownership, and how it shall be managed. Very few owners are willing to intentionally accept personal liability for business activity, so the limitation of liability is always paramount.
Partnerships can have very flexible management arrangements, whereas corporations typically have a more rigid management structure. However, general partnerships do not insulate personal assets, making the individual partners joint-and-severally liable for the activity of the other partners. This is often unacceptable to the owners, especially when it is easily mitigated.
Further, the owners should understand the tax ramifications of their choice of entity, which can be easily explained by working with good advisers. But while it’s important to understand the tax ramifications among the entity options, taxes should not entirely control the business structure.
Why would a company change entity type, and what would that process look like?
An entity formed as one type may convert to another, meaning, for example, that a corporation can become an LLC and vice versa. Typically, the entity seeking to change its form must notify certain state agencies before taking action. Further, a corporation typically must obtain a certificate of tax clearance from the Department of Taxation indicating that all prior tax liabilities have been satisfied. Other entity types do not share this requirement when converting.
A formal plan of conversion outlining why the entity wants to convert and how it will be accomplished must be adopted. The plan must be authorized at the appropriate level of governance. Note that tax-elections, such as the ‘S-election,’ do not constitute a formal change of entity type.
The reasons for a conversion can vary and may include tax considerations or ownership changes. For example, an S-corporation is restricted as to who the permitted owners are. Therefore, admitting a new owner that does not meet the tax code’s requirements may necessitate a conversion to an LLC.
Another factor to consider in conversion is the owners’ exit strategy. It may make sense to change entity type to obtain certain tax benefits at the time of exit, if possible. Foresight and careful planning are required when contemplating this type of action.
What do people tend to overlook when setting up a business entity?
Dispute resolution is often ignored by individuals starting a business. At the beginning, optimism and a desire to control costs keep owners agreeable. But those initial good feelings often fade, and if the governance documents do not adequately address dispute resolution, the problems compound. It is easier to reach agreements on dispute resolution at the start when everyone is looking forward to a peaceful and prosperous future. Processes for dispute resolution should be documented early in the business formation.
For these reasons, professional advisers, both lawyers and accountants, should be consulted. Candid and honest conversation is critical and allows the lawyers and the accountants to ask important questions to help their clients reach the proper conclusions that shall fundamentally shape the business for years to come.
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