Wednesday, September 15, 2010

Why You Must Carefully Choose Your Legal Business Structure

I get a lot of calls and emails from people who ask me to help them set up an S-Corporation or an LLC.  The first thing I ask them is "why do you want that form."  At least I give them credit for calling me with the question.  To many business owners, the question of "legal structure" begins and ends with the completion of a pre-printed form from the office supply store and the payment of a nominal filing fee to the Secretary of State.  The fact of the matter is that many business owners leave money on the table and unknowingly take significant risks by failing to select the appropriate business entity when they start out, or by forgetting to reexamine their choice at different stages in the companies development.

In order to make an educated decision regarding entity choice, the business owner must carefully examine the following issues:
  1. Tax considerations;
  2. Day-to-day operations;
  3. Growth Opportunities;
  4. Exposure to liability; and
  5. Exit strategy.
TAX CONSIDERATIONS.  Sole proprietorships, limited liability companies, S-Corporations and Partnerships are the so-called pass-through entities in which profit and loss is taken at a personal level for the owners.  Other entities are subject to different tax treatment.  I always recommend consulting with a CPA before choosing an entity.  The failure to match the type of business to the legal structure can result in significant (and often unnecessary) tax liability.

DAY-TO-DAY OPERATIONS.  Business owners are called upon to make countless decisions in the course of a typical day.  Vendor selection, the placement of orders, which contracts to sign or projects to undertake, hiring, promotion, demotion, firing, taking on an investor, liquidating or expanding - the list is endless.  Some of these decisions are ordinary.  Many decisions have long-term repercussions.  The question of who has the authority to make these decisions, therefore, is very important.  Legal structure, and the agreements through which the company are formed, determine the identity of the decision-makers as well as the procedures for ensuring that all necessary voices are heard on the issues that matter.

GROWTH OPPORTUNITIES.  Choice of entity can and should be influenced by the founder's vision of the company's growth.  If outside investment will be sought, corporate or LLC status are usually preferable to a general partnership or a sole proprietorship inasmuch as most investors  insist on shielding themselves from liability.  In addition, certain types of entities, for example an S Corporation, are statutorily prohibited from taking on a corporate shareholder.  Accordingly, the company's timeline and preferences for growth should play a large role in selection of the entity.

EXPOSURE TO LIABILITY.  Depending upon the type of business, limited liability companies and corporations are often vastly preferable to other structures because they insulate their owners from personal liability for acts of the entity.  An owner's personal assets (such as a house, cars, bank accounts, and personal property) are often directly at risk when business is being conducted through a sole proprietorship or in a partnership setting.  Protection from risk constitutes a fundamental basis for selecting a business structure.

EXIT STRATEGY.  This is one of the most important and most ignored business planning issue.  All good things must come to an end.  Whether the business owner is anticipating a fifty year career or a two year cash-out in the business, exit strategy must always be considered in business formation.  If one is looking to approach the investment community for a capital infusion, anticipates bank financing or hops to sell to employees or a third party at a later date, it is best to select a business structure and negotiate terms with co-owners most amenable to the particular scenario envisioned.

Finally, regardless of their current business entity, business owners can decide to change their structure at any point in the company's evolution.  It is, however, easier said than done, and such change is often accompanied by significant legal, accounting, and tax expenditures.  So, although change is possible, it is better (as in most things) to get it right the first time.  Getting it right involves considering all the above factors before choosing a business structure.

If you have any questions or concerns about any of the above, please contact a qualified business attorney in your area.  If you are in California and would like to explore any of these issues you can contact me at (951) 737-4040 or (415) 633-6702.  You can also reach me by email at The Out-House General Counsel.

No comments:

Post a Comment