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Business Startup Issues That May Find You – Even if You Don’t Go Looking For Them

TD02169In my practice, I have found that a majority of my clients who create significant wealth do so through ownership of a private business or a concentrated stock position in a publicly traded company.

What that means for you is that if you haven’t yet started a business or taken an ownership position in one, it’s probably only a matter of time until you will.

Among many others, reasons you might start (or end up owning part of) a business include:

  • You buy a vacation rental property
  • You start investing in multi-family or commercial real estate
  • Your start your own professional practice
  • You and some friends invest in a chain restaurant franchise
  • The large corporation where you work sells your division to you and a small group of co-workers
  • A merger requires you to “pursue other opportunities,” so you do, and start a competing, smaller business with colleagues
  • You are a co-founder of a startup
  • You are optimizing your college financial aid position

Businesses formed for these sorts of purposes often include limited liability companies, C-corporations, and S-corporations.

Choosing which business type is best for your purpose often involves mundane and subtle issues in several key areas, including ownership, governance, allocation of profits and losses, tax planning, exit planning, and paperwork.

The discussion provided here isn’t comprehensive. That said, a brief reconnaissance of the choice of business entity issues that are likely to come up during your career or in your estate plan is time well spent.

Ownership 

The business will have owners. For an LLC, these are called members, and for corporations, they’re called shareholders.

Unless you know you will be the only owner of your business over its entire life cycle, it may be wise to create the business with voting and nonvoting equity (membership interest or units in a LLC, and shares in a corporation).

With nonvoting units or shares, you can much more easily separate ownership and control of the business. This can be useful for admitting new owners, transferring equity to employees, and/or gifting ownership to family.

Decide how ownership of the business will be split among the owners before the business is started. (This is rather obvious, but clients sometimes defer this decision long after the start-up phase, and tax reporting problems and disputes among owners can result.)

Governance

Someone will have to control the business. A corporation has directors, who are elected by the shareholders. The directors elect officers, who manage the corporation’s business. A LLC may be managed by its members (owners), or by managers elected by the owners.

As above, unless you’re very confident you’ll be the only owner of a LLC during the LLC’s entire life, I think manager-managed LLCs create more flexibility. This is because a non-voting member will have no opportunity to act on behalf of the LLC, reducing any worries about “rogue” actions by minor owners of the LLC.

If a business will have more than one owner, think carefully about whether a supermajority requirement for action by shareholders (or members) and directors (or managers) makes sense. Supermajority requirements can incent consensus and protect minor owners (at best), or cause delay and deadlock (at worst).

Dividing Profits and Losses

The profits and losses produced by the business need to be allocated among the owners. The corporation and LLC statutes have default rules for pro rata allocation of profits and losses.

It’s possible to opt out of these default rules by creating different classes of stock in a corporation’s articles of incorporation, or different classes of membership interest in a LLC’s operating agreement. (Bear in mind, however, that a corporation with more than one class of stock cannot elect to be taxed as an S corporation.)

Income Tax Treatment

A LLC with only one owner (member) is a disregarded entity for income tax purposes, with the result that all of the LLC’s income tax attributes flow through to the personal income tax return of the sole member.

An LLC with more than one owner is typically taxed as a partnership. Income tax attributes will be allocated to the members in accordance with the operating agreement (or the statutory pro rata default rule), and the members will pay the resulting tax obligations. (This opportunity for “single level” income tax treatment is an attractive feature of LLCs.)

A C corporation is a separate income tax paying entity. Additionally, when the C corporation makes distributions to its shareholders, those distributions are typically taxed as dividend income to the shareholders. (This “double level” income tax treatment is a comparatively unattractive feature of C corporations.)

An S corporation offers “single level” income tax treatment for an eligible corporation that has made an election to be taxed as an S corporation. To be eligible for an S election, a corporation’s shareholders must be US citizens or green card holders, estates, or certain types of trusts. In addition, the corporation may not have more than 100 shareholders.

Exiting and Transferring the Business

Usually, third parties don’t want to buy non-controlling interests in private businesses. Nonetheless, it’s wise to give some thought to whom you want to be allowed (or disallowed) as an owner.

  • Should an owner who doesn’t work at least part-time in the business be required to sell his or her shares?
  • Should a divorced spouse of an owner be required to sell shares awarded to him or her in a divorce?
  • If one owner sells his or her shares to a third party, should the other owners have a “tag along” right to participate pro rata in the exit opportunity?
  • Conversely, if more than a certain percentage of ownership is sold to a third party that wants to buy all of the ownership, should shareholders be subject to “drag along” in a required exit?
  • Should co-owners have a reliable way to exit the business (at least in part) from time to time? (A pro rata annual tender offer is one way to provide for this.)
  • If an owner is disabled, should he or she be able to sell his or her ownership? Should he or she be required to do so?
  • If an owner dies, should his or her estate be able to sell the deceased owner’s shares? Should it be required to do so?
  • S corporation shareholders should be subject to restrictions preventing them from transferring shares in the S corporation to ineligible shareholders – which would cause the corporation to face “double level” taxation as a C corporation.

Many of these triggering events for a purchase or sale require valuation of ownership interests. To avoid heartache and/or litigation, a valuation formula or other appraisal approach should be provided for.

Paperwork

You’ll have to file articles of organization with the Secretary of State to start a LLC, or articles of incorporation to start a corporation. You should also have bylaws (for a corporation) or an operating agreement (for a LLC).

Buy-sell provisions dealing with exit and transfer issues raised above can be included in the LLC operating agreement, or a separate buy-sell agreement for the corporation (or LLC).

To preserve the creditor protection advantages of the business entity and comply with applicable laws, you should keep regular meetings of the minutes of shareholders or members, and (if applicable) directors or managers.

Which Type of Entity to Use?

In many instances, a manager-managed LLC may be a good option.

For a business that will produce losses in its early years, a C corporation is unlikely to be an optimal choice, because “double level” tax treatment will prevent those losses from flowing through to the personal income tax returns of the owners, where they might be put to much better use.

Beyond these general observations, issues of business entity choice are necessarily case-by-case and fact-intensive.

Before choosing your type of entity, a thorough evaluation of your current situation and future plans (and those of other owners) should be balanced against your tax situation and objectives, along with your tolerance for paperwork, annual reporting, administration, and compliance.

That said, with at least a quick sense of the issues you should be thinking about, planning appropriately when choice of business entity issues present themselves becomes a little easier.

Photo credit above: Boys Selling Kool-Aid in Tallahassee, 1965, Jim Rogers. State Archives of Florida, Florida Memory, http://floridamemory.com/items/show/272727

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