Today we are addressing the age-old question, what type of entity should I be? I know you are thinking “wait a minute I could close my eyes and do a google search with almost any combination of random words and at least one of the results will answer this question.” Well, you are correct. The search “choice of entity” results in over one million hits. Most of the choice of entity articles, however, focus on what is the best choice for the first day of starting a business. The LLC is the current popular choice. Its ease of formation, limited liability, streamline operation (no need for those pesky formal corporate documents) lends itself well to new owners starting a business. Focusing solely on your needs starting a business is too simplistic especially given the impact your choice of entity has on your business’ endgame.
Succession Planning. You Built Your Business On Your Terms. Exit It On Your Terms Too.
Business succession planning is the process of protecting the integrity of a business. Often the major source of wealth for owners of a business is the business itself. Unfortunately, many owners do not know how they will extract this wealth once they’re ready to exit. Generally, this is not equal to the sum of the moving parts. In fact, the value of a business is a function of many factors. These include the value of the widget produced, the value of the group producing the widget, the ability to replicate the production of the widget without the prior owner. Thinking about your exit strategy from the beginning allows you to set up the business in a way that facilities your long-term goals.
Sole Proprietorship: When Easy is Too Easy.
The choice of entity when starting a business often dictates how easily the value of the business can be extracted for owners and their families and their employees. The granddaddy of the group is the sole proprietorship. The ease of formation is the selling point for this often-used entity but the lack of limited liability is initially the stumbling block for using this dinosaur. From a succession planning viewpoint, the sole proprietorship is a dud. The death or disability of the individual ends the business. There is no ability to transfer ownership or realize the underlying value of the business. The best feature about choosing the sole proprietorship when starting a business is the ability to easily change to any other entity type when you’re ready.
C Corps: High Growth Darling. Main Street Headache.
Pros. When starting a business, the best entity to choose in order to maximize the value at end, is one that has an existence beyond the life of its owner. The C corporation fills the bill on perpetuity. Its existence is separate from the owners and thus its underlying value is less affected by death or disability of the owner or in fighting by a family-ownership group. The perpetual existence of the corporate entity also makes it the hands down favorite for owners who are positioning to capitalize (no pun intended!) on outside funding. Angel investors, venture capitalists and institutional (retirement) investors tend to focus their investments with the more easily divestible stock issued by corporations.
Cons. The C corporation is the well-established giant of the business entities. It is often avoided because of its expensive formation and strict formalities in operations. However, unless you’re planning on taking on outside funding (i.e. from angel investors or venture capitalists), this giant falls even harder on its face in succession planning as a result of the high cost of double taxation when the entity is sold. Tax free reorganizations help reduce the impact of the corporate tax burden, but the inability to convert to other more flexible and less costly entity structures make this giant very small in the choice of entity arena.
S Corps: Two Sides of a Coin.
Pros. The S corporation is the smaller, faster, younger sibling of the C corporation. The S corporation improves on the C corporation by avoiding the double taxation burden. It is an attractive cousin of the partnership/limited liability company with the financial results of the S corporation “passed-thru” to its owners. The ability to differentiate between shareholder w-2 wages and capital appreciation distributions has catapulted the S corporation’s desirability. You can read more about being an S corporation here.
Cons. The high cost of formation and the strict operating formalities that hallmark the C corporation are an inherited factor on the corporation gene. The single class of stock requirement does hinder using the S corporation for succession planning in instances where some of the next generation are in the business and some are not. The S corporation is also not a viable entity for owners who want to attract institutional investors.
Limited Liability Companies: Flexibility Is the Name of the Game.
Pros. The limited liability company offers the best of all worlds in so far as choice of entity. The LLC is agile enough to allow changes in structure, usually without a heavy tax burden. It has the luxury of affording its owners limited liability, ease of formation and operating informalities. Overall the LLC is a great vehicle for the many faces of succession planning including, the sale of the entity (no double taxation), the division of the entity into separate operating businesses for different product lines, the modification of the equity structure to accommodate those in the next generation working within the business and those holding an investment interest and importantly a flexible structure for a stream of income should the owner become incapacitated.
Cons. Like its fraternal twin, the partnership, there are the complications from self-employment tax on what is arguably earnings from capitalization and even more frustrating there are the headaches caused by the ever-looming capital account maintenance regulations. Starting a business as an LLC can also be less attractive to institutional investors. These funds do not want to hold the relative illiquid membership interest.
Which Entity Is Right For You?
Overall, the choice of entity when starting a business depends on many factors that are particular to your business and vision. Many main street businesses can function seamlessly as LLCs and many high-growth businesses need C corporation structure to attract investment – but that doesn’t mean those forms are great fits for all. The moral of the story is that regardless of what Google (or this article) says, you should think through where you want your business to go and how you want to exit when you’re trying to determine which structure works best. And when you’re ready to talk through the options, we’re here to help you define your goals and sort through the pros and cons of each to find the right choice of entity for YOU!
This article is for informational purposes only and does not constitute legal advice nor does it create an attorney-client relationship. Always consult appropriate legal counsel for specific questions related to your business. Some states may consider this attorney advertising.
Terri Amernick is an attorney with Linden Legal Strategies PLLC, a Richmond, Virginia-based law firm focusing on small business law and development. To learn more about how Terri and Linden Legal Strategies can help you start, grow and protect your business, or to schedule an initial consultation, contact Terri.