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For New Businesses, First Step is to Consider Choice of Entity

December 2014
James H. Gallagher, II
Delaware Business Times

In forming a business, entrepreneurs should use an entity appropriate for the management needs and tax and estate planning desires unique to the business and its owners. Although forming an entity such as a corporation, partnership, or limited liability company (LLC) requires some time and thought at startup, the advantages of using the best entity will be evident long thereafter. 

Traditionally, entrepreneurs would choose a corporation – which provided maximum protection from business liabilities, but has its income taxed both to the corporation and again to stockholders upon distribution – or a partnership – with its “pass-through” income taxed only once, but without limitation of liability for general partners active in the business.  Federal law developed the “subchapter S” corporation, and Delaware (early among states) adopted the LLC form, two developments that melded the best aspects of both – the corporation’s limitation of liability and the partnership’s single level of taxation. 

Simplicity and flexibility are also important considerations.  Corporations involve more formalities in operation, though minimum requirements are not onerous.  LLC owners are permitted to implement governing rules tailored to their skills and wishes. 

The original playbook for entity formation may seem rote; however, changing tax and business laws have turned conventional wisdom somewhat on its head.  It is important for small business owners to be aware of common misconceptions, such as the following:

“I need to form an LLC.”  No other entity can boast the limitation of owner liability, pass-through taxation structure, relative lack of management formalities, flexibility of operation, and simplicity of management and reporting that an LLC allows.  However, the LLC is not a one-size-fits-all solution.  Tax considerations – self-employment taxes, the ongoing reduction of rates on most dividends, and the new Medicare surtaxes – may make the LLC a suboptimal option. 

Operating the business through a new entity will protect my personal assets.”  Limitation of liability is fundamental to business formation, but owners preserve this benefit only by following requisite formalities.  Courts may refuse to enforce the entity’s liability shell when it is not operated distinctly from the personal interests of the owners – i.e., with business assets alone in the entity’s accounts, and business and personal owner expenses never commingled.  Corporations must hold annual stockholder meetings and conduct business through directors and officers.  Businesses should not be undercapitalized, or hold inadequate insurance for known or obvious risks. 

“I need a corporation to allow for stock options.”  Stock/equity compensation, though an attractive idea, can often yield underwhelming results to owners – who will have to manage minority owners – and employees – who may find that the in-pocket benefits of equity compensation are slow to materialize.  Alternate bonus structures may be more suitable, plus owners may find it preferable to separate succession planning and compensation structuring from one another. 

Because laws governing state entity management and federal taxation are constantly in flux, individuals starting a new business will find it beneficial to consult legal and accounting professionals to ensure that their business is formed in a manner that satisfies their management and financial goals.