When we started this series – The American Dream – we had no idea what was about to emerge in our world: COVID-19 . Economies have been shattered, social distancing is now the norm, and many small businesses have had to temporarily shut down (with many closing their doors forever). This column is written to help small businesses succeed and one of the best ways to succeed is by learning from the mistakes of others. Why do some businesses fail when others prosper? I think we will all agree that it is usually a combination of many things: product, location, economy, working capital management, owner(s), relationships, etc. Businesses also fail because they have a corporate structure that is far too simple or complex from what is needed.
Thanks to the world of Google, many entrepreneurs are able to create their own entities before fully understanding what is needed. It is my belief that this is usually the 2nd biggest mistake an entrepreneur can make during the business’s infancy. The 1st mistake is getting the advice of others on what their entity should be. In this case, the term “others” refers to those that are not trained in this area (i.e. non-CPA, non-attorney, etc.)
When we meet with a new client who is in start-up mode, the first two questions we usually ask are:
- “Why did you choose that corporate entity?”
Based on the entity chosen;
- “What tax structure did you choose?”
The two responses we get most of the time are:
- “That is what my buddy told me to use”
- “Say what?”
While I say this tongue in cheek, my point is not to skimp on the front end just to save a few dollars. It’ll cost a lot more and be much more painful in the long run.
Note: There is an old saying – “A picture paints a thousand words” and when making a decision like this, I find that the best starting point is to compare and contrast using matrixes. You will see this format used throughout this article for simply those reasons.
Overview of the basic entity formations
Operation & Control
Although liability and tax implications are important, the legal structure of your business will dictate certain aspects of how you operate in the years to come.
If you plan to raise capital through equity investments, your legal structure will be especially important for defining the role that investors will have in governance and the distribution of profits.
Continuity & Transferability
Even though you’re just starting out, you should begin with the end in mind. What will happen to your business when you retire or die? Each legal structure provides a different answer.
For many business owners, liability is a serious concern. Although a CPA can provide you with detailed advice on the tax implications of various legal structures and general advice on liability protection, you should direct any specific liability questions to an attorney who specializes in corporate law. Additional liability protection is available to any business structure by purchasing insurance.
Compensation & Payroll
Did you know that the structure of your company will also dictate how you are paid and who is responsible for the tax bill? Employees are paid a salary, and federal, state, Social Security, and Medicare taxes are withheld. The employer matches the Social Security and Medicare taxes withheld for each employee. An individual who is self-employed pays federal, state, Social Security, and Medicare taxes on net self-employment income.
Which Legal Status is Right for Your Business?
The 1st important consideration when starting your business is determining the best legal organizational structure. Why? Because it will affect operating efficiency, transferability, control, the way you report income, the taxes you pay, and your personal liability. Knowing the Pros and Cons of each is crucial when making this decision.
The choices can be complicated — and errors can be costly. Time spent in the beginning can save you a lot of money down the road.
Your 2nd most important decision will be determining how the legal entity will be taxed. To make this more difficult, federal and state tax structures are not always the same as the legal entity chosen. For example, if you choose your legal entity structure to be an LLC, you have to also choose what your tax structure will be – Partnership, S-Corporation, etc. However, if you choose your legal entity to be a Partnership, your tax structure automatically becomes a Partnership because that is your only option. What’s more, current tax laws make it difficult to change your legal structure after you begin operating. Making the right decision before you open for business is very important.
LCPA can help you decide what type of entity and structure is best for your particular situation and type of business. There are situations where forming multiple entities may better accomplish your objectives. For example, a family business may want to separate its land, buildings,or other fixed assets from the operating business and lease them back to the operating business to have a different equity ownership by family members who may not be active in the business’s day-to-day operations.
You should evaluate the decision to choose an entity in which the tax attributes pass through to the owners in light of the other income or losses that you and other owners have and the extent to which you will have a tax basis in the entity. Other considerations include your objectives for an exit strategy or transitioning the business ownership on to the next generation.
Making the Decision
Having reviewed the above, the question still remains: How do you decide which legal structure is best for you and avoid potential problems? Our answer – consult with Lesemann CPAs. We can help you make well-informed choices, explain how business structure affects your organization’s bottom line, and assist you in filing the necessary paperwork to start your business.