In our continuing series about starting a new business, we will now focus on your entity structure.
Your entrepreneurial vision and participation in the business world requires a business entity. The business must be separate and apart from you as an individual. This concept is often difficult to understand and sometimes even more difficult to implement. Financial accounts, contracts, loans and other obligations must be in the name of and on behalf of the business entity. The entrepreneur should avoid, to the maximum extent possible, signing personal guarantees, contracts in her own name or assume personal obligations. This is not always easy to do in a start-up situation, but often you may be able to limit the personal guarantees or personal obligations as to amount, limit the time or the scope of the personal obligation. There should be a clear line of demarcation between your personal affairs and finances and those of your business.
My choice to get started in Arizona is either a limited liability company (”LLC”) or a Sub-Chapter S Corporation (“S Corp”). You should avoid sole proprietorships, general and limited partnerships, and business trusts.
An LLC is a business structure that combines the benefits of limited liability of a corporation with tax benefits as a result of a pass-through taxation of income and losses. An LLC has characteristics of both a corporation and a partnership and, if there is only one member, a sole proprietorship. However, it is neither a corporation, a partnership, nor sole proprietorship, but a distinct legal entity that can sue and be sued and carry on business.
An S Corp is a closely-held corporation that is to be taxed under Sub-Chapter S of Chapter 1 under IRS Code. Generally, S Corps do not pay any Federal income tax because the company’s income and losses are divided among and passed through to the individual shareholders, who in turn report these on their own tax returns. Both an LLC and a traditional corporation are eligible entities to be treated as S Corps for tax purposes by making an election and filing IRS Form 2553.
There are several important business considerations favoring either an LLC or an S Corp:
- These structures give the business an entity legal status in dealing with the business world. Contracts, agreements and obligations are incurred in the name of the business entity, which in many ways limit the personal liability or obligations of the entrepreneur. These entities are a separate person for legal and business purposes.
- Both an LLC and an S Corp provide a vehicle for capital infusion by others. There will always be a need for additional resources for the start-up business. The entrepreneur must be careful to temper her exuberance and not to over extend by incurring obligations through credit cards, bank loans, personal obligations or loans from third parties.
- In order to secure capital, you may be required to give up a portion of your equity in the business. This will be one of the biggest decisions you make because now you have added other parties to whom you will be responsible. The caveat is to always remain the controlling person, and to be guarded and careful about giving up too much control.
- If substantial capital infusion is required to grow your company, you will necessarily have to deal with the complexities of state and Federal securities laws. Specialized and technically-qualified attorneys and CPAs are required to deal with the complexities of securities law.
- There are also tax benefits to both an LLC and an S Corp. Both generally avoid double taxation. Both LLCs and S Corps can deduct pre-business expenses that are incurred in the ordinary course of business. The tax benefits should be discussed with your CPA.
The next installment will review the pros and cons of both of these entities in order to aid your decision-making and your entity structure choice.
Lat J. Celmins
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.