Choice of Entity: The Fundamentals to The First Step in Starting a Business
So you’ve decided to start the business of your dreams. You have the perfect idea, the time, the experience, the financing and, most of all, the excitement and passion to build the business that is all your own, facilitating the way of life for which you have always hoped. Soon enough you will be steeped in cash flow statements, purchase orders, marketing and payroll, but before the day-to-day decision making begins, one of your most important fundamental steps is organizing the business entity that will match the unique nature of YOUR venture.
In addition to meeting the future needs of your business, the choice of entity process can be a very informative step in the substantive development of your overall business plan. You should begin with a simple set of questions to identify each of the key categories comprising your venture that may look something like: (1) What is the nature of your business? (2) Who will be the key decision-makers and investors? And will these roles overlap? (3) How will taxes affect your overall financial picture? (4) Is the nature of your business such that liability protection is an important consideration? How and to what extent? (5) How will decisions be made and which decisions will be made by whom? Each of these decisions (in addition to the myriad other entity-specific questions you should ask yourself), in light of the potential options for formation, drive to your ultimate goal of determining which entity type most efficiently meets each of your business’ particular needs.
A myriad of possible entity types and iterations exist (as well as some state-specific classifications), but generally the options we typically consider and discuss with our clients are Limited Partnerships (LP), Limited Liability Companies (LLC), or Corporations. It is also important to consider whether it may make sense to operate as a sole proprietorship (if an individual) or general partnership (if 2 or more people), which are essentially the default classifications for conducting on-going business ventures. Each of these entity types has a very specific collection of unique benefits and downsides. In very general terms, your two main considerations (from a legal perspective) will be protection of your personal assets against entity level liability and taxation. LPs, LLCs and Corporations all offer levels of protection of your personal assets against entity level liability, with LLCs and Corporations providing the strongest shields (LPs only offer this protection for the passive limited partners). General Partnerships and sole proprietorships offer no protection in this regard. With respect to taxation, LPs, LLCs and General Partnerships offer the advantage of the option of electing pass-through tax treatment, and avoiding the dual level taxation (at both the entity and shareholder level) associated with corporations.
A number of additional differing characteristics bearing on your ultimate decision will be necessary for your consideration, but a comprehensive discussion of those differences is for another article. The next step in the process will be formation with the appropriate state and federal authorities (typically the secretary of state and the IRS). Finally, regardless of the final decision on your particular entity type, if your entity will involve more individuals or entities that just yourself, it is our strong recommendation that you formalize the agreement of those parties on each of the key areas related to its operation into a written document. While all states have a set of default rules governing some of the major areas affecting entity operations for each of the types described above, your entity is unique and should be organized accordingly to avoid issues down the road. A list of a few of the major items you will want to consider including in your agreement are: Nature of the Business, Assignment and Definition of Decision-Making, process and timing of Distributions, Profit and Loss Allocation, the Process for Addition, Removal or Withdrawal by Partners, Buyout Provisions, if applicable, Initial Capital and Additional Capital Calls and the requirements or penalties for failure.
Hopefully this article has given you some valuable considerations in forming your entity. It is important to remember that your entity is unique and so your decisions regarding its formation and planning for operation must be very carefully considered. Please contact us if we can help you in your quest or explain some of the topics address above.