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What Kind of Company Should You Start?

By Maya Dollarhide

Mar. 23, 2017
Group of young entrepreneurs talking
Choosing the right legal entity for your business is important. (Photo credit): Gettyimages.com/Creative RF

Picking the right legal entity for your business can save you a lot of money.

When creating a new business, it’s important to closely consider how it will be legally formed, because its form will act as a roadmap—giving direction on taxes, potential investors, growth, and, ultimately, how to protect (personally and financially) the owners.

When Pepper Gallagher, a New York-licensed pediatric occupational therapist, started her business in 2009, she chose a “professional limited liability” company (PLLC). Initially, she planned to run a small, part-time and potentially home-based business, but she didn’t want to be a sole proprietor, which offers no legal protections.

“In my line of work, liability is always a concern, and that's why the business is under a name versus being in my name. If it was under my name, someone could come after any personal assets that I have, or try to undermine my professional credibility by suing me,” shared Gallagher, who recently moved her family and business to Maine.

Because she is a professional, Gallagher could not legally file for an LLC. Why? Because most states, New York included, require state-licensed professionals like doctors, lawyers, therapists, and architects to file as a PLLC, in order to receive the same benefits of an LLC.

Both offer protection of the owners’ personal assets, and it can also travel, if the owner moves to another state. “My current PLLC, which is now being changed over (utilizing the same Employer Identification Number to ensure credit and all other benefits follow) to Coastal Kids Occupational Therapy, PLLC., since we moved to the coast of Maine,” she said.

Gallagher is still shopping around for the right location but is relieved that her PLLC traveled with her with minimum fuss. The downside to her PLLC? Gallagher states, “paying quarterly taxes is never fun.” Otherwise, she is very happy with the entity she selected and said, “I wouldn’t do it any other way.”

Professionals, especially in the medical profession, will often band together to form a partnership, but not Gallagher. “I’ve seen firsthand what can happen in a business when two people have a falling out, and I didn’t want to risk that happening, either.”

Because there are pros and cons for each business form, it is important for entrepreneurs to consider their individual needs. For example, if you take two clothing designers, each running his or her own business, one may decide to legally form as an S corp, and the other an LLC.

“The advantages and disadvantages of using a particular entity type should be considered on a case-by-case basis,” said Michael Callier, a DWT De Novo attorney and legal process strategist, who works for Davis Wright Tremaine LLP in Seattle. “For example, an owner might use a different entity if he also plans to work as an employee of the business rather than act as a passive investor. Accordingly, a proper choice of entity analysis begins with determining the owner’s intended purpose for the business.”

According to Callier, entities are generally used to protect individuals from personal liability and to positively impact tax liability associated with the income that the entity produces. “All entities provide some measure of limited liability, although that protection is not absolute and can be pierced under certain circumstances, such as in cases of fraudulent behavior or other impropriety,” he shared.

Sole proprietorship

A sole proprietor is simply a freelancer person who owns and/or runs an unincorporated business.

Pros:

  • Easy to create, no required paperwork to file. If someone is a freelance photographer, for example, you are automatically a sole proprietor if you haven’t set yourself up as another entity.

Cons:

  • A sole proprietor can be held personally liable for any business-related obligation. This means, if someone sues your company, in effect, they are personally suing the owner and his or her personal assets are at risk.
  • Lack of continuity, and the business cannot be “sold,” meaning there is no financial gain in an exit strategy.

C corporation

The “C” in a C corporation refers to the subchapter C of the Internal Revenue Code (IRC), specifying that its profits are taxed separately from its owners. Most major U.S. companies file for taxes as C corporations. Not surprisingly, this type of entity is the most complex to set up and maintain. This is because a C corp requires that shareholders maintain corporate minutes and shareholder resolutions when making decisions subject to shareholder vote.

Pros:

  • The company is legally a separate entity from its owners.
  • The owners can sell stocks or shares of the company to raise capital funds.
  • Owners are not personally liable, if sued.

Cons:

  • It costs more to run the company. For example, C’s have to pay state and federal fees, plus the costs to retain needed lawyers and accountants.
  • An avalanche of paperwork—get ready to double down on signing and filing due to increased regulations and rules. Corporate bylaws, certificates of good standing, and articles of incorporation are just a few.

S corporation

A smaller corporation taxed under the subchapter S in the IRC. Why do it? It offers liability protection to the owner, and allows them to run business gains and losses through his or her personal tax returns.

Pros:

  • Fewer taxes to file. Owners file a single return for both the company and themselves.
  • Its existence is typically perpetual, making it easier to sell when the time comes. And owners can covert an S corp into a C corp, if they want to do in the future.

Cons:

  • Harder to raise capital for the business.
  • Shareholders in the company are limited to 100.

LLC /PLLC

These technically offer the same protections. The P in the PLLC stands for professional, and most states require a PLLC form for licensed professionals in lieu of an LLC.

Both forms are lower cost to set up than an S corp, and definitely less expensive and time consuming than a C corp. Something to remember: since many LLCs get seed money from debt equity rather than capital, it is important that LLCs and S corporation owners protect their assets. For example, if the owner has put in $22,000 and owes a creditor $24,000, most likely the owner will only be on the line for the investment if the company folds.

Pros:

  • Simple regulations and management requirements.
  • Can be run with one or multiple owners.

Cons:

  • As a member of an LLC, you cannot pay yourself wages.
  • Many investors can’t or won’t put money into an LLC.
  • Some states, including California and New York, require LLCs to pay a franchise or capital values tax.

The pros and cons of the various business forms can be complex to navigate, said Callier. Sorting out the complexities of each entity can be intimidating at first but with the right guidance from a legal professional and/or an experienced accountant, they don’t have to be.

Not being prepared or advised can result in big problems, as Bryan Clayton, CEO of GreenPal, found out in 2012, when he formed what he calls the “Uber for lawn care” business. “We made a huge mistake when forming our company initially that ultimately cost us $20,000 in legal fees to correct,” he shared.

“When we formed the company in 2012, we did it simply as a Tennessee LLC. Quick and easy and cheap; we figured it was the best way to get our company up and rolling. However we did not realize that an LLC is a no-go for institutional investors.” Why? “Because any outside investors, such as private equity, angel investors, or venture capitalists will insist that your company be a Delaware C corp,” he reported. “Delaware has an abundance of case law that is favorable to corporate structure, investors, and board members, and is generally accepted as the standard by the investor community.”

When Clayton worked to raise capital last summer, he sat down with potential investors and, as he explained, “nearly got laughed out of the room because the LLC was listed in Tennessee.” Clayton ended up paying a specialist attorney to dissolve the old LLC and “carefully assign everything to the new, proper entity,” he shared. “We are now a C corporation listed in Delaware. My advice to anyone forming their company is to carefully consider going with a Delaware C corp if they plan on raising outside investors capital.”

When it comes time to start a business, most entrepreneurs agree it is essential to do the research and speak to professionals. “Take it slow. Talk to other business owners, talk to an accountant and a lawyer. It took me a few years to figure out what kind of business form I needed to protect my assets and best support my clients,” shared Gallagher.

And remember: whatever business form is chosen, ultimately, there should always be an exit plan, too. “Make sure you are prepared when it comes time to sell,” advised Gallagher. “Make sure you have all of your records ready to go, for an easy transfer of sale. Personally, I think a PLLC makes it easier to sell than if I had incorporated.”

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