planning stand in the way of making good business decisions. Given that, it is hard to play down the importance of a structure that has saved tens of millions of dollars over time.

The successful business determines what is important and focuses on it. If employee ownership is important, it is even more important to be structured in a way that is understandable and where rewards can be realized. Too often, incentive programs come with enough tax complexity that the benefits are overlooked. When receiving an annual salary, taxes are due at ordinary rates. Employees get used to this and understand it. Other, more tax-efficient, forms of compensation are, by design and law, more complex. But it is important for entrepreneurs to keep sight of the overall goals. It is better to give someone a dollar and have him or her keep 65 cents and appreciate it than it is to give that person a dollar where the individual gets to keep 80 cents but doesn’t quite understand.

Choosing the legal form under which a business will operate used to be one of the more complex decisions an entrepreneur had to make when organizing a new business or purchasing an existing business. Today, however, due to tax- and corporate-law changes that began in the early 1990s and accelerated through the decade and into the first years of the twenty-first century, new businesses are increasingly organized as limited liability companies (LLCs). This chapter outlines various reasons for organizing and operating a business in a particular way. The information is not exhaustive; indeed, whole books have been written on the subject.

While many entrepreneurs consider the LLC the optimal choice, there are still reasons to choose to organize a business in a different way. There are often considerations that go beyond the simplicity of the LLC. The question of legal form is one that should be studied carefully by an entrepreneur or executive contemplating a change in corporate organization, working in close consultation with lawyers and tax accountants.

MAJOR VARIABLES The four major variables an entrepreneur or executive must deal with when choosing the legal form of a business are:

1. Liability

2. Control

3. Ease of bringing in new investors

4. Taxes

In general, all businesses are organized as sole proprietorships, partnerships, or corporations. There are variations possible within each of these designations. All options should be evaluated. To assist in the examination of the various legal forms, the entrepreneur or executive must consider the following issues:

Will the entrepreneur be the sole owner? If not, how many other people—either operators or passive investors—will have an ownership interest? How much control will each

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owner have? In what manner will the risks and rewards of the business be shared? Is it expected that people will be able to buy and sell their ownership interests freely or with great restrictions?

How important is it for all owners to limit personal liability for debts of or claims against the business?

Which form of business organization affords the most advantageous tax treatment for both the business and the individual owner(s)?

What legal form is the simplest and least expensive, both to establish and to maintain?

What are the business’s long-term plans?

Sometimes, the answers to these questions conflict with one another. At this point, professional assistance by lawyers and accountants can help sort out the issues. The remainder of this chapter examines the four major variables and then considers various legal forms against each one.

LIABILITY We live in a litigious society. While insurance is the primary vehicle by which we protect ourselves against unanticipated claims and damages, the form of a business can afford a secondary line of defense against potential losses of material amounts of net worth. Financing arrangements might create a situation wherein a lender may want an entrepreneur to put personal assets on the line, but there is no reason to expose personal assets to claims in the event of actions beyond the owner’s control, such as mishaps on business property or otherwise related to the business. For these reasons, many entrepreneurs want to adopt a business form that limits their personal liability.

Various state laws, including the laws of operating in a profession such as medicine, law, or architecture, include clauses that limit the ability to totally shield oneself from personal liability. However, for a consumer-driven business or any other business, it is important to consider liability protection in the business plan.

A sole proprietorship does not offer the protections that other forms of business organizations offer. This is the cost of the simplicity in operations and structure that are the primary benefits of the sole proprietorship. Legal liability for defective products, accidents, credit defaults, and other types of claims fall directly on the single owner. While insurance can sometimes protect against these risks, and personal asset-protection planning can offer some sophisticated alternatives for protection, a sole proprietorship has a high level of personal risk. Therefore, many businesses, even if a sole proprietorship is appropriate for a host of other reasons, choose to organize as a separate legal entity.

Similarly, a general partnership also involves a high level of personal exposure to claims. While a general partner cannot be personally sued for the actions of his partners, the risks of the business are shared by all the partners. A business failure can cause a claim on personal assets beyond what is generated from, or initially invested in, the business.

Ford, B. R., Bornstein, J. M., & Pruitt, P. T. (2007). The ernst and young business plan guide. John Wiley & Sons, Incorporated. Created from capella on 2024-10-14 00:22:02.

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Given these risks, many businesses initially adopt a structure that offers protection against risk. Again, the primary vehicle for protecting against most forms of risk is insurance, but organizing a business in a way to insulate personal assets from claims resulting from the business should be a primary consideration in the decision concerning what form of business to utilize.

While limited partnerships are sometimes used to organize new businesses, the ability of this form of business organization to protect the founder from risk is somewhat limited. A limited partnership offers a way for an entrepreneur to raise money from outside investors, and provides these investors an investment vehicle that insulates them from risk, potentially offers some tax benefits, and minimizes their role in the business so as to not dilute control. However, every limited partnership needs a general partner; therefore, someone can potentially be at risk for the claims against the business. This can be mitigated by creating a corporate entity to serve as the general partner. Such a creation is an example of how certain planning devices offer solutions but have an offsetting cost in increased complexity in running the business and adhering to corporate formalities.

A corporation offers a higher level of risk protection. In general, absent special situations, the assets and liabilities of the corporation are separate from the owners. While the owner’s entire investment is at risk, personal assets cannot be attached to pay the claims of the business. Corporations, as we discuss later, come in several different varieties, each offering somewhat different tax and other characteristics.

As the introduction to this chapter indicated, a relatively new vehicle is the limited liability company (LLC). These devices, formed according to state corporate law, offer protection from liability and a great deal of flexibility around many other issues such as taxation, ease of entry and exit, and so on. For this reason, many new businesses, whether start-up ventures owned by entrepreneurs or new divisions of major corporations, are organized as LLCs. The vehicle can operate with one or many owners and can be relatively straightforward to operate. As with any choice of entity for business reasons, however, it is important to operate according to the form you choose. Operating as an LLC has some hurdles to be cleared in order to avail yourself of the benefits it offers.

CONTROL Another crucial decision is the issue of who will control a new business and how that control will be sustained. If you are the only person with invested capital in the business and the only person operating the business, the issue of control is relatively moot. However, if you need to raise money from other investors, or if you have several employees, the issue of control becomes much more important. This is an issue for all businesses; the takeover battles and proxy fights that began in the 1980s and continue to this day are an indication of how important the issue of control is to all companies.

Control can be gained through legal means by operation of law or by agreement. Certain types of entities have implied positions concerning control.

For instance, by definition, a limited partner in a partnership typically has little or no input into

Ford, B. R., Bornstein, J. M., & Pruitt, P. T. (2007). The ernst and young business plan guide. John Wiley & Sons, Incorporated. Created from capella on 2024-10-14 00:22:02.

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operations, although a limited partnership agreement can grant limited partners some say in the operations.

A corporation is run by its officers and directors; the status of shareholders allows them to participate in the election of the board of directors, but does not offer any special operating rights or control other than the votes their shares represent. The ability to control the voting of a majority of the shares usually implies control over the corporate entity, although it is not uncommon for shareholder agreements to offer some concessions. In privately held companies, it is common to offer a minority investor some control over the selection of one or two board members, even though absent an agreement the entire board could be elected by the majority shareholder. An investment agreement can provide certain triggers, upon the occurrence of things good or bad, that shift the control between the parties.

A general partnership operates according to a partnership agreement. These documents can cover a host of legal and tax issues as well as simple issues such as division of duties and operating rights and responsibilities.

Obviously, a sole proprietor does not face the same issues of control as an owner in a more complex business organization. However, as a business grows and hires employees, it is important to have an organizational structure in place with defined titles and, more importantly, rights and responsibilities. A sole proprietor will be responsible for the actions of his or her employees, and therefore their duties must be clearly defined in employee manuals, training devices, or similar items. Even though a sole owner legally has control, to the outside world the people they deal with in your organization who appear to operate with authority have an implied level of control. It is easier to give guidance about what the company’s policies are in advance than to try to argue that employees did not have the authority to make certain decisions later.

A limited liability company is run by a board of managers. These are typically identified in the LLC’s initial operating agreement. Again, certain agreements between the members may result in representation on this board in ways that are disproportionate to ownership.

Frequently, lenders want some opportunity to influence management or control. This can be accomplished through loan agreements that provide for representation on boards or management committees and in other ways. Loan agreements can be written with triggers that cause certain things to happen or give the lender certain rights if certain operating goals are not met.

EASE OF ADMITTING NEW INVESTORS Growth and access to capital is an essential ingredient for any business’s success. A business started by two people developing an idea in a garage could be initially funded by the owners, but at some time there will come a need to find new money and admit new investors. This event could occur several times during a company’s life. Venture capital funding is typically not a one-time event. There are specialized funds that typically invest in businesses at different stages of their growth cycle. And, even prior to the ability to access any venture capital, a

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business might raise money from friends and family or angel investors.

While each funding event is a major transaction and creates a need for specialized legal, tax, and financial advice, the initial choice of a business form can affect the ability to raise money in the future or minimize some of the collateral effects of financial transactions on existing shareholders.

A corporation’s ability to raise money by issuing more stock is limited by its bylaws and articles of incorporation. A corporation has to initially make a determination of how many shares of common stock it is authorized to issue. This is a seemingly simple decision, and intuitively you might say, “Why not make it as high as possible?” However, many companies have been surprised by the Delaware Franchise Tax, which imposes a tax that can be calculated by the number of authorized shares. In our practice, we have seen companies take steps, prior to initial public offerings (IPOs), to increase the number of authorized shares of stock. Then, for one reason or another, the IPO is postponed and the company is faced with a much higher Delaware Franchise Tax based on this new number of authorized shares.

In the corporate form a company can issue new shares of stock to investors without observing a lot of formalities, so the incremental funding is fairly simple. Once that business is publicly traded and subject to the oversight of the Securities and Exchange Commission (SEC), there might be some requirements to file certain financial data with the SEC prior to issuing those shares, but in general, new investors can be admitted to a corporation without affecting the existing shareholders or involving them in the process. In a smaller business, organized in corporate form, shareholders’ agreements and voting-trust agreements might need to be revised as part of this process.

A partnership structure also creates the need for additional documentation at the time of admitting a new investor. Again, these issues can be addressed in the initial partnership agreement, which can cover many issues such as valuation methodology, antidilution rights of the current owners, and so on. To be admitted to a partnership, the new investor needs to do more than just write a check. The new investor needs to review and sign the partnership agreement to signify becoming a member of the partnership. Certain venture funds or institutional investors have their own issues that might prevent them from investing in partnerships. For instance, a pension-fund investor might need to be concerned with certain tax consequences of directly owning interests in an active business. Certain mutual funds or venture firms also want to invest only in corporations, so their tax affairs are not affected by the tax affairs of the companies in which they invest.

A sole proprietorship by definition won’t have outside equity investors. To raise equity money, the entrepreneur gives up some equity in the ownership; therefore, a sole proprietorship will automatically evolve into a multiowner business operating in a different format.

LLCs operate similarly to partnerships with respect to raising money from new investors. The operating agreement indicates how new investors can be admitted and typically covers many of the tax effects of that transaction. There are no preset limits from a legal perspective other than the terms of the operating agreement. A major financial transaction frequently requires the

Ford, B. R., Bornstein, J. M., & Pruitt, P. T. (2007). The ernst and young business plan guide. John Wiley & Sons, Incorporated. Created from capella on 2024-10-14 00:22:02.

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rewriting and readopting of a new operating agreement, which all parties must sign.

When evaluating the ease of admitting a new investor, consideration must also be given to the effect such a transaction has on existing investors. From a tax perspective, there can be many different effects or none at all. From a manangement and control perspective, teaming with new people involves decisions to be made:

Are the new investors merely financial investors, or will they become part operators of the business?

If they are financial investors, such as private equity or venture firms, do they bring any special skills unique to the industry, and how will they bring those skills to the company’s operation?

Having new investors with their own votes and views obviously affects the level of control an entrepreneur continues to have. These are all terms to be worked out, and many are as important or more important to the company’s long-term success than the financial terms of the deal. Think about it. Would you give up a 10 percent higher valuation of your business to maintain a majority vote and control? What would you want the impact to be of missing a sales growth goal by 10 percent? Would you want that to dilute your ability to run the business and cause you to answer to others? These are the difficult nonfinancial questions an entrepreneur faces when raising new money.

TAXES Justice Oliver Wendell Holmes observed that “taxes are the price we pay for a civilized society.” These words are carved into the granite above the doors to the headquarters of the Internal Revenue Service in Washington, D.C. While this is no doubt a true statement, other noted justices have made it abundantly clear that no taxpayer has any duty to pay more taxes than legally required.

Legions of accountants and lawyers are available to help entrepreneurs fulfill their tax obligations, but not to pay any more than is legally required. The choice of business form has a significant impact on the tax obligations associated with starting, owning, operating, and disposing of a business.

Tax choices and tax planning are complicated affairs. The tax law is constantly in a state of flux due to activity in Congress, the Internal Revenue Service, the states, and the courts. There are multiple tax jurisdictions—federal, state, and local. Different tax jurisdictions rely on different tax structures to fund their budgetary needs.

For instance, personal income taxes are the main revenue source of the federal government, while real estate taxes are the main revenue source for most school districts and municipalities. Some states rely on sales and use taxes, while others rely on income taxes to fund their budgets. However, while income taxes are the main source of federal revenue today, there have been discussions in Congress about switching to a consumption-based tax.

Finally, tax legislation is not always written to answer tax issues; the tax code is often used to

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promote or discourage behavior. When Congress feels it is important to promote retirement savings, it does so by offering tax incentives for retirement accounts. When a state government wants to attempt to influence smoking, it does so by imposing taxes on cigarettes. So sometimes the reason a tax law exists is to address an issue other than raising revenue for the government. These factors make thinking about taxes very complicated.

When evaluating tax considerations, there are two distinct tax events to focus on. There are the ongoing taxes imposed on the profitable operation of the business (or the ability to deduct the losses from unprofitable operation) as well as the “exit” or transactional taxes imposed on some business events such as a sale or IPO. Frequently, the exit taxes are far more significant than the annual operating taxes incurred during a business’s start-up phase.

The United States tax system operates on a system of double taxation of corporate profits, such that the earnings of a corporation are taxed, and then the shareholders are taxed on dividends received or gains on the sales of their investments. This double taxation is not as common in other parts of the world economy, such as European countries. The reduced tax rates on dividends and capital gains have started to reduce the impact of double taxation, but have not eliminated the issue. A sole proprietorship offers a single level of tax, which is a far more preferable situation. Other business forms, such as partnerships, LLCs, and S corporations, also offer some or all of this single-level-of-taxation benefit.

Sole Proprietorships A sole proprietor has the simplest tax structure. Income or loss from the business is reported on a schedule attached to the 1040 individual tax return. This schedule is known as Schedule C. Sole proprietors are required to pay self-employment tax on their business earnings. Self- employment tax is the equivalent of Social Security and Medicare taxes paid by an employee and the employer. A sole proprietor pays both shares of the tax as part of his or her annual federal income tax liability by reporting self-employment income on Schedule SE of Form 1040.

A sole proprietor does not pay Social Security taxes on compensation paid to spouses or minor children who work for the business. This technique can be used for planning purposes to reduce self-employment taxes and can provide other benefits such as enabling spouses and children to fund individual retirement accounts (IRAs) and the like. In addition, they pay no unemployment tax for the owner, unlike other legal forms in which unemployment taxes are paid for owner/employees.

Over the years, through various amendments of the tax law, Congress has attempted to level the playing field between the tax effects of being an employee and being self-employed. The biggest difference was always that a self-employed person was not able to deduct health insurance costs unless they exceeded, with other medical expenses, a specified percentage of adjusted gross income (currently 7.5 percent). Employees generally received health insurance benefits as a tax-free perquisite from their employers, and if copayment of premiums was required, the payment was usually 100 percent deductible by virtue of something known as a cafeteria plan. Today, a self-employed person can fully deduct health insurance premiums

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without regard to other medical expenses, and the deduction is available even to taxpayers who don’t otherwise itemize their deductions.

Limited Liability Companies Tax and legal reform during the 1990s created a new entity that offers the liability protection benefits of a corporation combined with the flexibility and single-level-of-tax benefits offered by sole proprietorships. A limited liability company, or LLC, is a corporation organized under state law that can be treated in several different ways for tax purposes. As a corporation, it provides its owners with full-scale protection against liabilities (subject to other rules, such as the rules governing professional service corporations with regard to malpractice and negligence claims). For tax purposes, the LLC can be treated as a “disregarded entity” if it has only one owner. As a disregarded entity, the income and loss from an LLC’s operations are reported similarly to sole proprietorship income, that is, on a Schedule C attached to Form 1040.

Multiple-owner LLCs operate under the terms of an operating agreement, which in many respects is similar to a partnership agreement. The usual legal and other terms of partnership agreements are discussed below. Typically, a multiple-owner LLC is treated for tax purposes as a partnership, and the operating agreement typically has clauses relating to taxes that are similar to those clauses that might be found concerning tax matters in a partnership agreement.

Either the single-member LLC or the multiple-owner LLC affords the ability to operate with a single level of tax. Sales of membership interests, or the assets and business of the LLC, are subject to only one level of tax on the owner. A purchaser of membership interest in an LLC typically receives certain tax advantages concerning his investment such as the ability, if appropriate, to have certain deductions allocated directly to him, and to obtain increased depreciation or other deductions reflecting his investment in the enterprise.

The flexibility offered by the LLC structure means that many large corporations use LLCs internally in their corporate structure for various planning purposes. This wide-scale use means the LLC has been accepted universally as a bona fide form of business organization. This can be seen in the labelling of food products. The tax transparency has created a situation where many new entities are LLCs even in the largest public companies. The LLC offers an opportunity to separate and insulate assets from liability without creating a cumbersome tax structure. For this reason, LLCs have surpassed partnerships and S corporations as the most popular form of business operation today.

Partnerships Partnerships offer the pass-through benefits of a single level of taxation. For most tax impacts, there are only subtle differences between operating as a partner versus being a sole proprietor. The partnership, being a separate legal entity, files its own tax return, but it does not pay any tax. Partners report their share of the profits on their individual tax returns.

For some ventures, the partnership structure is ideal. Limited partnerships have been the structure of choice for real estate investors. The passive investors in the transaction can

Ford, B. R., Bornstein, J. M., & Pruitt, P. T. (2007). The ernst and young business plan guide. John Wiley & Sons, Incorporated. Created from capella on 2024-10-14 00:22:02.

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