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Selection of an Entity for a Business Acquisition or Start-Up?

Selection of an Entity for a Business Acquisition or Start-Up?

IBA, as the premier business brokerage firm in the Pacific Northwest, is firmly established as a respected professional service firm in the legal, accounting, banking, mergers & acquisitions, real estate, and financial planning communities.  Periodically, we will post guest blogs from professionals with knowledge to share for the good of owners of privately held companies & family owned businesses. The following blog article has been provided by Eric Moore of Accounting Solution Partners (www.asp-nw.com):

Selection of an Entity for a Business Acquisition or Start-Up?

During the formation process, founders have an important question to answer

which business entity is best for my business?

​Deciding among available business types is a decision that should not be rushed or approached casually.

Business entity distinctions have wide-reaching implications affecting everything from legal protections to tax considerations. Furthermore, differences in startup and maintenance costs can vary substantially, as can flexibility in ownership structure. These elements affect both the business’s initial formation and daily operations, making them vital considerations for any new business owner.

Understanding the differences in the six types of business entities is an important first step in starting a new business. While some business types are categorically different than their counterparts, others have more nuanced differences between their startup requirements and ongoing regulations.

Sole Proprietorship

  • About: In a sole proprietorship one person serves as the owner and operator, controlling both strategic decision-making and daily operations. This business type is the default selection when a new business is created, which is why more than 70% of US businesses are sole proprietorships. There is no need to register it with the state during formation; however, depending on the industry and location, some companies may still need a business license to operate locally.
  • Considerations: This business type is common among service professionals, freelancers, and consultants. Any business with a single owner can be a sole proprietorship, but most are converted to LLCs or corporations eventually as the business grows.
  • Pros: A sole proprietorship is easy to start up because it does not need to be registered with the state, which is a benefit that many paperwork-fatigued business founders appreciate. This ease of set up extends to ongoing maintenance as well through tax simplicities. Tax filing only requires an addendum to the owner’s personal income tax return, and business losses can be deducted on personal tax returns.
  • Cons: Unfortunately, the same lack of separation between the person and the business that makes formation and maintenance easy also increases liability. Because the owner and business are considered one entity, personal assets like bank accounts, cars, and real estate are not protected in the case of a lawsuit against the business.

Additionally, sole proprietorships are not generally considered as professional as other business types, making it difficult to get a loan and build business credit. Financiers like lenders and investors prefer to work with more established business types, meaning that sole proprietors typically need to rely on home equity, investments, and family loans to fund their businesses instead.

Partnership

  • About: The general term “partnership” is a shortened version of the formal name General Partnership (GP). This business type is similar to a sole proprietorship, except it has additional owners. All partners take an active role in the business’s day-to-day operations and share its profits and losses.
  • Considerations: While a partnership bears a lower risk than starting the business alone, it also changes the risk level in a way that is unique to this business type. Partners provide a built-in support system, but finding the right people is essential because liability is shared between them. This arrangement can lower an owner’s individual risk level while potentially raising the overall risk level because each partner is responsible for making business decisions to determine the outcome of the business, increasing cumulative legal liability.
  • Pros: Like a sole proprietorship, a partnership does not need to be registered with the state and most business losses can be deducted on each partner’s personal tax returns. Any losses are shared among owners, making business ownership less risky.
  • Cons: While sharing losses reduces the risk level, sharing returns reduces the profitability as well. Diminished profits are not the main drawback to a partnership, however. Partner disputes and personal politics can interfere with running the business and making strategic investment decisions. These issues can be especially detrimental when funding is already difficult to come by because business loan grantors prefer to work with corporations and LLCs.Much like in a sole proprietorship, owners are personally liable for the business in the instance of a lawsuit. Additionally, in Washington (as well as several other states) “joint and several liability” laws can result in each partner being personally liable for the full burden of a partner’s negligence as well.

Limited Partnership

  • About: Unlike a GP, a limited partnership (LP) is considered a registered business entity, meaning that it must have the appropriate paperwork filed to be registered with the state. In an LP, owners can be either general partners or silent partners. As the names would imply, general partners help operate the business, but silent partners are only investors. Due to their instrumental roles in its operation, general partners assume full liability for the business. Silent partners, however, do not control the business and as such have reduced liability.
  • Considerations: Limited partnerships are desirable for investors that want partnership opportunities without the liability associated with backing a partnership or other unregistered entity.Note: An LP differs from limited liability partnership (LLP), which is an entity available in some states, such as Washington, for professional services like doctors, lawyers, and accountants. LLPs safeguard partners against the actions of other partners to minimize professional liability.
  • Pros: The most common reason for establishing an LP instead of a GP is to raise capital. Lining up silent partners allows owners to secure funds while still retaining control of the business. Additionally, silent partners provide flexibility because they can be removed at any time without needing to dissolve the partnership.
  • Cons: While silent partners are protected by their limited roles, general partners are personally liable for business debts. Silent partners, however, risk their limited liability status if they become too involved in the business, whether intentionally or unintentionally.

C-Corp

  • About: A C-corporation is an independent legal entity, which separates it from its owners. It consists of shareholders, a board of directors, and officers; however, one person can fill all these roles when the business is in its infancy until additional personnel can be hired. As the business grows, the number of shareholders is not limited.
  • Considerations: Small business owners typically shy away from registering business ventures as C-corps because they are intimidating, but they can be beneficial as the business grows and needs better legal protection. For owners that plan to reinvest profits back into the business, C-corp entities provide the biggest rewards.
  • Pros: A separation between the business and its owners protects their personal assets from business liabilities. This key distinction is the main benefit of registering as a corporation, although tax advantages set C-corps apart from other entities. With more available tax deductions and reduced self-employment taxes for owners, c-corps are a strategic choice for more experienced owners.
  • Cons: With fees of around $200 in Washington, C-corp formations are pricier than other business types. Additionally, the maintenance upkeep is more extensive. Requirements like posting bylaws, holding annual shareholder meetings, and filing detailed minutes are cumbersome for smaller businesses, requiring extensive planning and record-keeping.Additionally, C-corps are double taxed – on profits and dividends. While there are situationally-specific ways around this taxation encumbrance, managing this double taxation burden often requires the aid of a tax professional.

S-Corp

  • About: An S-corporation is categorized as a “pass through entity,” meaning that the profits or losses of the business pass through to the owner, allowing it to be claimed on the owners’ personal tax returns. This advantage eliminates the double taxation issue that C-corporations face, making it a potentially lucrative choice for savvy business owners.
  • Considerations: A business can either be created as an S-corp from the start or converted to an S-corp later. This unique business entity is a good alternative to a C-corp for owners that want the rigid structure of a corporation with increased tax flexibility.
  • Pros: Essentially, an S-corp combines the characteristics a C-corp with the best attributes of a sole proprietorship or partnership (limited liability and profits or losses that can be passed through to an owner’s personal tax returns). The result is an entity that reaps the tax advantages of a corporation without double taxation woes.
  • Cons: As is the case with any corporation, it is more expensive to form and formalities around bylaws, shareholder meetings, and other requirements can hinder business flexibility. Additionally, shareholder numbers are limited, and they must meet citizenship qualifications. Even among these reduced shareholders, stock issuance is limited.

LLC

  • About: As the name indicates, a Limited Liability Corporation (LLC) offers the personal liability protection of a corporation with the startup ease of a sole proprietor or partnership. The creation of this business entity is governed by an operating agreement, which is laid out by the owners prior to or during formation.
  • Considerations: LLCs are popular with freelancers and other single-person businesses; however, the number of owners is not limited so there may be more where needed.
  • Pros: With minimal paperwork required to get started, LLCs still provide full liability protection for owners without being subject to the same stringent corporation requirements as C-corps or S-corps. An exclusive advantage reserved for LLCs is the ability to choose whether they will be taxed as a partnership or a corporation. This taxation flexibility allows owners to select a taxation structure that will benefit their specific businesses.
  • Cons: ​As is the case with any corporation, state registration fees are more expensive than sole proprietorship or partnership entities

Because of last year’s tax reform legislation, the IRS recently sent a notification which said “Some S corporations may want to convert to C corporations”.  Issue Number: Tax Reform Tax Tip 2018-179. This can be a complicated topic and you should not take anything for granted or make decisions based on an IRS tip.  (Though the tips can be helpful.)

If you are about to set up a new business entity or have been advised to convert your company to a different entity, you will likely require different bookkeeping and accounting procedures. We can help!

 

If you have questions relating to entity selection or the content of this article, Eric Moore of Accounting Solutions Partners would welcome the opportunity to answer them.  Mr. Moore can be reached at (425) 492-1901 or moore@asp-nw.com.

 

IBA, the Pacific Northwest’s premier business brokerage firm since 1975, is available as an information resource to the media, business brokerage, and mergers & acquisitions community on subjects relevant to the purchase & sale of privately held companies and family owned businesses.  IBA is recognized as one of the best business brokerage firms in the nation based on its long track record of successfully negotiating “win-win” business sale transactions in environments of full disclosure employing “best practices”.

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