Choose Your Company Part I
Think before you act.
You have got a great idea for a company, but you’re unsure of what type of structure to use: C-Corp, LLC, partnership, S-Corp, Sole Proprietorship, etc. My advice is take a step back and first think about what you want to accomplish, how you will go about it, and with whom you should partner.
I find these questions not only help my clients choose a company structure, but also assist them to focus on their dreams and what they need to achieve them. So, let me share with you some of my secret sauce: a few of the questions I ask (some would say force) my clients to answer, before we go any further with my recommendations.
Disclaimer: The following information does NOT constitute legal advice and is only for general educational purposes. Each situation is different and specific legal issues usually require additional research and investigation, so do not rely on this article to address a particular legal issue; use this as a starting point to gain a general understanding. This article, although educational in purpose and substance, nevertheless, might be deemed attorney advertising, and prior results do not guarantee future success.
1. Warning
You may find this article both disorienting and disturbing - mostly, I hope, because it forces you to think; I mean really think … about who you are, what you want, what you’re doing. If you’re having trouble answering the questions, you either need someone to help you sort this out, or maybe you’re not yet ready for prime time for this particular venture.
There’s no shame if it’s the latter, but trust me - the more you tease these out, the closer you are to creating a successful business plan, and well, you know that old aphorism “people don’t plan to fail, they fail to plan.”
2. What’s Your Goal?
Ok, let’s get to it. What do you want to accomplish? This may sound silly, but it’s not as clear cut as you might believe. Are you looking to make a quick buck and get out? Is capital appreciation your game? Do you want to create a lasting financial empire, by playing Monopoly for real, that will outlast even you? Are you hoping a VC will swoop in and buy you, and you don’t care how much you make until then?
Why do I ask these things? Because, your needs will be very different if say, you are looking to make money off of dividends vs. revenue vs. salaries vs. sales vs. pocketing the massive long term profits of the sale of some or all of a successful business.
If you read that quickly and then thought, “whoa,” then good, you are paying attention. I find many well meaning and energetic individuals say, “I wanna have a business selling Ultra-Chocolate ice cream cones,” but then can’t tell me if they imagine conducting the sales from a stand outside their home, using a truck to travel to different neighborhoods, or boxing it up for sale at supermarkets, and so forth. Usually, I get the answer “well, I was thinking…” instead of “I plan to start out doing so and so, and then hope to expand to this, and then….”
Today’s young entrepreneurs are surprisingly knowledgeable (I suspect the Internet has a lot to do with that, since you can just look up nearly anything, no matter how technical) but sometimes even they are caught by surprise by truly simple concepts. For instance, did you know the current top federal tax rate on long term “capital gains” is roughly 20%[1] compared to about 40%[2] for “Ordinary Income?”
Ordinary Income is basically commissions, wages, sales, etc.[3] Capital Gains are basically profits you made from appreciating assets like stock, personal property, and real estate.[4] In other words, if you start a successful business, and you earn a lot of money every year, you could be taxed as high as about 40%. On the other hand, if you don’t earn so much money, but your company becomes highly valued over time, and you sell it to an investor, you might only be taxed at 20%. This can make a big difference.
Obviously, a lot of strategy will hinge on future events, but anticipating prospective needs will enable you to choose a good company structure ahead of time.
3. Lone Wolf or the More the Merrier?
Probably the very next key issue to decide is how many of you are there?
The answer to this will help you right away rule certain things out. For instance, if you have a partner, you can’t be a sole proprietorship (at least not for that enterprise). On the other hand, if you are alone, you can’t be a partnership. Then things get a tad more complicated when you have C-Corps (your standard type of corporation), LLCs (limited liability companies) or S-Corps (ugh, don’t even get me started), because you can go it alone or have others involved.
Incidentally, if you are professionals, it can get even more complicated, because a group of lawyers or other professionals for instance, will need a PLLC (professional limited liability company, or a professional services corporation) as opposed to an LLC. Also, not all professionals can all join the same companies because of their internal ethics rules.
Next, how much flexibility do you want? Will partners (or shareholders) come and go frequently? Or is everyone locked in, brothers and sisters to the end, do or die? Will new partners or shareholders be added freely, without permission from the other partners / shareholders or only with unanimous consent? Or somewhere in between. If someone wants to leave, can they? Or will their leaving dissolve the entire endeavor. If they do, what happens? Is the timing of their leaving important? Will you penalize those who bail early? Will you reward those who stay the longest?
Working with others in common enterprise is like agreeing to a potentially long term contract. It could be a contract that permits you to exit at will at a moment’s notice, is a lifetime engagement, or even lasts longer than your lifetime. Depending on your business vehicle you could have a lot flexibility in what you demand or permit your partners or shareholders to do.
4. What’s Mine Is … Yours?
If you have more than one person involved, invariably you will run into questions of what do with the property the company acquires. Some of these questions can lead to sticky tax situations.
For example, who will contribute what? Will some partners lend property to the endeavor rather than transfer ownership to the partnership? Does everyone have control over all assets? Can anyone withdraw assets, in whole or in part, and with what notice? Who will own the assets when it’s time to wrap-up? Will anyone contribute services (i.e. “sweat equity”)[5] to the company in exchange for a piece of the action? It’s real easy to value cash ($20,000 = $20,000) but how do you put a price on the contribution of future services? Also, how will you ensure that future-services contributor is forced to live up to expectations?
So, let’s say in your “Ultra-Chocolate” company, you contribute the ice cream truck (for 40% of the partnership), someone contributed the recipe of “Ultra-Chocolate” (40%) and a third partner is going to sell the ice cream cones from the truck (20%). What if the salesperson goofs off? They aren’t an employee, so you can’t really fire them per se. If you can’t ensure they perform the business may begin to fail and everyone will go their separate ways.
If that happens, who will own the intellectual property, i.e. the recipe of Ultra-Chocolate? By default, it could slip into the common ownership of the partnership if you aren’t careful; that means any of them can now use the recipe and compete with each other if the partnership dissolves (or worse, sell it to a well funded competitor that knows what they are doing).
Similarly, what happens with the ice cream truck? You contributed it to the partnership but now that everyone is splitting up, you want to take your truck back and your other partners say, “whoa, that belongs to us as well now.” What?! It doesn’t have to happen that way (for instance, you could loan the truck, or the partnership could rent the truck), but if you aren’t careful it can.
5. "I believe we should all pay
our tax bill with a smile.
I tried but they wanted cash." - Anonymous
Will some people contribute property, but others contribute services? If so, you might want to consult an accountant. Those contributing services for something other than future profits (i.e. for instance, a piece of the property you donated to the partnership), could incur a tax liability.
Let’s say that truck was worth $50,000 and is subject to joint ownership upon contribution, i.e. everyone owns it from now on. This could trigger a tax consequence to the other partners immediately! - even though you all haven’t earned anything yet. Arguably, the value of the recipe for Ultra-Chocolate also could be construed as contributed property and generate even more tax liability for the other partners.
Did you know you, that within certain limits and perhaps with certain consequences (tax and otherwise), you can make these details as complicated as you want? The salesperson could receive 20% of the partnership profits, receive no "loss income," have no claim to any capital assets (i.e. the truck), but be paid a salary for $15,000 plus 10% of the profit of anything they sell. Sounds great right? But what happens when Ultra-Chocolate becomes so successful they buy their own factory. If they dissolve the business and sell the factory, the salesperson may or may not have a right to distribution of the physical property, i.e. the factory.
Conclusion
Your accountant, lawyer and other professionals can help you arrange things properly, but only as well as you instruct them; you’ll need to (well, you don’t, but you really should) think about these things BEFORE you start your venture, and then discuss it thoroughly with them. If they do a good job they should attempt to guide you, but they won’t be able think of everything, and you need to do most of your own homework.
It’s not important you figure out the consequences of your actions, that’s what they are for, but you should know what *intended* results you want to achieve, rather than just the general idea that everyone be happy and be rich.
Help your professional help you, and think through some of these issues.
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[1] http://www.fool.com/retirement/general/2015/12/14/long-term-capital-gains-tax-rates-in-2016.aspx
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