Entity Selection

BARRY:
So number 12. I get excited about it. It’s bold. As a reminder, bold means excited. Number 12 is entity selection. Entity selection. To me, there’s a lot to talk about. I like to give Chad the first crack at the apple every time.

CHAD:
We’ll try to keep this really high level because there are a lot of different things that go into entity selection, both from a financial and the legal standpoint.

From the legal side, obviously, different entities differ in terms of liability exposure. They differ in terms of control that you have in the decision-making process, and there’s a lot of other things as well in terms of raising capital, etc.

Financially speaking, one of the biggest impacts is on the tax side. How the entity selection could affect taxes. You know, whether you’re paying self-employment tax, which typically if you’re an LLC without making any other tax election, you’re gonna be paying self-employment tax.

Maybe you want to chime in on the legal side of things, because it’s predominantly legal-driven, I think, in terms of the entity selection. In terms of liability, bringing in partners. How the accounting for capital contributions and all of these things really play out.

BARRY:
I don’t think it’s all legal, actually. There are a lot of dimensions to looking at it. I think that people unfortunately knee-jerk into doing it themselves because they can in today’s world. They can do it themselves.

No offense to you as a CPA, but I find CPAs tend to knee-jerk their clients into things that they’re more familiar with, and not always the right or appropriate entity. Sometimes that’s really hard to fix.

CHAD: 

Probably because they can’t keep up with all the different variations of LLP, LLLP, LP — I can go on and on and on with the different variations of the limited liability arrangements you can set up.

BARRY:
Yeah, there’s a lot. But I like to think we can keep it simple depending on the needs and goals. If you just start with the needs and goals, the pool narrows tremendously.

So I’d characterize the dimensions of entity formation. And we can keep it high level, because we’ll do a breakout. I would call– Let’s talk about legal in terms of limited liability. Everybody knows about that. That’s why most people form companies.

CHAD:

Everyone can probably agree on one thing: don’t be a sole proprietor.

BARRY:

Yeah, don’t do that. Don’t be a sole proprietor. People form companies because they want limited liability for the business. If someone slips and falls at the business, they’re not going to sue the owners, the shareholders.

There’s a whole other element of liability exposure that businesses can help address, and that’s the asset protection of the shareholders who are exposed to claims from creditors that have nothing to do with the business at all. Just because the business represents an asset to them. And that’s beyond the scope of today, but it’s definitely an area which we play in a lot. And we’ll get to it later. Another time.

But basically limited liability in the general sense of separating the shareholders from the business is a common driver. It’s common to– Tax is a big driver. Minimizing payroll tax, liability, capital gains, stuff like that. Holding periods. There’s allocations of profits and losses, distributions. Which are more flexible in certain entities than others.

It becomes more relevant when you’re raising capital. When you’re raising capital, there’s a whole other dimension to it where you want to structure the business in a way that facilitates multiple rounds of raising capital. And usually that comes along with different tiers of management and control. And that lends itself to a discussion of management and control. When you go into business with a partner and you don’t have an agreement, you don’t have anything set up, the law will characterize you in a certain way, and the tax code is gonna charactorize you in a certain way. And you have the ability to change all of that by just doing some thoughtful planning.

CHAD:

I think we have a general theme developing here.

BARRY:

What’s that?

CHAD:

You can control what you want to happen down the road just by planning ahead of time. As best as possible. Obviously, you can’t control everything, but you can prepare yourself.

BARRY:

I’ve been working on a really good image for my social media on this concept of choosing that I’m excited to post. I haven’t done it yet. But, yeah, it’s all about control now or roll the dice later. That’s what it comes down to.

And I gamble. I play poker and blackjack. I understand odds and probability. I’m trying to impress upon people the connection between odds, probability, gambling, risk, with planning ahead.

CHAD:

Why have the risk?

BARRY:

Yeah. Plan ahead. To recap: entity selection is driven in large part by limited liability, minimizing tax, dealing with control, being flexible on how you’re structuring profits, losses, distributions, things like that. Raising capital. And I would kind of nestle underneath tax things like IRC 1202, which can have a substantial financial or economic effect of the sale of a qualified small businesses. You can have substantial benefits because it will recognize less tax. But it’s very complicated, far beyond the scope of this video. The point I’m making is that there’s so many ways to look at it that it’s not so simple as you go on Sunbiz for 10 minutes and you’re done. You’re done, but you might be setting yourself up for a a problem later.

CHAD:
I’m sure you see that a lot. Someone develops an LLC but doesn’t create an operating agreement to go with it.

BARRY:

Or they do create an operating agreement, but they got it online and it’s toilet paper with some writing on it. In fact, and I have to be mindful of what I say here, but I am involved in litigation right now representing a client where the main issue is the operating agreement. It’s a terrible operating agreement. Ambiguity on what certain things mean, and those ambiguities have big impacts on how the business is being run or the rights of shareholders. And guess what? A lot of money is being spent fixing this problem. And there’s a lot of lawyers, it’s already taken a lot of time. And it’s sad because all this stuff should have been done right the first time. Yeah. Great point.

Did I mention the types of entities? Just to kind of throw out spaghetti at the wall. You mentioned sole proprietor. That’s like a lemonade stand. Then you’ve got your c corp and your s corp. I’m sure if you want to chime in — c corp and s corp legally are the same, but tax-wise they’re different.

CHAD:
Correct. The S corp is really a flow-through entity where the profits and losses flow through to the individual owner and that’s where they pay tax. You only pay tax once at the shareholder level. The C corp actually has double taxation because the C corp as an entity pays tax, and then when the dividends and distributions go to the others, they have to pay tax again on that. And I don’t want to get too much into which one is the right one or wrong one, because it really is a case by case scenario. Especially with the lower corporate tax rate world that we’re in right now. It’s really a case by case analysis and decision client by client as to what the right route is to go.

BARRY:
That’s true. The corporate taxes are much lower than they used to be historically and that’s a consideration as is the double tax. Like you said, it’s fact-specific. There’s no canned solution. I just would mention that there are benefits to forming a C corp. It just depends on what you’re doing. What your goals are. What your vision is.

CHAD:

Yeah. As a C corp on the financial side there’s actually a lot of things a business owner can do planning for themselves through the business and receive tax deductions for the business that they normally wouldn’t be able to receive with an S corp. We can touch upon this later, but there’s a lot of different things. Like executive bonuses, for example. The owner of a C corp can give themselves an executive bonus and receive a deduction for it, and that’s not the case with an S corp. So everything kind of needs to be looked at as a whole with all the different factors, and not just one at a time.

BARRY:

Yeah. So we have sole proprietor. C corp, which can elect S. We have LLC. I’m a big proponent of LLCs, which are relatively new. Relative to the length of time.

CHAD:

Which you can also elect S or C status on from a tax standpoint.

BARRY:

I would say you can do an LLC four ways. You can be disregarded. You can elect S or C. And by default if you have multiple partners, you’re a partnership. So they’re really flexible.

And that brings us to partnership, which really should have come after sole proprietor because it doesn’t really have a formal incorporation. If I could do the flashy light thingy from Men in Black, I would do that and start over. But I can’t, so a partnership is just two people who are in business together. Basically you have a business and there’s liability, there’s exposure, there’s rules, there’s a whole body of law governing that relationship. You looked like you were gonna chime in there.

CHAD:

No.

BARRY:

Partnerships, like sole proprietorships, are ill-advised. Don’t do it. There’s liability. Why do that? But it is an option. So sole proprietor, partnerships, general partnerships, C corps which you can elect S, LLCs, which you can elect multiple things. Or as default a couple of things. And you have limited partnerships, which is LP. Historically used for tax planning back in pre-1986. A lot of cool things you can do with LPs that we can talk about another time. But basically those are structured in a very particular way that are different from corporations.

CHAD:

Very popular with big law firms. You see a lot of LPs, right?

BARRY:

No, those are LLPs. That’s where you get to the “L”s. There’s a lot of variation with the “L”s. LP is just the general partner and limited partner, where the limited partner is just kind of riding along on the wave. They have no managerial control. General partners completely control the business but also have 100% liability exposure with the business. Which is why you usually have another entity serve as that general partner. And there’s a lot of good things I could say about LPs except they’re expensive and there’s no need for them anymore with the advent of LLCs.

LLP and LLLPs are where you get your law firms and CPA firms. And the idea there is that you can insulate liability among partners much better than you can as a general partnership. And at the same time you can be involved in the business unlike an LP, which is mostly made up of limited partners. So there’s a lot of ways to do this. And control, financial planning, tax structure, raising capital. Just really thinking through the vision of what you’re doing is important. I could talk about this all day, so we should probably move on, right?

CHAD:

We’ll add it to our list of individual things to cover. We’re getting good at list-making, Barry.

BARRY:
If nothing else, we’re getting good at list-building skills. I agree.