In the Game Plan, Warren Barhorst briefly discusses the necessity of the entrepreneur selecting the appropriate form of business entity. These are a few additional comments.

There is a smorgasbord of entity forms available which all impact tax, liability, ownership, control and management issues. Some are simple. Some are complex. To avoid getting lost in the details of the many alternatives, the following comments are limited to the corporation and LLC formats.

LIMITED LIABILITY

To operate in a sole proprietorship format or general partnership format is similar to a tight rope walker operating without a net. Yes, you can insure around many of the potential liabilities which are ready to pounce upon the small business owner, but, unfortunately, you can’t insure against every contingency. Why unnecessarily subject the assets which you have accumulated outside of your business, or which you may have inherited, to aggressive litigants suing on some novel theory not covered by the policy or for an amount in excess of policy limits? Just as large businesses form subsidiaries to isolate potential liability issues, you need to isolate the potential liability generated by your business enterprise from infecting your family’s personal assets. (The protection afforded by a limited liability entity such as a corporation or LLC is undermined whenever you provide a creditor of your business entity with your personal guaranty. The realities of operating a business, particularly at the early stages, may necessitate that you provide a personal guaranty. Obviously, to the extent possible, it is best to keep these to a minimum and get them cancelled ASAP once your business is on a sound financial footing.)

EASE IN TRANSFERRING A”SLICE” OF OWNERSHIP

The share or units in corporations and LLCs are easy to transfer. The individual assets held outside an entity usually are not. Although many types of licenses are personal, many others as well as permits, etc., belong to the entity and thus are transferable with the entity. Intellectual property rights, such as trademarks and service marks, are made easily transferable if owned by an entity rather than being personally held. If you have service marks, trademarks, permits, licenses, vehicle titles, etc., in a sole proprietorship, you are going to have to transfer each one of them if you sell all or part of your business. The same issue arises if you transfer an interest in the business to a family member, whether by a lifetime gift or a bequest at your death. If assets instead are held in a business entity (whether in a corporation, LLC, etc.,), the assets remain owned/titled in the entity, and all that need pass from you to the buyer or family member is the document evidencing your ownership of the business (eg., stock certificate for a corporation or membership or unit certificate for an LLC). You are transferring to them a “slice” of the corporation or LLC which owns all of the various assets of the business. This is much easier than transferring a slice of each and every asset of the business.

The easy transferability of the entity’s business interests also:

(1) increases the ability to raise capital and provides a better platform to attract additional investors if needed: and

(2) eliminates the need for separate probate proceedings at your death (in a state or states other than your state of residence) if business real estate assets are owned by your entity in other states. (If held individually by you, business real estate is subject to a separate probate proceeding in each of those other states.)

CENTRALIZED MANAGEMENT

The formation of a business entity also brings order to the management of the company. The responsibilities and authority of members of management can be clearly defined within the organization, as well as to third parties, such as banks and vendors, dealing with the organization. Also of importance is that management and control can be separated from less active or inactive owners of the business, in sometimes very creative structuring (ie., there can be differing ownership interests with differing voices in management and control).

TAX ISSUES

Selection of business entity or any applicable tax elections are best left to your individual consultation with your tax advisor who is familiar with your individual situation. Having said that, there are a few generalizing comments to be made about taxes and entity selection.

A regular “C” corp is taxed at two levels: the corporate level and then again at the shareholder level when net earnings are distributed. Put simply, there is double taxation. Not a good thing unless you really want to pay more than your “fair share” to the government. The corporation can make an “S” election with the IRS to basically be taxed as if the business was owned directly by each owner in each owner’s proportionate share. The corporation files a tax return but there is no tax liability due by the corporation. Put simply, you are only taxed once. You don’t have to be a theoretical physicist to figure out why the Sub-S election has been popular.

More recently on the scene is the LLC which provides both the benefits of limited liability and single level taxation. The popularity of the LLC is reflected in the numbers: nationally, nearly 2 new LLCs are formed for every corporation formed and over 34 LLCs are formed for every new limited partnership formed. (These numbers are from an unpublished 2009 study by Rodney Chrisman.)

For those entrepreneurs seeking tax filing simplicity (ie., no additional tax return), yet with the umbrella of limited liability, the one member (owner) LLC may be the entity of choice. The reason: a one member LLC does not file a separate tax return for the entity but rather reports on Schedule C of the Form 1040 of the tax return of the LLC owner (unless the LLC elects otherwise). The caveat, as Warren has pointed out in his book, is that you still have not removed yourself from a position of increased audit risk. Schedule Cs pose increased audit risks for Form 1040s.

You’re probably all asleep now. Talking tax issues usually puts a pretty heavy glaze over people’s eyes. But the tax issues are probably the most complex, but also one of the most important elements, in selecting the entity to use in your business. As they say, don’t try this yourself at home. Seek out professional advice for your situation.

WALK THE WALK

Whatever business entity format you choose, you need to be sure you respect the existence of the entity. The business assets are no longer is your back pocket. Entrepreneurs often achieve success because of their notorious nonconformity. This is not an area to express your nonconformity. It is extremely important that you always properly designate your capacity (eg., “XYZ, LLC, John Doe, President /Manager”) when signing documents. Ignoring this little detail can totally void your well planned efforts to build that fortress around your personal family assets because it may expose you to personal liability.

Other “window dressing” corporate formalities are also still important, but have been neutralized somewhat in the “piercing the corporate veil” offensive tactic employed by creditors trying to reach an owner’s personal assets. For example, the Texas Business Corporation Act and the new Texas Business Organizations Code both provide that failure to follow corporate formalities is not a basis to hold a shareholder liable for any obligation of the corporation. Other states may differ on this, so caution is still necessary.

SUMMARY

Regular “C” corporations, Sub-S corporations, LPs, LLPs, LLCs …. It’s an alphabet soup out there! It’s complicated! Do not try this at home without the help of a professional. But you need to educate yourself on the available alternatives. The important point is that if you are currently operating your business as a sole proprietor or in a general partnership with another owner, do yourself, your family, your retirement years, your stress level (and thus your health insurer) all a favor and contact a professional advisor and seriously look at reorganizing your business under one of the limited liability entities available in your state.

Marv Wurzer earned his J.D. from the University of Houston, followed by an LLM in Taxation from New York University. He is Board Certified by the Texas Board of Legal Specializiation in Tax Law. Since 1979, he has been a practicing attorney at Johnson & Wurzer P.C. in Houston, where he focuses in general business transactional practice with an emphasis on tax related issues and private foundations.

[The above is accompanied by the usual caveat: This article has been prepared for informational purposes only and does not constitute legal advice.]