Starting a Business? Do This First.
Limited Liability Company, “C” Corporation, “S” Corporation, General Partnership, Limited Partnership . . . or something else? When you start a business, your first order of business should be choosing a corporate form.
But what to choose? And where to domicile your company? And what are the potential consequences of your choices? Or rather, what are the potential consequences of bad choices?
Generally speaking, I form more LLC’s for my clients than anything else, and with good reason: for many (but not all) small to medium sized companies, particularly startups, it’s the most flexible corporate form in which to do business.
At the startup phase, you usually don’t know how far your business will go, how much capital it’s going to need to fuel its growth, whether it will need to reorganize to accommodate growth down the road, or how many investors or equity partners you’re going to end up with. LLCs are ideal under these circumstances. They keep your options open while shielding the members’ personal assets from liabilities of the company. Plus, LLCs are relatively easy to operate (more nimble than Corporations and less startup paperwork than Partnerships). They can also end up costing you less in taxes each year than Corporations, and are easier to convert into another corporate form down the road if it becomes advantageous to do so (and I can tell you if and when it would be advantageous to consider a format conversion as your company grows).
On occasion, though, I’ll recommend that a startup client use an “S” Corporation or a “C” Corporation, particularly if paying salaries to the stockholders is important, or if bank or venture capital financing is essential to capitalizing the business from the getgo, or if offering stock options in order to attract top talent is important. Most banks and venture capital investors will want the permanence and stability of a Corporation before they’ll lend or invest money, and investors particularly like the ease with which a Corporation permits transferability of shares once the business is profitable. However, you’ll pay for these powerhouse advantages: corporate earnings are taxed twice. The Corporation itself is treated as a taxable person, so it will pay taxes on its overall income (the 1st level of taxation). Then, after the remaining income is distributed to stockholders as dividends, the stockholders will pay income tax on those dividends (the 2nd level of taxation). Thus, choosing to operate as a “C” Corporation can be expensive, and a major issue when determining whether to choose this corporate form is whether the company will generate sufficient cash flow to make this double taxation worthwhile.
Whichever corporate form we choose, we also need to decide where to domicile your company (i.e., in which state). Decisions on domicile will depend on the type of business you’re in, the states in which you anticipate providing goods or services, and the complexity of your operations. For most Maryland-based companies, a Maryland domicile is satisfactory. However, your company may present circumstances that would warrant a hard look at another state. Ever wonder why virtually every Fortune 500 corporation and quite a few LLCs are domiciled in Delaware? (Yes, I know this burning question keeps you up at night). Let’s talk about it.
A few weeks ago, I wrote about what sorts of nightmares lawyers have (if you missed it, click here). Here’s the worst nightmare of all: you start a company but don’t use a lawyer and an accountant to help you choose and properly set up a corporate form. You make no filings with the proper governmental agencies (or you make inadequate filings) and you draft no documents evidencing your intended operating format. You adhere to no corporate formalities and keep no records of corporate decisions and actions. Instead, you simply open up your doors for business, sign a lease, enter into contracts with a few vendors and suppliers, put the letters “Inc.” or “LLC” or “Corp.” after your company’s name, and begin servicing customers or clients.
Guess what? Under these circumstances, the law presumes you’re operating a General Partnership. And I’m here to tell you that you NEVER want to be operating a General Partnership without talking to me first. Why? Because, among other things, General Partnerships do NOT shield their partners from the liabilities of the company. Which means that if anyone sues your company for any reason and wins a judgment against it, your personal assets (your house, your car, your savings, etc.) could be used to satisfy that judgment. Was that something you planned on?
Of course, there’s a lot more to selecting a corporate form than space and time allow me to discuss here. If you’ve got questions about what type of entity your company should be, or if you want to review whether your current corporate form is best for your business going forward, feel free to give me a call. I’d be happy to discuss it with you. [Free of charge, as always.]
