When you’re setting your company up as an entity, there’s no one right way to go. There are many things you need to consider before deciding which type of entity is best for your company.
“It depends on what your circumstances are, and it depends on what you’re trying to accomplish,” says Craig Schmitt, senior manager in the Tax Practice of Burr Pilger Mayer. “You could take two identical businesses with identical assets and choose different, alternative forms based on the expectations of the person forming the business.”
Smart Business spoke with Schmitt about the different kinds of entities and how to choose the one that’s right for your business.
What is the first step when choosing the type of entity for your business?
It’s important to involve your tax adviser at the earliest possible point in the process of setting up a new business. The primary purpose of having an adviser is to avoid unintended tax consequences because there are some very tricky aspects of tax law related to certain ways of forming new businesses. You first need to make sure you have the right adviser and keep the adviser in the loop. For example, contributing appreciated or depreciated property to a new business has different tax impacts for different business forms and is further complicated if the new business assumes debt related to the property.
How do you find the right adviser for your situation?
Early in the process, you have an idea and a concept, and you’re fairly certain of the economics of it. You know whether it’s going to be a service or product or an investment, such as a development. Once you have a fairly good idea of what you’d like to do in terms of a business, then you go from the concept stage to the implementation stage, and that is where you really need to bring in your adviser.
The approach is to identify what is important to you in setting up your new business. You have to ask yourself, ‘What industry am I in? What do I anticipate will happen to my ownership of this business in the future? How do I expect this business to develop? Will it be profitable near-term, or will it be a long development process?’ From that point, you can start to identify the qualifications of the adviser you will need to help you implement your plan.
You also need to look at that person’s experience and their area of expertise. Ask yourself, ‘Are they experienced in the same industry that I am in? Do they have other resources that will help me?’ Then you match your needs to the adviser and the experience.
But sometimes you’re not even aware of these things, and that’s when you sit down with one of your regular advisers, whoever that might be, and say, ‘This is what I’m doing. What do I need to think about?’ Then that adviser can give you a referral.
What should you ask your adviser?
Start with very general questions, such as, ‘What type of entity do I need to use? Do you go with a limited liability company, which is very popular these days, very flexible and has the ability to structure the economic deal with a lot of variation?’ Real estate developments frequently take advantage of this structure, as do a lot of operating businesses. This is a good structure for someone who would like to take advantage of losses during the early phases of a new business.
On the other hand, if you are more concerned about raising capital and you’re going to be dealing with institutional capital investors, you’re more likely to consider a corporation. That would avoid a problem that pass-through entities like an LLC — which passes through income to its owners — would have, in that it creates unrelated business tax income that a corporation does not.
A corporation is a good entity for businesses looking to generate capital from their operations, to keep capital in the business in order to grow the business.
How long through the process will an adviser stay with you?
He or she should stay with you at least until you start the business, until you’ve got it up and running, but it could be a relationship that lasts all the way through the whole cycle of the business, all the way to liquidation.
Once you’ve established which entity works best for your company, is it ever possible to change that?
Yes, that could change at some point. In some cases, you may start as an LLC, but then you may develop your business to the point that you look at it and say, ‘I think I would like to take this concept and go public.’ At that point your current entity type may have outlived its purpose and a new one will be required. You will also need to check with your adviser to find the right support to make such a move.
