Last week, we talked about starting your business out on the right foot. Today, let’s continue that conversation and talk about choosing the entity for your business. The beginning of protecting your business is to make sure you have chosen an entity with some form of liability protection. With that you are looking for an entity that is either a “Corporation” or has “Limited Liability” in the name. Just remember, when you choose an entity you are entering into a contract with the government. You are choosing the vehicle through which you will operate your business.

The decision you make on the front end can have consequences down the road including:

• how you deal with your partners;
• how you take money (equity or debt);
• how you retire (or exit); and
• tax consequences

With each entity choice, there are rules about how you relate to your partners, to your customers, and how the business is run. This is all part of your contract with the government and with the IRS. Depending on the entity you choose, you must:

• run your business a certain way
• have certain meetings
• file certain forms
• report certain activities

In exchange, the government says the owners will personally be limited in their liability. The company becomes a legal person separate from the owners.

Once you have made the determination of your legal entity, you will enter a contract with the government in the form of a Certificate of Formation. In that contract you will tell them how you plan to run your company and when you need to amend your agreement with the government. If you choose a certain tax election, you will enter a contract with the IRS by completing a certain form that outlines what type of taxing structure you want. Once you do that, you must follow the rules.

Your Contract with the Government Impacts Your Relationship with Your Partners

Depending on what legal entity structure and tax structure you choose, the contracts you have with your fellow owners and the business will change. Let’s talk about a few examples:

• Corporation – You have complete flexibility in how you handle dividends. The owners can also be employees. You are required to have a board and annual meetings, but you have complete flexibility. You do agree that you will pay taxes as a corporation and as individual owners. This is known as Double Taxation.
• S-Election for a Corporation – The S-Corporation, which you may have heard of is a tax election, not a different type of entity. But, if you take it, your relationships change. You only pay taxes as shareholders, but you can only offer your shares to qualified holders and there can only be 100. All shareholders must be equal when it comes to distributions. You can only have one class of stock. You still need a board, but there is more flexibility in how you structure the board because the IRS and the state expect your company is smaller and likely run by its owners.
• LLC –  You have complete flexibility. You can do almost anything a partnership can do. You can agree to share money the way you want. You can choose to have a board or an individual manager who makes decisions. You can decide who gets to vote on what and how money is paid to owners who work in the business. Everything is based on your contract, which is called an Operating Agreement.
• S-Election for an LLC – You can choose to be taxed as an S-Corporation if you are an LLC. But, you give up a lot of the flexibility. You must act like a Corporation and have a board and bylaws and all of the other limitations we just discussed.
• Taxation as a Corporation – You can also choose to be taxed as a Corporation (twice) as an LLC. This changes the relationship of the owners.

Once you have determined how your entity selection impacts your relationship with the owners, you can begin to think of the relationship you want for the owners to have. This is a new contractual relationship. But, it is completely controlled by your relationship with the government. Think of them as contracts that work together. Your agreement with your partners can’t violate your agreement with the government (or the IRS) because, if it does, the government will consider you in breach and you will lose the Liability Protection you were seeking with your entity in the first place.

If you want to know more about the agreement with your partners, you can check out these posts:

• Operating Agreement

• Buy-Sell Agreement – Voluntary Transfers

• Buy-Sell Agreement – Involuntary Transfers

Of course, if you aren’t sure what entity to choose, you can always follow this rule of thumb.