San Diego Business Lawyer and Contracts Attorney providing a first class “one stop shop” for all your business, contract, will, tax and estate planning legal needs. Contact us today: (619) 400-4942.
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Phone: (619) 400-4942
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Once the principals have a good understanding of the various alternatives available to them in the entity selection process, they should work with their professional advisors to collect and evaluate all the information necessary to make an informed decision. The legal or accounting professional will generally distribute a list of required information, including business and financial information on the proposed business and each of the principals. If possible, a business plan and detailed projections should be prepared so that proper consideration can be given to specific risks and amount and timing of profits and losses from the enterprise.
Once the information is collected, a good deal can be sorted out by asking the following basic questions:
• Are there any nontax factors that would require utilizing the corporate form? These might apply when the business activities are particularly risky or the principals intended to raise significant amounts of capital from outside investors.
• Will the business generate losses during the early years of operation that makes it desirable that one of the forms of “pass-through” entities (i.e., partnership or S corporation) be used?
• Are there any special tax planning considerations that must be taken into account? Anticipated transfers to family members for estate planning purposes may dictate the use of a limited partnership. If flexibility with employee benefits is desired, a corporation may be the best choice of entity.
• Are there any special nontax considerations that must be considered when no clear choice has emerged from the balance of the above referenced factors? Formation and administration costs are sometimes very important for very small businesses.
Even when a preliminary choice has been made based on the foregoing analysis, a variety of other issues must be considered, if not already taken into account. They include the following:
• The participation of various types of entities, such as a corporation, a nonresident alien, or certain types of trusts, may prevent use of a S corporation, as may the number of participants.
• Participants who must be actively involved in managing the business must be general partners, members, or shareholders, with the choice depending upon the need for limitations on liability from the entity itself, rather than from insurance. The degree of involvement in the business may also impact the deductibility of losses for partners under the “passive activity” rules.
• Transfers of ownership interests may result in a variety of adverse tax consequences when the partnership form is used. Also, planning for the withdrawal, retirement, or death of a principal may have an impact on the form of business entity selected.
• The need to reinvest profits from the operation of the business may require using a C corporation, since the “pass-through” forms will tax the profits at the ownership level, thereby necessitating some distribution of assets to meet the current tax liabilities.
• If the principals are related to each other, any disproportionate relationship between the property and services contributed to the entity and the proprietary interests of the owners in the business may result in a reallocation of income between the parties if the partnership or S Corporation is used.
Evaluating each of these factors requires extensive consultation with professional advisors. They can assist the principals in comparing the various alternatives, often by reference to a chart that lists how each of the entities addresses specific tax and nontax issues. Software programs are also available to create projections of the anticipated tax liabilities for the entity and each of the owners based on an assumed selection of a particular organizational form.
The participants are not necessarily limited to a single organizational form. For example, there may be situations where certain elements of the business should be separated, perhaps because of the disparate functional skills associated with the activity or the degree of potential liability. A separate entity might also be formed to handle activities associated with a specific product line or in order to gain access to benefits provided for businesses organized in specific localities. However, before two or more entities are used, consideration must be given to the added complexities, including the need to keep multiple sets of books and records.
Selection and use of any entity organized under laws other than those of the state of California is also a possibility; however, as mentioned above, this decision should not be made with consulting experts in the law of the chosen jurisdiction. For example, businesses contemplating an eventual public offering of their securities may incorporate under Delaware law because of perceived advantages of Delaware corporate law as it relates to public companies. However, certain provisions included in California’s corporations laws effectively override Delaware law until the specific conditions based on the number of shareholders and situs of business activities are satisfied.
Finally, the principals need to remember that while the initial selection of the form of business entity is important, changes in the form of entity can be made as the needs of the business and its owners evolve over the life of the enterprise. For example, California law allows for conversion of one form of entity into another with a minimum of regulatory paperwork as long as the economic interests of the owners remain essentially the same after the conversion. Also, a sole proprietorship may be converted into another entity to admit additional owners and/or limit the liability of the principals.
San Diego Business Lawyer and Contracts Attorney providing a first class “one stop shop” for all your business, contract, will, tax and estate planning legal needs. Contact us today: (619) 400-4942.
Contact Kehr Law today
Phone: (619) 400-4942
Text Message: (619) 823-8230
Email: dan@kehrlaw.com
