All too often, when companies are created there is little thought about what the legal structure of the organization should be. Even when there is extensive counsel with legal advisors, the true consequences and impact of the choice are rarely understood, because the legal structure of corporations and small businesses itself is highly complex and difficult to comprehend, especially in the early stages of a company’s development.
In addition to the complexity of the structure itself, different points of view (depending on the chosen advisor or decisionmaker) come into play. Lawyers frequently recommend legal structures without taking into consideration the tax and strategic impacts of the choice. Accountants (e.g., CPAs) typically provide advice solely from the perspective of tax consequences. Company founders make decisions based upon the advice of others and often what seems the simplest (or the cheapest) to do. For example, a company founder may perform a perfunctory website search, complete some forms, file the papers and pay a fee. Easy as 1-2-3 … until the business is up and running, and the founder discovers the practicalities of running the business—not to mention the filing of the first tax return and annual report.
A typical legal structure in the high technology sector—and one legal and tax advisors traditionally recommend—is the Limited Liability Company (LLC). The benefits of an LLC can be ideal for companies that do not plan to raise investment capital, project significant organizational changes or that place an emphasis on “simplicity” of setup and maintenance. In addition to the ease of setup, the flow-through tax structure for profits and losses is important to founders.1(Flow-through entities allow the profits or losses of the company to be taxed on the owner(s) tax return, rather than paying taxes as a business and having profits, dividends, etc. taxed when they are distributed to the owner(s) – eliminates double taxation.)
While LLCs are a fairly simple structure to set up, it is essential to understand the broader impact of selecting the LLC as your business structure. LLCs are excellent legal and tax structures for businesses including holding companies, joint ventures, and investments (e.g., real estate). They can also be highly effective for organizations that cannot structure profit and loss allocations satisfactorily under standard corporate structure constraints. Beyond these situations, however, technology and entrepreneurial entities need to think long and hard about the potential impact of an LLC structure on future operation.2
Often, LLCs also have structural consequences when it comes to funding. Some Federal and state grant programs will exclude LLCs from participation based upon the nature and types of owners they have. It is not so much the LLC as it is how the investors/owners/members participate that is the stumbling block: for instance, if a large, non-profit entity (like a university) has a significant ownership stake in the LLC. Other issues around grant funding for an LLC involve the ability to determine costs of performance of managing members of a organization that is not yet profitable; if the owning members do not have substantiated cost to the company for work performed (that can be independently confirmed through tax filings) then the costs that can be billed to a grant are essentially zero.
LLCs also have other issues that may include:
- Significant tax consequences can occur when members have negative capital account balances at the time of conversion to corporation.
- Conversion of ownership can be proportionately altered when transitioning from an LLC to a corporation. Some founders/members may find themselves going from a 10% claim on profits and losses to a tenth of that (less than 1%) when the capital account balances are evaluated.
- Potential venture investors may automatically exclude LLCs from investment consideration or require conversion to a corporation before they will invest.
- Tax advantages like credits for technology investment may be available to corporations, but not other legal entity types.
- Operational agreements that require 100% agreement on legal/tax structure changes may not be easily obtained if minority interest members, or those whose proportional interest in the entity, will be impacted by capital account balances.
- Differences in state requirements for operation. (For example, a state may require at least two owners of an LLC.)
- The tax consequences of taxable “phantom” income to members and a potential need to distribute funds to the members to cover taxes versus keeping the funds invested in the organization’s growth plans.
Whatever the initial choice of legal and tax entity, it is important for founders to understand that the longer an entity operates under one structure, the more complex (and potentially costly in time and dollars) will be the conversion to a new legal or tax entity choice. Timing becomes everything when you are pursuing funding, making operational decisions and looking for the “best” structure for growing your business.
While setting up an LLC may seem as easy as logging on to a website where you can get the forms and “guidance”, the reality is that taking your time and making an investment in advice, research, and “what-if” analysis is usually time and money well spent.
Copyright ©2010 F.O.C.U.S. Resource, Inc.
All Rights Reserved.
1 Keep in mind that LLCs that do not properly address the requirements for maintaining limited liability can expose the founders themselves to personal and financial liability
2 Yes, legal entities can be changed, but this is often complicated by tax issues for the owners and takes time and resources – something many entities do not have a lot of at critical junctures in the organization’s growth.