United States: Business Startup Issues That May Find You – Even If You Don't Go Looking For Them

Last Updated: April 8 2015

In my practice, I have found that a majority of my clients who create significant wealth do so through ownership of a private business or a concentrated stock position in a publicly traded company.

What that means for you is that if you haven't yet started a business or taken an ownership position in one, it's probably only a matter of time until you will.

Among many others, reasons you might start (or end up owning part of) a business include:

  • You buy a vacation rental property
  • You start investing in multi-family or commercial real estate
  • Your start your own professional practice
  • You and some friends invest in a chain restaurant franchise
  • The large corporation where you work sells your division to you and a small group of co-workers
  • A merger requires you to "pursue other opportunities," so you do, and start a competing, smaller business with colleagues
  • You are a co-founder of a startup
  • You are optimizing your college financial aid position

Businesses formed for these sorts of purposes often include limited liability companies, C-corporations, and S-corporations.

Choosing which business type is best for your purpose often involves mundane and subtle issues in several key areas, including ownership, governance, allocation of profits and losses, tax planning, exit planning, and paperwork.

The discussion provided here isn't comprehensive. That said, a brief reconnaissance of the choice of business entity issues that are likely to come up during your career or in your estate plan is time well spent.

Ownership

The business will have owners. For an LLC, these are called members, and for corporations, they're called shareholders.

Unless you know you will be the only owner of your business over its entire life cycle, it may be wise to create the business with voting and nonvoting equity (membership interest or units in a LLC, and shares in a corporation).

With nonvoting units or shares, you can much more easily separate ownership and control of the business. This can be useful for admitting new owners, transferring equity to employees, and/or gifting ownership to family.

Decide how ownership of the business will be split among the owners before the business is started. (This is rather obvious, but clients sometimes defer this decision long after the start-up phase, and tax reporting problems and disputes among owners can result.)

Governance

Someone will have to control the business. A corporation has directors, who are elected by the shareholders. The directors elect officers, who manage the corporation's business. A LLC may be managed by its members (owners), or by managers elected by the owners.

As above, unless you're very confident you'll be the only owner of a LLC during the LLC's entire life, I think manager-managed LLCs create more flexibility. This is because a non-voting member will have no opportunity to act on behalf of the LLC, reducing any worries about "rogue" actions by minor owners of the LLC.

If a business will have more than one owner, think carefully about whether a supermajority requirement for action by shareholders (or members) and directors (or managers) makes sense. Supermajority requirements can incent consensus and protect minor owners (at best), or cause delay and deadlock (at worst).

Dividing Profits and Losses

The profits and losses produced by the business need to be allocated among the owners. The corporation and LLC statutes have default rules for pro rata allocation of profits and losses.

It's possible to opt out of these default rules by creating different classes of stock in a corporation's articles of incorporation, or different classes of membership interest in a LLC's operating agreement. (Bear in mind, however, that a corporation with more than one class of stock cannot elect to be taxed as an S corporation.)

Income Tax Treatment

A LLC with only one owner (member) is a disregarded entity for income tax purposes, with the result that all of the LLC's income tax attributes flow through to the personal income tax return of the sole member.

An LLC with more than one owner is typically taxed as a partnership. Income tax attributes will be allocated to the members in accordance with the operating agreement (or the statutory pro rata default rule), and the members will pay the resulting tax obligations. (This opportunity for "single level" income tax treatment is an attractive feature of LLCs.)

A C corporation is a separate income tax paying entity. Additionally, when the C corporation makes distributions to its shareholders, those distributions are typically taxed as dividend income to the shareholders. (This "double level" income tax treatment is a comparatively unattractive feature of C corporations.)

An S corporation offers "single level" income tax treatment for an eligible corporation that has made an election to be taxed as an S corporation. To be eligible for an S election, a corporation's shareholders must be US citizens or green card holders, estates, or certain types of trusts. In addition, the corporation may not have more than 100 shareholders.

Exiting and Transferring the Business

Usually, third parties don't want to buy non-controlling interests in private businesses. Nonetheless, it's wise to give some thought to whom you want to be allowed (or disallowed) as an owner.

  • Should an owner who doesn't work at least part-time in the business be required to sell his or her shares?
  • Should a divorced spouse of an owner be required to sell shares awarded to him or her in a divorce?
  • If one owner sells his or her shares to a third party, should the other owners have a "tag along" right to participate pro rata in the exit opportunity?
  • Conversely, if more than a certain percentage of ownership is sold to a third party that wants to buy all of the ownership, should shareholders be subject to "drag along" in a required exit?
  • Should co-owners have a reliable way to exit the business (at least in part) from time to time? (A pro rata annual tender offer is one way to provide for this.)
  • If an owner is disabled, should he or she be able to sell his or her ownership? Should he or she be required to do so?
  • If an owner dies, should his or her estate be able to sell the deceased owner's shares? Should it be required to do so?
  • S corporation shareholders should be subject to restrictions preventing them from transferring shares in the S corporation to ineligible shareholders – which would cause the corporation to face "double level" taxation as a C corporation.

Many of these triggering events for a purchase or sale require valuation of ownership interests. To avoid heartache and/or litigation, a valuation formula or other appraisal approach should be provided for.

Paperwork

You'll have to file articles of organization with the Secretary of State to start a LLC, or articles of incorporation to start a corporation. You should also have bylaws (for a corporation) or an operating agreement (for a LLC).

Buy-sell provisions dealing with exit and transfer issues raised above can be included in the LLC operating agreement, or a separate buy-sell agreement for the corporation (or LLC).

To preserve the creditor protection advantages of the business entity and comply with applicable laws, you should keep regular meetings of the minutes of shareholders or members, and (if applicable) directors or managers.

Which Type of Entity to Use?

In many instances, a manager-managed LLC may be a good option.

For a business that will produce losses in its early years, a C corporation is unlikely to be an optimal choice, because "double level" tax treatment will prevent those losses from flowing through to the personal income tax returns of the owners, where they might be put to much better use.

Beyond these general observations, issues of business entity choice are necessarily case-by-case and fact-intensive.

Before choosing your type of entity, a thorough evaluation of your current situation and future plans (and those of other owners) should be balanced against your tax situation and objectives, along with your tolerance for paperwork, annual reporting, administration, and compliance.

That said, with at least a quick sense of the issues you should be thinking about, planning appropriately when choice of business entity issues present themselves becomes a little easier.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.