Three Important Considerations for Your New Business Entity

So, you’ve decided to start a business entity! Congrats on wanting to do things the right way! You now have some critical decisions to make and documents to create regarding said business entity. While it may seem daunting at first, these decisions & documents are the keys to having a sold foundation that clearly lays out how your company is set up, the rules that must be followed, and how it runs day-to-day.

If this is all brand new to you, don’t worry, this article will give you background & guidance on three essential issues so you can proceed with confidence.

1. Type of Business Entity vs. Choice of Tax Classification

Two of the first decisions you must make when creating your business entity are choosing a type of business entity and choosing a tax classification. The first of these decisions is choosing a type of business entity. For most business owners, this is choosing between an LLC, a Corporation. Then you must select how you want this business entity to be taxed. This is usually a choice between having a disregarded entity, a C-Corporation, or a S-Corporation.

The first choice, what type of business entity to create, is handled at the state level. That means you’ll be dealing with a state government, not the federal government, when doing this. You’ve probably been browsing your state’s Department of State’s website while researching this decision. Depending on your state, you could have numerous options including nonprofit corporations, limited partnerships, benefit corporations, general partnerships, Series LLCs, special purpose corporations, among others.

Once you make your decision on what business entity to form, you’ll have to file a document with the Department of State of your chosen state to formally create the business entity. This document will almost certainly contain the word “Articles” in the title. For example, in Florida the document is called the “Articles of Incorporation” if you’re forming a corporation. If you’re forming an LLC, the document is called the “Articles of Organization.”

Once the filing is accepted, your business entity will exist. This is a good time to make the second decision: “How do you want to be classified for tax purposes?” or, put another way, “How do you want to be taxed?”

Each business entity has a default tax code that the Internal Revenue Service applies to it. LLCs and Partnerships are considered “disregarded” or “pass-through” entitles by default. They are called “pass-through” because the business does not pay taxes, instead the owners report their share of the business’ gains & losses on their personal tax returns and pay taxes at their individual tax rate. Corporations are taxed as C-Corps by default. A corporation is treated as a separate taxpayer from its owners. As a result, a Corporation must file and pay taxes for its own gains and losses at the corporate tax rate.

These defaults can be changed however. The ever-so-popular S-Corp, for example, is not a type of business entity, but a tax classification that businesses can choose. If you like to change your business’ tax classification, you need to file a document with the IRS letting them know. This document will be called an “IRS Form” or “Form.” For example, if you’d like to be taxed as an S-Corp, you’d need to complete IRS Form 2553.

So no, you don’t have an S-Corp. You have a business entity (LLC, Corporation, or Partnership) that has elected to being taxed as an S-Corp.

2. How to Structure Management

A Company’s management structure explains who makes decisions for the business. This information is usually contained in the Articles described above or another organizational document. The name of these organizational documents depends on the type of entity. For partnerships, this document is called a Partnership Agreement. For LLCs, it’s called an Operating Agreement. For Corporations, it can be split between the Bylaws and a Shareholder Agreement.

The amount of flexibility you have in shaping the management structure also depends on the type of business entity you’ve selected. Corporations have a rigid structure. The shareholders elect the board of directors who select the officers who ultimately run the corporation. Nonprofit corporations are even more rigid, requiring at least three directors on their board and limiting the purpose of the organization.

By comparison, LLCs have a very flexible management structure, allowing for the owners, called “Members”, to manage the business directly or allowing them to outsource management to others, called “Managers”, who oversee the business’ day-to-day operation. If one desired, they could even structure their Operating Agreement to recreate the rigid structure of a Corporation, using a Board of Managers, which operates like a Board of Directors does in a Corporation. But, ultimately, with an LLC, the choice is yours.

3. How to Structure Equity

Equity is your ownership in the company. In a for-profit company, equity or ownership essentially boils down to two things: the right to receive profits from the company and the right to make decisions. However, your choice of your tax classification can limit your ability to structure your equity.

As mentioned, equity comes down to your right to receive profits and make decisions. You can structure equity in your business to give some business owners different rights. These are called classes of shares. For example, you could create shares that have the right to receive profits but not make decisions (these are called non-voting shares). Or you could create an equity structure where some business owners have the right to be paid out before others if the Company were to go bankrupt (these are called preferred shares).

However, how much flexibility you have in structing your business entity depends on your tax classification. Those being taxed as S-Corps can only have one class of shares. Meaning every owner of the company has to have the exact same rights to receive profits from the business, according to IRS regulations. This one class can still have voting & non-voting shares, however.

Get the Right Structure In Place with TealAcre

This is just the tip of the iceberg, there's many more questions that need to be answered. If you’re considering creating a business entity, reach out to TealAcre to get the guidance you need. Don’t leave it to chance, or an online D.I.Y option, or the cheapest lawyer you can find! You read this far because you’re care about your business. And, you care about your business because it’s how you provide for your family, acquire your assets, take care of your employees. Instead of going at it alone, let TealAcre help you get the clarity and peace of mind you’re looking for. To contact us you can:

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