Entity Selection: Four Practical Case Studies

1) Service Business

Scenario

Adam and Bill want to form an entity to conduct consulting business.  Each will own 50% of the business and both will be actively involved in the business.  Both want to ensure their personal assets are protected from business creditors, but they do not have a lot of money for legal fees and set-up costs.  They also want an entity that does not involve complicated accounting which would increase the cost of operating the entity.

Which entity type should they choose?

Answer

Form an S corporation

Why?

  • Salary subject to social security tax (FICA), but profits distributed from S corp. avoid FICA tax (not so with an LLC, LP or GP).
  • Only have shareholder level tax.
  • Simple to form.
  • Tax returns and accounting is not complex.

2) Now What?

Scenario

What if Adam and Bill had already formed an LLC one year ago and are now want to change the LLC into an S corporation because their accountant told them they could save FICA taxes by operating as an S corporation.  The corporation has many contracts with clients, nearly all that contain assignment restrictions; at least one that Bill thinks the client would ask for a substantial consulting fee reduction for the assignment consent.

What can they do?

Answer

  • An LLC can elect to be taxed as an S corporation. They would just have to file the Form 2353 (at the beginning of the next fiscal year)
  • No filing requirement with the state for an LLC to make an S election.
  • But … the LLC Operating Agreement should be amended to follow the S- Corporation

3) Different Economic Rights

Scenario

Adam and Bill want to buy a duplex as an investment property.  Adam will contribute $100,000 in cash and Bill will manage the property.  The first $100,000 in yearly profits and any gain on the sale of the property will be returned to Adam and then the balance will be allocated 50%/50% to Adam and Bill.   Adam has substantial personal assets and wants to limit his liability in this $100,000 investment, but also wants to have some control in the day to day management decisions.  They both want to save on income taxes.

Which entity type should they choose?

Answer

Form a LLC

  • Allocation of $100,000 to Adam requires a non-pro rata distribution, thus eliminating an S corp.
  • It is generally not advisable to hold real estate in a C or an S corporation.
  • LLC will probably best meet Adam’s needs for some governance control, liability protection, and also minimize his tax liability.

4) When?!

Scenario

Joe Smith is in the process of turning his entrepreneur dreams into a reality.  He is currently working for a large Fortune 100 company as a W-2 employee.  Joe’s wife has a consulting business that she runs from the couples’ home.

When should Joe form an entity?

  1. Joe does not have a name for his business idea. Joe estimates he has spent 500 hours of his time developing the business plan and marketing strategy for his business and building a proto-type.  Joe estimates he will need to spend another 100 or so hours of his own time to get the business beyond the dream stage.  Now?
  2. Joe has figured out what he wants to call his business and he is ready to start putting the pieces together. He wants to grab the url and start working on his website (he thinks he can do it himself). Now?
  3. Joe’s brother is a coder and he wants to help Joe work on some elements of his business. While he would love to get paid, he is willing to take some equity in Joe’s business when he gets it off the ground.  Now?
  4. Joe’s brother has gotten pretty far with building Joe’s business and now the two of them need bring some money in to get the business off the ground. Now?

Answer

At “number 2” above, Joe should form a SMLLC

  • For state governance and liability law purposes, a SMLLC is treated as a separate entity even though it is disregarded for tax purposes.
  • Since the SMLLC is disregarded for federal income tax purposes, this won’t complicate Joe’s taxes (all he has is expenses now anyway).
  • A SMLLC is simple and satisfies the tax, management and liability issues.
  • SMLLC can be scaled and converted as Joe’s needs change.

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