Entity formation – What’s Best for Your business?

Hi everyone! Welcome to Kinetic Legal, LLC’s first blog post. I recently attended MB One’s inaugural conference/community event in San Francisco and had the amazing opportunity to meet many fitness studio owners. Being the only attorney on-site, I naturally got asked numerous questions across the board, which gave me a lot of talking points for my speech at the MindBody One event in the Denver/Boulder area coming in June! I would say one of the biggest issues these studio and gym owners confronted as small business owners was what kind of legal entity they should use for their business. This question is huge – it is the most important early legal decision a company make as it can protect a business owner from personal liability, minimize taxes, and establish the rights and obligations of the owners and managers. The proper choice of entity and sound documentation can limit potential conflict down the road, create a structure attractive to potential investors, and eliminate one more unknown that might keep owners up at night. If you fail to set up an entity, your business is treated as a general partnership for U.S. tax and legal purposes if it has more than one owner (and each partner is jointly and severally liable for all activities of each other partner), or is considered a sole-proprietorship if it has a single owner, thereby exposing all of the owner’s assets to the liabilities of the business. So, in short, a business owner should be proactive, understand the available options, and set up the entity that works for their business.

There are numerous legal entities to choose from, and vary state to state, but this post focuses on the three most common and relevant to companies in the fitness industry – The C-Corp, the S-Corp, and the Limited Liability Company. There are additionally some new “for benefit” corporate entity forms available in some states that are used for businesses with a social purpose, which we will blog about in a later post.

Determining what works for you and your business can be a tedious and sometimes expensive endeavor as it should likely involve attorneys and accountants, but making this effort will better protect your business in the long run and eliminate potentially business ending liabilities down the road. Below is a discussion of some the key features of each entity and considerations to think about when choosing the right one for you:

C-Corp

A corporation is a legal entity owned by its shareholders, who receive equity in the company in the form of common and preferred stock. The shareholders elect a board of directors who are responsible for the major decisions of the corporation, and who in turn appoint officers of the corporation (a president, secretary, and treasurer) who report directly to the board and manage the day-to-day business of the corporation.

The advantage of forming a corporation in general is the limited liability of its shareholders. Any creditor of the corporation can only look to the assets of the corporation for payment, and may not pursue shareholders individually for the corporation’s liabilities. Thus, if a corporation fails, a shareholder can only lose the amount of capital she has contributed, and one of her personal assets are at risk.

By default, a corporation is taxed separately from its owners. Most major companies (and many smaller companies) are treated as C corporations for U.S. federal income tax purposes. The corporation is taxed based on its net income at the corporate income tax level, and distributions to shareholders in the form of dividends are subject to a second level of tax, for which shareholders are responsible for paying. (Corporations, unless they elect to be taxed as an S-Corp, are generally referred to as C-Corps because they are taxed under subchapter C of the IRS Code.)

C-Corps are often preferred by external venture investors because profits and losses don’t flow through directly to owners. Other benefits of a C-corp are the ease of transferring ownership of stock and the very well-developed corporate law jurisprudence.

Limited Liability Company

There is a clear trend towards the election of LLC status for businesses in fitness industry. This is because the ease of filing, flexibility in structure, and the amount of control members can have over the LLC. Unlike S-corp and C-corps, LLCs are not owned by shareholders, but members of the company. A member can be an individual, corporations, partnerships. An LLC are creatures of contract, and are governed by an operating agreement, which can be structured in numerous ways to meet the individual needs of the LLC. For example, while an LLC may have several members who contributed capital to the LLC, if an LLC is “manager-managed” (you can elect member-managed or manager-managed when forming the LLC), the manager will retain control over the direction and the key decision making of the business. Essentially, the manager (or board of managers) of an LLC acts in a similar role to the entire Board of Directors of a-corporation.

An LLC also offers flexibility to share profits creatively. Unlike corporations, where profits must be generally distributed to shareholders based on the number of shares that shareholder owns, in an LLC, members can draft a preferred distribution provision into the operating agreement based on the terms of a business deal between members. For example, certain equity contributions by members may want a preferred dividend for a fixed period of time in return for the risk of investing in the business, but after the preferred distribution has been paid out, all future distributions of the business can then be split equally by all members based upon their ownership interest in the LLC.
Another benefit of the LLC over a general partnership or sole proprietorship is that it provides limited liability protection to its members, meaning that a member has no personal liability for the obligations of the LLC, but is only liable in the amount of the capital it has contributed. An LLC also has pass through (i.e. partnership) tax status, and a member is only taxed once at the membership level.

S-Corp

S-Corporations can be either corporations or LLCs. By making a subchapter S election with the IRS, the entity is considered a pass though entity – its tax liability for both profits and losses are passed to shareholders directly; except that the S-Corp’s owners only pay self-employment taxes on a reasonable income, rather than on all corporate profits. Businesses with considerable annual dividends to working members could see considerable tax savings by making such an election.

While there can be considerable benefits to an S-corp election, the IRS places certain limitations on S-corps:

  • The corporation may not have more than 100 shareholders;
  • All of the shareholders must be individuals, certain tax-exempt organizations, qualifying trusts, or estates; and
  • The corporation, unlike a C-Corp, can only have one class of stock.

Because the shareholders of an S-Corp generally must be individuals, this prevents companies who wish to raise equity from venture funds, corporations, or other investors from qualifying as an S-Corp.

In the end, the goals of your business, the structure you want to create, and the stage in the business’ development will dictate the best structure for your business. By being proactive, understanding the implications of each choice, and consulting quality advisors, you can ensure your business will not face undue tax or liability burdens that could have been avoided by a bit of due diligence on the front end.

About Sarah April

Sarah knew she wanted to return to her roots to practice law and start a family. She began her career as a judicial clerk and then a commercial litigator at large firms in the Denver area. She transitioned to a transactional based practice as in-house counsel at a Fortune 500 company, where her practice focused on commercial contracts, real estate transactions, and providing practical legal counsel to her clients.

2 Comments