Starting a Business Los Angeles

1. Starting a Business in Los Angeles: What’s the Right Choice of Entity for Your Business

2. As a practical matter, there are 5 choices as to the form of entity through which an entrepreneur might choose to operate a business: (i) a Sole Proprietorship (no business entity); (ii) a “C” Corporation; (iii) an “S” Corporation; (iv) a Limited Partnership (LP) or (v) a Limited Liability Company (LLC). Making the choice as to which form of entity to use – especially after a little online or other research – can seem like a daunting challenge. A quick search of the Internet can be overwhelming. There is lots of data posted by government agencies as well as by legal and accounting professionals as to the tax and business characteristics of each option… lots of data but often very limited direction. All of the data notwithstanding, I believe that answering the 5 following questions will lead you to a sound and workable decision:

3. Question #1: Is limited liability an unconditional requirement of your business structure? If limited liability is required (as it should be), it eliminates the sole proprietorship as a structural option. Even though a sole proprietorship is easy and doesn’t require the payment of any legal expertise/fees, a good non-negotiable, first principal of business organization is that an entrepreneur should never expose personal assets to liability for business risks unless (i) it is expressly intended to do so and (ii) the exposure is quantifiable and acceptable in order to achieve a strategic business goal on a case by case basis (as, for example, in connection with a personal guarantee in order to obtain a bank loan for the business

4. You don’t want any big and adverse surprises, which may be uninsurable as well as not reasonably foreseeable. Suppose, for example, your employee – while on an errand for your company – stopped for a couple of drinks en route, had a bad car accident on his way back to your office while driving under the influence (paralyzing the other driver, a 40 year old plastic surgeon) and incurred a $30,000,000 judgment based on some calculation of the present value of the doctor’s future lost earnings. The driver’s employer (you) would be personally liable on the foregoing facts. Bottom Line: For the foregoing reason, in all cases, I NEVER recommend the use of the “sole proprietorship” option of “business organization” (i.e., operating your business individually, and not through a viable liability-shielding entity). It’s not worth the risk.

5. Question #2: Will you want to incentivize your employees with equity? If so, a corporation (“C” or “S”) is preferable to either an LP or an LLC because of the availability of Incentive Stock Options (ISOs) which have significant tax advantages for the recipients. While a Profits Interest in an LLC or LP is not taxable upon receipt by an employee, its considerably more complex, more difficult and expensive (in terms of legal fees) to draft and understand, much less frequently used as an equity incentive and – for the foregoing reasons, much less appreciated and much less effective as an equity incentive than an ISO. Bottom Line: If incentivizing employees is important, you will want to organize as a “C” Corporation or “S” Corporation, rather than a LP or an LLC.

6. Question #3: Will you be seeking angel and/or venture capital investors? If so, they will want a “C” Corporation with customary preferential rights, the terms and conditions of which are well-established for seed round and preferred series transactions. Those terms and conditions are very intricate and complex and are difficult and confusing (and therefore expensive in terms of legal fees) to translate standard corporate preferred shareholder rights into comparable preferences in an LLC Operating Agreement (Note: A Limited Partnership is not an option because, unlike an LLC, an LP affords limited liability only to “passive” investors; the preferred rights would afford too much “management participation and control” for the professional investors to maintain limited liability protection.). An “S” Corporation is a highly unlikely option because professional investors will almost always insist upon rights and preferences that would constitute a second class of equity (and an “S” Corporation is limited to a single class of equity). Bottom Line: If you are targeting angel and/or venture capital investors, you will most probably be further narrowing your choice of entity to a “C” Corporation. .

7. Question #4: Given the initial and ongoing cost of heightened complexity of an LLC as referenced in Questions #2 and #3 and the preferences of angel and venture capital investors, are there more important and more compelling tax reasons that would nevertheless trump those considerations and mandate the use of an LLC entity? a. Argument #1: An LLC is preferable to a “C” Corporation because “C” Corporation shareholders will incur “double taxation” (i.e., taxation at both the corporate level and the shareholder level). This is probably NOT a compelling consideration because (i) the “double tax” hardly ever in fact occurs (except in a business that generates very high and ongoing positive cash flow); (ii) with proper planning, corporate expenses and other taxable deductions can often offset much of a “C” Corporation’s income and (iii) the various tax and other economic benefits of a corporate structure will offset all or part of any such increased tax liability.

8. b.Argument #2: An LLC is preferable to a “C” Corporation because an LLC can make special allocations of losses and expense items. The ability to make special allocations of losses and expense items is possibly, but not necessarily, a compelling consideration, because of limitations on the extent to which passive investors can utilize the benefit of loss pass-throughs.

9. C. Argument #3: An LLC is preferable to a “C” Corporation in a real estate venture that involves significant debt that needs to be included in the tax basis of certain investors. An investor’s tax basis also limits the extent to which the investor can utilize losses, subject to the passive loss limitation referenced above. There is one situation where there would likely be a compelling consideration for organizing the company as an LLC rather than a “C” Corporation: if there will be significant liability for debt (recourse or non-recourse) that can be specially allocated to the tax basis of certain of the investors. Utilization of the highly flexible structure of an LLC in a real estate venture can provide favorable significant and otherwise unattainable tax benefits to those investors. Even if passive loss limitations restricted an investor’s current utilization of pass-through losses, the deferred pass-through losses could be beneficial to the investor upon disposition of the property and recognition of gain.

10. Bottom Line: Absent compelling considerations to contrary referenced in Argument #3 of Question #4 above (special allocations of tax basis), a startup entity should be organized as a “C” Corporation. If founders want to take advantage of pass-through tax treatment of losses before there is any angel or venture capital financing, it is possible for them to do so by making an “S” Corporation election (as long as there are no entity or foreign investors, which are not permitted to own “S” Corporation stock). The “S” Corporation election can be easily revoked prior to such financing, which would cause the entity to automatically revert to a “C” Corporation.

11. Question #5: Are there additional good reasons for organizing as a C Corporation rather than as an LLC? Yes, the following are at least five (5) additional good reasons for organizing your business as a “C” Corporation, rather than an LLC. a. Additional Reason #1: You don’t have to issue a Form K-1 to each investor, (i) which would make the investor liable for income tax even if the income is not distributed to the investor and (ii) also make the investor potentially liable for state income tax in any state in which your business has a sufficient connection for income tax purposes.

12. b. Additional Reason #2: You don’t have to negotiate an agreement with investors to make minimum distributions of cash to at least cover the investors’ federal and state tax liabilities with respect to company income allocable to them. That cash can be reinvested in the business. c. Additional Reason #3: You can avoid the tax accounting complexities (and associated professional and other administrative expenses) related to the accurate maintenance of capital accounts in accordance with applicable rules and regulations, particularly when there will be multiple rounds of financing.

13. d. Additional Reason #4:You can avoid the otherwise required reporting and withholding of company payments to foreign investors (which is why such foreign investors generally prefer a “C” Corporation rather than an LLC). e. Additional Reason #5: You can participate in a tax-free reorganization with a “C” Corporation (with investors paying taxes on the stock received only when that stock is subsequently sold); whereas, if you were to exchange LLC interests for stock, the receipt of such stock would be a taxable event even if the stock cannot be sold to generate cash to pay the taxes due. For any question about starting a business in Los Angeles, please contact Attorney Robert D. Krintzman, at (323) 496-4272, or visit http://www.companycounsel.com