January 16, 2019

So you want to start a business?  If so, two immediate and crucial decisions to make are: (1) choice of entity and (2) how to properly raise capital.  Aspiring entrepreneurs need to be aware of the benefits and pitfalls that each decision can bring. 

Choice of Entity

For small businesses, the choices typically involve either an S corporation or limited liability company (LLC).  Both offer "pass-through" taxation, meaning profits are only taxed once at the owner-level.  Some view this common, tax-saving feature between the two as a wash and tend to focus on other short-term advantages available.  This is usually where the S corporation wins.  The difference between the two for self-employed business owners is that all income earned through an LLC is subject to self-employment taxes (FICA).  However, with an S corporation structure, business owners can divide a reasonable portion of their earnings between a salary that is subject FICA, and a dividend payment, which is not.

In the early years of a new company with a small number of owners and employees, this "FICA play" may make the most immediate, bottom-line sense from a tax-savings perspective.  But business owner beware, prioritizing a FICA play at start-up could be short-sighted, and lead to unintended tax consequences down the road.

The benefit to operating as an LLC is that, by default, it is subject to the partnership tax rules of Subchapter K.  Partnership tax is complex, but it is also wonderfully flexible in satisfying the economic and business arrangements dreamed up by business owners.  For example, if you want to grant a profit share to key employees or provide a preferred return to a crucial investor, then the LLC allows you to do that.  If you want to differentiate how profits, losses, and deductions are shared among the owners, you can (within reason) do that also.  S corporations do not have this flexibility.  The S corporation is allowed only limited numbers and types of owners, can only have one class of stock, and can only make distributions pro rata based upon ownership.  In short, this means that no profits interests or preferred returns can be issued by an S corporation.  For a growing company in need of retaining and attracting key individuals and investors, this rigidity in structure can be very limiting.

Another major item to consider is the different way that the corporate tax rules (S corporation) and partnership tax rules (LLC) treat contributions and distributions of property.  With the LLC, a business owner typically can extract appreciated property from the business in a tax-deferred manner.  This is great when the business reaches the point of restructuring or an acquisition.  However, there is an immediate tax cost in removing appreciated property from an S corporation.  Under the corporate tax rules, distributions of property are treated as a sale of that property, and any gain is immediately taxable to the shareholder.

None of the above is intended to suggest the LLC is superior to the S corporation.  Rather, the point is that not all pass-through entities are the same, and the differences will really manifest themselves later in the business life-cycle.  Awareness of these issues and careful planning are crucial.  And, if the S corporation is the proper entity choice, it should be formed as corporation and make an S-election with the IRS.  It is true that LLCs can elect to be treated as S corporations, but just because you can do something, doesn't mean you should!

Raising Capital

There are an unlimited number of ways to fund your business idea and structure the equity or debt instruments necessary to accommodate it.  That much is obvious, but what is often overlooked are the applicable federal and state securities laws that can be a trap for the unwary and over-zealous entrepreneur. 

Breaking down all the possible situations, restrictions, and exemptions of the securities law is well beyond the scope of this article.  But know this: if you offer an investment opportunity to someone in exchange for their money, it is almost always the case that you have made a securities offering subject to both the federal Securities and Exchange Act and one or more state securities regulations. 

Aspiring entrepreneurs need to be keenly aware of this fact before they get started raising money for their business idea.  As onerous and encompassing as the securities laws are, there are, however, several exemptions typically available at the federal and state level that are perfect fits for start-ups.  For example, Rule 506 of Regulation D (a "Reg D offering") allows businesses to raise unlimited amounts of money from accredited investors through private placement.  Reg D offerings are also exempt from state registration (except for basic notice filings and fees).  Also, if an offering is made to a small group of investors from within the same state, an "intra-state" exemption could apply for both the federal and state rules.  This means asking for money from a small group of your family and friends is likely fine and easy in most circumstances, but you need to look (at the rules) before you leap.

The key takeaway to remember about securities laws is that you just need to be aware that they are out there!  Violating them can potentially spell big trouble for you and your business before it even gets off the ground.  Awareness and patience go a long way in making a successful capital raise.  Indeed, in this area, an ounce of prevention is definitely worth a pound of cure.

Conclusion

A new and exciting business idea is a good thing, but don't let your enthusiasm and naiveté out-pace sound decision-making.  There is more than meets the eye when it comes to both entity formation choices and raising capital.  However, just a little bit of focused discussion and planning can go a long way towards making informed choices in both regards.

This Insight is intended only to provide an overview of the matters addressed herein and does not constitute legal advice.  If you have any questions regarding a specific issue, please seek appropriate legal counsel.