Why it pays to select the right corporate structure now

Filed under Columns

By Elisha Prero and Alan Maclin

 Jewish Business News

A fool learns from his own mistakes, the late Rabbi Noah Weinberg used to say. But a  wise person learns from the mistakes of others. Weinberg, who was founder and dean of Aish HaTorah, taught a generation how to apply principles of the Torah to business. His dictum had a kicker: At least be a fool.

What can you learn from the mistakes of other startups? One lesson: Structure your business up front in a way that will give you the flexibility you need later. So, you’ve crystallized your money-making concept and are ready to rock and roll. Will your business be structured as a limited liability company, a corporation or a limited
partnership? Does this stuff make your eyes glaze over? Picking a structure is largely about how you will pay taxes on money your business makes and how much exposure you personally will have for your business’s liabilities. Each corporate structure on the menu comes with its own rules.

Some really popular structures might not suit you at all. For example, a flow-through entity (such as a partnership, S corporation, or LLC) doesn’t itself have to pay federal income tax. Its owners do. Specifically, its owners pay the tax on income that’s attributable to them. Now, attributable is a curious notion. Imagine that instead of having common sense, you had federal-tax-bureaucrat sensibilities. Guess what happens when this flow-through entity you own doesn’t distribute to you any of the money it makes. You are correct if you said you still can be liable for tax on that income your pockets never saw. Sweet deal for Uncle Sam, eh?

How would this play out? Karen Client comes to us with a problem. The S corporation she co-owns did well last year, and she owes substantial tax. But her co-shareholder, Lucifer, controls the finances and is trying to force her out of the company. Karen and Lucifer never signed a minimum-distribution agreement, and Lucifer isn’t distributing any of the money the company earned last year. Does Karen still owe tax on attributable amounts her business hasn’t paid her yet? She does. And she’s feeling kind of stuck.

Correction tends to cost more than prevention, as it does here. We assemble a team of litigators and financial professionals and eventually negotiate a deal in which Karen becomes the company’s sole shareholder. Now she controls the company’s finances and can distribute money to pay her taxes. That’s a happy ending to an avoidable problem.

The point is, to avoid locking yourself into financial conditions you’ll regret, you have two choices:

Master the pros and cons of the various corporate structures yourself. (Bright people with researching skills can do this. You learn enough about each kind of entity to choose one that fits you and enough about its pitfalls to have the right protections in place from the beginning.) This autodidactic approach builds mind-stretching skills that serve an entrepreneur well. The Internal Revenue Service provides articles with information about each structure on its website.

Or hire a professional whose experience substitutes for your mastering corporate-structure issues yourself. This approach costs less time and more money. But if you pick the right professional, you quickly can benefit from learning from the mistakes of others.

Elisha Prero and Alan Maclin are consultants with Blue Pencil Inc. in Chicago (adm@bluepencilinc.com). In various capacities over the past quarter century, they have been advising companies on how to avoid making mistakes others already have paid for.

 

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