One of the most critical decisions for any new business is choosing the right business entity. This decision can have far-reaching implications, and if not given careful consideration, it can be the difference between a business that reaches its full potential and a business that flounders, crashes, and burns. This decision can affect everything from liability, taxation, raising capital, and day-to-day operations. However, this is complex territory to navigate alone. We are more than happy to summarize the key advantages and disadvantages of the three most common business structures, C corporations, S corporations, and LLCs. 

Here are some of the most important factors to consider to ensure you know how to choose the right business structure when starting your business.

S Corp vs. C Corp vs. LLC

The main difference in S Corp vs. C Corp vs. LLC is rooted in their tax structures, ownership limitations, and administrative burdens. LLCs and S-Corps are both known for their pass-through taxation, which avoids the double taxation issue that C-Corps face. However, S-Corps have strict limits on the number and type of shareholders, whereas C-Corps and LLCs offer more flexibility in ownership, making them better suited for different business goals and growth strategies. This is a critical factor when choosing which structure is right for you, as it will determine how you can raise capital and distribute profits.

Choosing the Right Business Entity: S Corp vs. C Corp vs. LLC

When you are choosing the right business entity, you generally have 3 different options: an LLC, an S Corporation, or a C Corporation. Deciding between each can be daunting, and you’re probably wondering, What type of business entity should I choose? We’re here to help. 

Choosing the right business structure means understanding your unique business needs, the pros and cons when debating an S-Corp vs. C-Corp vs. LLC, and which one best aligns with your goals and vision. So, let’s get into it, starting with the pros and cons of an S-Corp!

Pros and Cons of an S Corporation (S-Corp)

The first type of entity you will encounter when trying to determine how to choose the right business structure is an S Corporation, also called an S-Corp. This type of structure offers some key advantages that you might want to capitalize on. Here are the pros of an S-Corp structure:

1. Pass-Through Taxation: Income, losses, deductions, and credits flow directly to shareholders, avoiding the double taxation seen with C-Corps.
2. Liability Protection: Like a C-Corp, an S-Corp generally shields shareholders from personal liability with very limited exceptions.
3. Tax Benefits: Shareholders can claim business losses on personal tax returns, potentially lowering overall tax liability. Shareholders can also, after paying themselves a reasonable salary, take additional profits from the company in the form of distributions, for which there is no self-employment tax imposed for Social Security or Medicare, resulting in cost savings for the shareholders (ie, 15.3% tax savings at the federal level).

It’s important to note that this type of business entity also has drawbacks that you should consider to ensure they are worth the reward. Here are the cons of an S-Corp structure:

1. Shareholder Limitations: S-Corps are limited to 100 shareholders, and all must be U.S. citizens or residents. In addition, with very limited exceptions, an entity cannot be an owner of an S-Corp. For example, a C-Corp or an LLC with more than one member could never be a shareholder in an S-Corp. 
2. Stock and Distribution Restrictions: Only one class of stock is allowed, which can limit flexibility in fundraising. In addition, the shareholders must receive any distributions from the S-Corp in the exact pro rata amounts of their percentage ownership of shares in the company. Therefore, if the ownership percentages were 50%-30%-20%, those three shareholders could only receive distributions from the company in those precise percentage amounts. This rigidity makes an S-Corp more difficult to use with businesses where the owners desire some flexibility as to how they pay themselves. 
3. Increased IRS Scrutiny: The IRS often closely examines S-Corps to ensure compliance with their rigorous distribution and salary requirements, and failure to comply with those requirements can lead to the termination of a company’s S election, which can have adverse tax consequences.

Pros and Cons of a C Corporation (“C-Corp”)

Similarly, the second structure you will encounter when weighing your options and choosing the right business entity is the C Corporation, also called a “C-Corp.” This type of structure has some benefits that could be appealing depending on your situation. 

The pros of a C-Corp structure are as follows:

1. Unlimited Growth Potential: C-Corps can issue multiple classes of stock and an unlimited number of shares, making them ideal for attracting investors and for a business with an objective of eventually going public.
2. Separate Legal Entity: Shareholders enjoy limited liability, meaning personal assets are generally protected, save for very limited exceptions.
3. Tax Advantaged for Reinvestment: Profits retained within the corporation are taxed at the corporate rate, which can be advantageous for growth-focused businesses looking to reinvest those profits in the business or ancillary businesses.
4. Easier to Raise Capital: C-Corps are the preferred structure for venture capitalists and other savvy institutional investors due to point number 1 above, as well as the various limitations that an S-Corp or LLC has with regard to raising capital at a heightened level or their suitability for serving as a vehicle for going public.

Still, there are some drawbacks that you should consider. Here are some of the most pertinent cons of using a C-Corp structure:

1. Double Taxation: Profits are taxed at the corporate level, and dividends distributed to shareholders are taxed again on personal returns. Therefore, many business owners do not find C-Corps suitable if the chief objective of the business is to distribute profits to owners rather than the owners receiving all compensation via salary payments. 
2. Complexity and Costs: Formation and compliance requirements, such as annual filings and board meetings, can be time-consuming and expensive.
3. Inflexibility: C-Corps are highly regulated, and changes to the business structure require formal procedures.

Pros and Cons of a Limited Liability Company (LLC)

The final choice that’s important to go over that you will surely encounter when choosing the right business structure is a Limited Liability Company, or an LLC. Here are some advantages of an LLC that are important for you to know:

1. Greatest Flexibility: LLCs can choose to be taxed as a sole proprietorship, partnership, or corporation, offering significant flexibility. A multi-member LLC taxed as a partnership has the discretion to pay its members (ie, owners of the LLC) virtually any way it wishes, allowing for the greatest amount of flexibility. 
2. Limited Liability: Members’ personal assets are generally protected from the company’s liabilities with very limited exceptions.
3. Fewer Formalities: LLCs are not required to hold annual meetings or have a board of directors, and thus legal compliance is simpler and less costly than with other entities. 
4. Pass-Through Taxation: Income and losses flow directly to members, avoiding the double taxation issue seen with C-Corps.

Like the other types of business structures, an LLC is not without its drawbacks. Here are some important cons of an LLC you should be aware of:

1. Self-Employment Taxes: Members must pay self-employment taxes on their share of the profits, which can be higher than corporate taxes.
2. Limited Growth Potential: LLCs are, by their nature and statutory law, designed to suit smaller business enterprises, and thus investors often prefer corporations, especially if the company plans to raise significant capital or go public.
3. Varying State Laws: Rules governing LLCs differ by state, which can add complexity for businesses operating in multiple jurisdictions.

Key Considerations for Choosing the Right Business Entity

When deciding on the right structure, entrepreneurs should consider several factors to make a strategic and informed decision that positions them for future prosperity. Here are 6 key considerations that will determine how to choose the right business structure:

1. Growth Plans: If your goal is to attract venture capital or go public, a C-Corp might be the best choice.
2. Tax Implications: Evaluate how the entity will impact your personal and business taxes. S-Corps and LLCs offer pass-through taxation, while C-Corps have corporate taxes. An S-Corp allows for tax savings for its owners by avoiding payment of self-employment tax on distributions, but also has rigorous requirements for who can hold S-Corp stock and how distributions may be paid. 
3. Liability Protection: All three entities provide limited liability, but compliance is crucial to maintain this protection.
4. Cost and Complexity: LLCs are generally easier and cheaper to form and maintain, while corporations require more formalities.
5. Number and Type of Owners: S-Corps have strict shareholder requirements, while C-Corps and LLCs offer more flexibility.
6. Long-Term Vision: Consider the scalability of your business structure, especially if you plan to expand nationally or internationally.

Set Your Business Up for Success from the Start with Expert Guidance in Choosing the Right Business Entity.

Choosing the right business entity is a critical decision that can dictate its success, so it’s not one to take lightly. That’s why understanding how to choose the right business structure is so crucial – this simple decision you make at the start can, in some ways, determine its fate. While each structure offers distinct benefits, it’s important to assess your business goals, industry, and future plans before making a choice. A professional can help you decide what’s best for you. 

Consulting with an experienced attorney, like those at Petersen + Landis, P.C., can ensure your business is set up for success from the start. Contact us today to learn how we can help.

Disclaimer: This blog post is for informational purposes only, and is not intended to be, nor shall it be considered, legal advice in any way. The topics herein are addressed in a general manner, whereas anyone seeking legal advice should consult with any attorney personally to address the specific facts and circumstances surrounding one’s personal legal objectives and needs. 

Closing a business in California, a brief overview

47% of new small businesses fail in the first 5 years — and 65% fail before they reach 10 years.  Sometimes they shutter because there are other ventures that are more pressing, sometimes because of market realities that prevent growth, and other times, the idea just didn’t have legs. No matter why you call it a day, there are steps every CA-based business owner must take to properly close their business.  Taking the proper steps will protect you from financial and legal trouble in the future. 

First and foremost, this article is not intended to be taken as legal advice.  As in any consequential business transaction, the counsel of a paid qualified California business attorney is the right choice to ensure no detail is left to chance.  This article is a cursory overview of some of the steps involved in closing a business in CA. 

Why businesses close

Running a business is hard work, it requires emotional investment, financial investment, and, usually running at a loss for at least the first 1 – 3 years.  Not everyone can weather that level of personal and financial sacrifice. While the majority of businesses that close (as opposed to being sold) are losing money, financial insolvency is not the only reason to shut down a business. 

Sometimes a business has to be closed because of struggles between business partners, other times, business partners are in different lifecycle stages, for example with one ready to retire while the other lacks the funds to buy them out. Other times there are new opportunities that present themselves, new ideas or partnerships that make the current venture unappealing.  Serial entrepreneurs leave businesses in their wake all the time. 

Whatever the reason for closing your business, there are steps to take to protect yourself in the future from legal liability or hidden risks. 

To end business dealings properly, you must legally terminate the business with the California Franchise Tax Board and Secretary of State.  This is only true if your business was formed in the state of CA, if it was formed in another state, you will need to “legal surrender it” (or, in the case of an LLC, cancel it).

Here are the top three steps you must take to properly close your business in the state of California from a legal standpoint.  Note: these steps are in a specific oder, step 3 requires that step 2 is complete and all must be accomplished within 12 months.  

Step 1: Get buy-in for the decision

Unless you are a sole proprietor, you must have a majority agreement to terminate your business. Document this well, get legal signatures to a written document for the records.

Step 2: Pay Uncle Sam

The Internal Revenue Service (IRS) and California Franchise Tax Board (CTFB) need to know that you won’t be filing next year so mark your final payments “FINAL” clearly and be sure to follow up. All dissolved businesses are subject to a final audit followed by clearance or consent for your dissolution from the CFTB.

Step 3: File more papers (Secretary of State)

File dissolution, cancellation, or surrender forms here: https://www.sos.ca.gov/.  Do these 3 steps in the proper order so you can send the SOS your CFTB proof of consent to dissolve (you have 12 months).

From a legal standpoint, these are the 3 most important steps.

From a business relations standpoint you should address the following 5 steps: 

ONE: Tell your employees, suppliers, creditors, vendors, customers that you are going out of business

TWO: Close your bank accounts and credit lines linked to your business

THREE: Cancel all business licenses and permits that might auto-renew or trigger an audit for suspension

FOUR: Post your impending closure online and on social media. 

FIVE: Pay your creditors

You may be closing your business to pursue a lifelong dream of travel in the rainforest, or you may have given it your heart and soul and the process may feel like defeat.  In either case, failing to follow the correct procedures can leave you open to future tax bills, liability for unpaid debts, unfilled orders, and more.  Take the time to do it right and, to ensure you don’t miss anything, hire a qualified business attorney to help. 

A letter of intent for the purchase of a business sets forth the major deal points for that transaction, including the purchase price, the structure of the deal (asset purchase, stock purchase, etc.), whether an earnout will be utilized, and so forth. The letter of intent is almost always non-binding, meaning that deal points may be modified as the parties mutually agree during the course of due diligence and drafting final documents.

The fact that the letter of intent is non-binding and chiefly addresses business points of the deal sometimes lulls business owners into a sense of complacency on the legal aspects of the deal, with the mindset being that the lawyers can hash out the legal terms later. This mindset can be bolstered by the boilerplate language used in letters of intent on legal items such as indemnification, where the letter of intent may just generally state that the parties will indemnify one another pursuant to standard indemnity terms.

Why Boiler-Plate Shouldn’t Be Ignored

Business owners would be well served, however, by taking the time and using counsel to put some concrete terms around the important legal aspects of the deal. Although the letter of intent will be non-binding, having these terms addressed will set the expectations for both sides of the deal, and without a major issue arising during due diligence, it will be difficult for a buyer to justify making significant changes on these legal items. On the contrary, if important items are not addressed, a seller is left to try to negotiate mid-deal, where the buyer has an exclusive period of 90 days or so where the seller is unable to sell to anyone else (generally one of the only binding terms in a letter of intent), and seller is incurring significant costs like attorney and other adviser fees. This circumstance gives a seller less leverage to negotiate important legal terms.

So what are these important legal points a business owner will want to address in that letter of intent? Indemnification is one major item. Rather than say indemnity will be provided pursuant to “standard terms”, the letter of intent should address several things, including: (1) an indemnity basket or cap for the seller, as well as the survival period for indemnity claims; (2) the exceptions to the basket, cap, or standard survival period; and (3) the use of any escrow or setoff for indemnity purposes.

The Indemnity Basket

An indemnity basket functions like a deductible, where generally the business owner is not liable to indemnify buyer until losses exceed a set threshold amount. Then, once that amount is met, the seller is liable for indemnification for the entire amount of any loss. An indemnity cap is a limitation on the amount seller will owe for indemnity, generally an amount in the range of 10-20% of the purchase price. One can see that having an indemnity cap limiting the amount of the indemnity obligation would be crucial for a seller. Lastly, it is important to address the survival period for representations and warranties, which governs for how long a buyer may make an indemnity claim for breach of representation and warranty. Generally speaking, this survival period is between 12 and 18 months.

The most common exception to the application of the basket or cap, or to the survival period, is for fraud perpetrated by the seller. For example, if a seller has willfully concealed a problem with the business resulting in a loss, it is fair and reasonable to say that loss should not be excused or capped, and that if the loss arises after say a one-year survival period, the defrauding seller should not be able to avoid liability for the loss.

Escrow Equal to Cap on Indemnity

Finally, buyers generally like to set up an escrow where a portion of the purchase price will sit for the survival period to ensure payment of any indemnity obligation that may arise. Typically, the escrow amount will equal the cap on indemnity. If an earnout is contemplated, buyers may also demand the ability to “set off” any amounts owing on an indemnity claim against any earnout payments owing to a seller. Say, for instance, that seller claims $200,000 in damages for an indemnifiable claim and has an upcoming $500,000 earnout payment to a seller. The buyer in this case would unilaterally deduct the $200,000 from the payment owing and remit only $300,000 to the seller.

With all the possible permutations in the indemnity provision, one can see that it’s helpful at the outset to nail down items like the amount of the indemnity cap, the use of an escrow, etc. Doing so will also reveal whether the buyer is contemplating inserting exceptions to the cap or survival period that are outside commercial norms. Finding this out sooner, and addressing it before a buyer is in the thick of the deal process, will provide a better negotiating position.

What About Earnout

Another important item to flesh out in the letter of intent is how the earnout will be treated. Generally speaking, an earnout will be tied to EBITDA or some other measure of financial performance, i.e., the seller will receive X amount of money based on company performance. Defining clearly in the letter of intent how that benchmark is measured is crucial. Will certain revenues be excluded, how is the time period for such benchmark calculated and will any adjustment be made for deals booked prior to the cutoff where revenues have not been collected yet? Each particular scenario will raise its own questions, but much better to address those specific questions upfront.

Lastly, on the earnout, a seller has the ability to categorize a portion of any earnout as deferred purchase price rather than income, which results in preferred capital gains tax treatment on that portion of earnout as opposed to an ordinary income tax rate. The resulting difference in proceeds can be substantial, so it is well worth putting in the letter of intent what the amount of fair compensation for services provided will be, with any earnout monies over that amount to be treated as deferred purchase price.

Selling a business is a complex and time-consuming process in the best of circumstances. Given that, it makes good sense to address the important issues at the initial stage in detail to provide a clear forward path. Whoever said an ounce of prevention is worth a pound of cure may not have worked in the M&A space, but they were right on the money when they said it.