Starting a Business Los Angeles

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Starting a Business in Los Angeles

• Whats the Right Choice of Entity for Your
  Business

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• 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

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• 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 doesnt
  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

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• You dont 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 doctors future lost earnings. The
  drivers 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).
  Its not worth the risk.
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•  

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•  
• 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.

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• 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.
• .

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• 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?
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• 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 Corporations 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.

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• 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.

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• 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 investors 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
  investors 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.

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• 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.

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• 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 dont 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.

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• b. Additional Reason 2 You dont 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.

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• d. Additional Reason 4You 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 [phone], or visit
  http//www.companycounsel.com

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