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Advising Clients about Choice of Entity

By Aastha Madaan

When I first started practicing business law, I quickly learned that although clients seek help with setting up a legal entity for their business, their main goal is usually profitability in their business—and rightly so. Clients seek legal help to attain this goal and to address their concerns. The three main concerns I commonly encounter from business clients are: (1) legal protection from liabilities; (2) tax liabilities; and (3) simplicity in recordkeeping and ongoing compliance.

As the business’s legal counsel, however, your concerns and considerations might be more nuanced. You will be responsible for clarifying misinformation, managing expectations, laying out a short-term and long-term plan, and, in some cases, understanding the business model in depth before you can suggest the right type of entity. This article does not cover how to form each type of entity but is a guide to how you can begin to advise your clients about the choice of entity.

Preliminary Questions

Early on in my practice, I met an attorney who told me he sets up all his clients’ businesses as limited liability companies (LLCs) because “that takes care of everything.” I never quite understood what he meant, and I still don’t.

Business entities are not one-size-fits-all; they require a little more finesse. The business entity you ultimately recommend for your client will be based on several factors. Some of these factors are discussed below. Before deciding how you would advise your client to structure, there are several things to ask the client:

  • What type of business is it? Some professional services, for example, are limited in the types of entities they can choose. This is usually restricted by state statutes. For example, lawyers in California cannot form LLCs.
  • How many people will be involved as principals of the business, and what will their roles be? This information will help you structure the business properly, whether it is an LLC with members and managers, or a corporation with shareholders, or even a partnership.
  • How much capital is each principal going to contribute? Will this have an impact on their rights and ability to participate in the decision making for the business?
  • What are the anticipated profit goals and projections? Will the principals need separate tax advice from another professional?
  • Will the business conduct transactions across state lines? You might consider incorporating in a state other than the state of the client’s domicile in this case.
  • Is your client thinking the business may need investors at some point? If so, a corporation might be a better option than other types of entities.
  • Is it an online or a brick-and-mortar business?
  • What will the business’s client/customer interactions be like? You will want to assess whether it’s a high-risk and high-liability business or a low-risk and low-liability business.
  • Are there ideas your client is attached to? I had a client not too long ago who was convinced that he wanted his corporation to be a Delaware corporation because he had heard that Delaware was the best option. Understanding a client’s preconceived ideas and the reasons for them can give you a good foundation of how to handle an entity formation.
  • What is the client’s end goal? To grow and expand a business? To have a stable source of income? Or to sell the business for a profit? A sale of stocks is organized very differently from a sale of all assets, so these considerations can lead your ultimate decision.

Once your client and you are on the same page about these goals, you can assess which type of entity will best suit your client’s needs. Below is a list of the most common types of entities that are permitted by statute in most states, accompanied by some things the attorney should keep in mind.

Corporations

Corporations are a type of business organized such that they have shareholders and a board of directors. State statutes in different states have created different structures and types of corporations, such as professional corporations, benefit corporations, close corporations, and more.

The business code or corporations code of each state contains the requirements that each corporation must comply with, and usually these requirements are more extensive than those imposed on other types of legal entities. Corporations must follow certain requirements, such as keeping meeting minutes, holding regular shareholder meetings and/or board of directors meetings, filing annual reports, and other recordkeeping.

Corporations can offer benefits such as protection for the shareholders from liabilities, especially those that occur in the course of conducting business, such as workers’ compensation, tort liability, etc. However, it should be noted that simply having a corporation does not protect the shareholders or employees from professional liability. For the types of business that are exposed to professional liability, malpractice or errors and omissions (E&O) insurance can be the first line of defense, and an attorney should advise the client of the types of liabilities covered by the corporate structure and carrying professional liability insurance.

Corporations are treated as independent entities and therefore must file taxes. In cities that are currently experiencing a boom of start-up tech companies, a corporation is a popular choice of entity because it allows the founders to raise capital in exchange for sale of stocks.

While the attorney prepares and files the articles of incorporation, drafts the bylaws, etc., he or she will also be managing client expectations. This includes informing clients that they have the additional responsibility of ongoing compliance and even additional tax consequences as a result of having a corporation. For example, California imposes an $800 tax by the Franchise Tax Board for every business entity registered in the state. Additionally, most states require corporations to file annual reports with updated shareholders or board information. Understanding and communicating these types of requirements to clients is vital for a business attorney because it manages expectations and prevents unhappy clients.

To go the extra mile, it is worth sending annual reminders to clients or even offering to file the annual report as an extra service.

Although corporations come with a unique set of compliance requirements, they also present unique benefits and opportunities to raise capital, offer stock options to employees, and realize unlimited potential growth.

Corporations are often the preferred entity of choice for service, software, and professional service industries, such as law firms, CPAs, start-ups, and tech companies.

Limited Liability Companies

Limited liability companies, also known as LLCs, are unincorporated entities. This means that they are considered legal entities but do not have to operate under the laws that govern corporations, which are stricter. While corporations are heavily impacted by their fiduciary duties to the shareholders, LLCs have members who can also serve as managers of the company.

Another way in which LLCs are different from corporations is that they offer a percentage of interest in the company to members, while corporations have the ability to offer stock, and, in some cases, different classes of stock.

A single-member LLC is often treated as a disregarded entity, which allows the taxes for the purposes of profits and losses to be recorded on the member’s personal tax returns. For this reason, when a business owner is by herself and is not intending to bring on investors, she might prefer the LLC status over a corporation. A multi-member LLC is considered a pass-through entity, which means the profits and losses are passed through the business to each member of the LLC. It should be noted that some states do tax LLCs, and some may have a business tax that is mandatory for each LLC.

The LLC structure also provides a unique benefit in that it affords extensive protection to the members for business decisions or actions of the LLC, such as debts, and protection of the personal assets of each member in the event of a tort or contracts actions. With this level of protection, it is imperative that members not commingle their personal assets with the LLC’s assets because the corporate veil is only as strong as the separation between the bank accounts of the LLC and its members. This is a point that attorneys need to clearly and repeatedly communicate to their clients if they are thinking of choosing the LLC structure for their business.

LLCs are often the preferred entity of choice for food and beverage businesses, clothing and other retail businesses, aesthetic service industries such as nail, barber, and hair services, and holders of smaller real estate and investment properties.

Subchapter S Corporations

In the legal industry and in society, there is a common misconception that an “S-Corp” is an independent legal entity. In fact, S corporation is simply an election made for tax purposes by an already existing corporation or LLC. Form 2553, which is used to make the S-Corp election, asks for the employer identification number (EIN), the date, and state of incorporation for the already-existing entity that is now electing to be taxed as an S corporation. Not all entities and individuals can take advantage of the S-Corp election. A company must be a domestic company with individual, non-foreign shareholders and must have less than 100 owners and only one class of stock.

If your clients will serve as shareholders and wish to elect to be taxed as an S-Corp, they should be advised to pay themselves a reasonable compensation. Also, they should be informed that they still must comply with corporate formalities as applicable in their state because the S-Corp is simply an election.

S-Corps are often the election of choice either of the LLCs or corporation types listed above, usually when there are one or two members/shareholders who know and trust each other, as in the case of family businesses or spouses who jointly own the business.

Partnerships

Partnerships are a natural fit for a business with more than one person involved. Partnerships, much like corporations, come in various forms. General partnerships, for example, are unincorporated entities that usually do not have any filing requirements in most states. With the lack of responsibility comes a lack of protection, as general partnerships do not protect the owners from personal liability.

Unlike a general partnership, a limited partnership (LP) offers some protection but only to certain partners. At least one partner in an LP must be responsible for the debts and other liabilities of the partnership; the remaining partners, however, can be limited partners with limited liability. Some states require that a limited partner cannot have any meaningful control over the company. Most states allow LPs to register with the state.

Another commonly used entity type is the limited liability partnership (LLP), which affords limited liability protection to limited partners. In some states, all partners of an LLP are offered limited liability. LLPs are registered with the state in most states; it should be noted, however, that states can vary in the protection and recognition of LPs and LLPs. State statutes will detail the protections provided to the LLP, and some states explicitly allow certain types of businesses, commonly professional services, to organize as LLPs. This limits the personal liability of partners to only their own wrongful acts.

The different types of partnerships mentioned here are easier to maintain than corporations, but an attorney should always advise the client to have a detailed partnership agreement that governs the terms of the partnerships. General partnerships, LPs, and LLPs are taxed as pass-through entities.

The attorney should also advise the client that each partnership must prepare a Schedule K-1 to report each partner’s share of the tax items and deductions for filing taxes.

Partnerships are often the preferred entity of choice for professional services, such as accounting and law firms with more than one owner, and family businesses.

Sole Proprietorships

Sole proprietorships are entities that rarely require engagement of an attorney. Sole proprietorships have only one member, and the owner is taxed directly for the profits and losses. This type of entity holds the owner fully liable for the actions of the company and any employee of the company.

Sole proprietorships are not registered with the state. Often, people are already conducting business as a sole proprietor without realizing it. If a sole proprietor retains an attorney, one of the best uses of the lawyer’s resources is to draft good contracts to protect the sole proprietor. Additionally, the lawyer should advise the client to obtain insurance to protect the business—even its umbrella insurance can protect the client from financial liability burden later on.

Sole proprietorships are often the entity of choice for freelancers and at-home businesses such as candle makers and soap makers.

Beyond the Initial Entity Selection

The above discussion of the most common types of business entities is meant as a starting point, but choosing a structure for a business entity is a multi-faceted process in which the attorney is responsible for managing expectations, advising clients of various regulations that may apply to them, recognizing the things that transcend their expertise, and more.

Managing expectations. Creating a business entity is the beginning, not the end, of the road. This means the attorney needs to clearly communicate the steps the client needs to take or that the attorney will take to ensure continued compliance as long as the business is in existence, including but not limited to filing annual reports, updating articles of organization or incorporation when needed, etc.

Regulatory compliance. In addition to ongoing corporate requirements, your client’s new business might be subject to other industry-specific regulations. Some business owners are aware of these regulations, but others need to be reminded or guided through the process of obtaining a business license, a health permit, or other permits and licenses required by the city, county, state, and agencies under whose purview that business lies.

Recognizing limitations. Business law inevitably touches on various other industries—immigration, taxation, family law, securities law, etc. Good attorneys understand the limitations of their knowledge and ability to help the client and will communicate the same to the client. When something becomes too complicated for me to handle, I have a list of attorneys whom I know I can comfortably refer my clients to and who are proficient in their area of law. If you are not proficient in tax law, advise your client to consult such an expert—there are some inevitable tax consequences that go along with becoming a legal entity. For example, some nuances and circumstances prevent an entity from becoming an S-Corp, so prior to advising a client, either make yourself proficient in such matters or refer to another attorney.

Conclusion

Guiding clients in the exciting time when they are starting a business and thinking about growth is rewarding and can lead to profitable long-term business relationships. Attorneys who are with the clients in these first steps can become trusted advisors if they keep each business’s individual needs and quirks in mind when choosing the right entity structure.

Aastha Madaan is a sole practitioner in Long Beach, California, where she practices business law and estate planning. She is a young lawyer leader and social media disciple. Aastha speaks and writes frequently on the topic of cultural competency in the practice of law. She is passionate about advancing diversity in the profession, legal technology, and coffee. She is a member of the Editorial Board of GPSolo magazine and writes the “Solo Pilot” column for the GPSolo eReport.