Starting A Business Los Angeles

Whats the Right Choice of Entity
for Your Business
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:
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
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.

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.
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.
.
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?
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.
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.
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 passthrough losses could be beneficial to the investor upon
disposition of the property and recognition of gain.
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.
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 K1 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.
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.
d. Additional Reason #4:You 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 (323) 4964272, or visit http://www.companycounsel.com

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Whats the Right Choice of Entity

for Your Business

As a practical matter, there are 5 choices as to the form of entity

Question #1: Is limited liability an unconditional

Question #3: Will you be seeking angel and/or venture

Question #4: Given the initial and ongoing cost of

a. Argument #1: An LLC is preferable to a C Corporation because

C Corporation shareholders will incur double taxation (i.e., taxation

C. Argument #3: An LLC is preferable to a C Corporation

Bottom Line: Absent compelling considerations to

Question #5: Are there additional good reasons for

b. Additional Reason #2: You dont have to negotiate an

d. Additional Reason #4:You can avoid the otherwise

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