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SMALL BUSINESS | Financing and Insurance

A Business Is Shaped by Its Legal Classification

July 21, 1999|JUAN HOVEY

What do business owners who have no trouble rounding up outside financing have in common with good chess players?

They think ahead--a habit formed early on and practiced every day, so that it becomes second nature. They do not allow the crisis of the day to get in the way. They know that it's never too early to start shaping the future, and they waste no opportunity to do so.

Indeed, they shape the future even as they decide what legal form to give their business venture, before they begin operations.

You may shape a business in one of at least six ways, and each differs in its impact on your taxes, your liability and not least of all your ability to raise outside capital for growth.

The choices:

* sole proprietorship.

* general partnership.

* limited partnership.

* limited-liability company.

* C corporation.

* S corporation.

Tax law treats the business enterprise of a sole proprietor as identical with the proprietor personally, and it taxes profit as personal income to the proprietor. The tax treatment of a partnership is similar.

By contrast, the law treats a C corporation as an entity distinct from its owner, and it taxes the enterprise's earnings once at the corporate level and again at the personal level--double taxation, as accountants call it.

With an S corporation, as with a sole proprietorship or a general partnership, the earnings automatically pass through to the owner. S corporations are subject to single taxation, in accountant-speak, which is often the overriding factor in an entrepreneur's decision to select this form.

Not surprisingly, many people consider only the tax consequences when they select a legal form for their enterprise. But because each form also differs in its impact on your personal liability, you should consider this factor just as carefully, according to William C. Staley, partner in the Woodland Hills office of national law firm Arter & Hadden.

Staley specializes in tax planning and general business law for closely held businesses, including start-ups, and he advises his clients to look carefully into their own futures when deciding what legal form to adopt.

State law gives the owners of limited-liability companies the same shield against personal liability it gives the owners of either C or S corporations. But so far, he says, there exists no body of case law upholding the doctrine. As a consequence, the entrepreneur concerned most about liability may choose to incorporate the business enterprise as a matter of caution.

"The liability protection is available in full for both C and S corporations," Staley says. "California law affords the same protection to the owners of a limited-liability company, but I know of no case law upholding that limitation.

"Most attorneys are confident that case law eventually will cover limited-liability companies as well, but it's just not there yet. So if you are risk-averse, you choose corporate status," he says.

If you expect to seek outside capital from equity investors, you might want to choose C corporation status, not S status, Staley says. The law limits the number of shareholders in an S corporation to 75, so if you intend to take your company public at some point, you will need C status anyway.

On the other hand, Staley says, a start-up might organize as a limited-liability company or an S corporation if it expects to post losses in its early years, since the shareholders could take the losses as deductions against income.

"I tell my start-up clients that an S corporation is like a Toyota Camry and a limited-liability company is like a Lexus. The same company makes both cars, and you don't see much difference if you drive one or the other for a few miles," he says.

"But the longer you drive the Lexus, the more you see it's the better vehicle."

In any event, Staley adds, when you launch a business venture, it pays to weigh your options, giving your business a legal form that will prove both comfortable and durable. Taxes, liability and the ease of raising outside capital must all come into play.

*

Juan Hovey can be reached at (805) 492-7909 or at jhovey@gte.net.

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