HOW TO INCORPORATE

In Search of the Perfect Form

The right business structure can save you money—and headaches
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When it comes to corporate structure, Deborah Williams has pretty much seen it all. Hard as it may be to believe, her company, Black Cat Computer Wholesale, in Amherst, N.Y., has gone through three different corporate forms in its first five years of operation. The computer-wholesaling business started out as a sole proprietorship, then became an S corporation, and most recently switched to C-corporation status. Williams admits that choosing the right form for her $7-million company "has been a nightmare, mainly because we grew so quickly that it was tough to figure out just what structure made sense for us.

"I'm an entrepreneur, not an accountant or an expert in corporate structure," she says. "I relied on the advice of accountants who really weren't qualified to advise a fast-growing company." Williams and her current accountant have spent several years undoing mistakes that she now knows could have been avoided with good planning.

Williams isn't alone. Decisions about choosing a new corporate structure are technical and complex, but they can have far-reaching consequences for your business. Business owners can sometimes achieve important results by changing their companies' corporate form--or by using new structures in future ventures. What's more, this area of law has gone through big changes: recent developments include increased flexibility in the rules about S corporations, as well as the growing popularity of limited-liability companies (LLCs). "I see clients all the time who come in and don't even want to think about this--all they want is for me to tell them quickly what's the best corporate form for them," notes Bob Franske, director of small-business services for Boulay, Heutmaker, Zibell & Co., an accounting and consulting firm based in Minneapolis. "But there's no quick answer to that question, even though I have a personal preference for S corps for start-ups. We absolutely need to discuss their goals for the company and all kinds of other issues."

Williams and her first corporate accountant never had such a conversation. It scarcely seemed necessary: she was operating a classic small home-based start-up and had no idea what kind of growth prospects she would face. As a result, she chose the simple sole-proprietorship form. (In fact, her company grew so fast, it made this year's Inc. 500 list of the fastest-growing private companies.) "I hadn't started up a company before, and I was ignorant about how much all this mattered," she recalls.

To Chris Aidun, a partner at the New York City office of law firm Loeb & Loeb LLP, there are two key benefits to focusing on corporate structure. "One is the entrepreneur's ability to do effective tax planning, which is a benefit that can be simple to quantify because you can calculate your savings. The other is more difficult to describe, but I like to think of it as the benefit of leading a tidy life." Business owners who want to attract sophisticated investors or take a company public or sell it can face big headaches if their corporate house is not in order, Aidun observes.

For Williams's company, growth came so quickly that she soon realized she needed to make some changes. "The big thing I was worried about was limiting my personal liability," she recalls. "After a year of operation, I switched to a new accountant, who suggested that I change to S-corporation status to give myself that limited liability." S corporations have other benefits for entrepreneurs, especially in how they are taxed. Put simply, their profits are usually taxed just once, at the shareholder level. Generally, profits in C corporations are taxed first at the corporate level and then again at the shareholder level, if they're distributed in the form of dividends. (See the chart below for a comparison of popular forms of corporate structure.)

Fortunately for Black Cat, the switch from sole proprietorship to S-corporation status was a relatively simple one. "There are some other corporate-structure switches that are enormously complicated and so costly that it just doesn't make sense for a company to carry them out," explains Jeffrey Hart, a principal at Tarlow, Breed, Hart, Murphy & Rodgers PC, a Boston law firm. Business owners face the biggest risks when they try to change a company from a C corporation into a limited-liability company. The LLC is a relatively new form of corporate structure that has gained popularity and acceptance by almost all states in the past 10 years. (Think of an LLC as a hybrid that combines the flexibility of a C corporation with the tax benefits of an S corporation.) "That conversion basically gets taxed as though the entire company was liquidated or sold off--which entails such an exorbitant tax bill that it's not worth doing," notes Hart. The transition from S to LLC status can produce a similarly huge--and usually insurmountable--tax bite.

Two years ago Williams made what she hopes will be her final set of transitions: to a new accountant with plenty of expertise with fast-growing private companies--and to C-corporation status, at his recommendation. "Some people might say, 'Why give up the tax benefits from being an S corp?' But the truth is, I was leaving most of my money in the company anyhow, to fund its growth--so the double taxation didn't really matter," Williams explains. "My real goal was to create a broader base of financing for the company, which I'm convinced is easier with C-corp structure."

Indeed, the biggest advantage to C-corporation status is the way it facilitates financing deals, especially those involving major equity infusions. "If you're thinking about going public, there's no question that C corps are the best vehicle," comments Hillel Bennett, a partner at Stroock & Stroock & Lavan, a New York City-based law firm. "S corps are completely unsuitable for a public offering. And although it's not impossible to carry one out with an LLC, these deals have happened so seldom that investors are wary of them."

Williams has no current plans for going public, but she recently got additional bank financing--and hopes to keep growing. "My accountant is still clearing up the confusion that came from all those switches in corporate status and the years when I had less-than-perfect accounting help," she notes. "But with the right structure and financing now in place, I'm in great shape to do what I want to do, which is go after new market opportunities."

Jill Andresky Fraser is Inc.'s finance editor.

Last updated: Dec 1, 1997




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