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HOW TO INCORPORATE

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Deborah Williams of Black Cat Computer Wholesale describes how she changed her company from a sole proprietorship to an S-corporation to a C-corporation in her first five years of operation.
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Business 101

The right business structure can save you money --and headaches

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.

The Corporate-Form Menu

The most popular types of corporate structure differ in many subtle ways, but these are the biggest differences among them. For a comprehensive discussion of the pros and cons of various forms, be sure to consult a qualified lawyer or accountant.
Corporate
structure
Ownership rules Tax treatment Liability Pros and cons
SOLE PROPRIETORSHIP One owner Pass-through federal tax entity* Unlimited personal liability for business debts Is easy to set up but leaves your personal finances at risk. Plus, you miss out on all kinds of business deductions
S CORPORATION Up to 75 shareholders; only one basic class of stock; slight flexibility on voting rights Pass-through federal tax entity* Limited Is easy to set up but may limit your financing options later on
C CORPORATION Unlimited number of shareholders; no limits on stock classes or voting arrangements Dividend income gets taxed at the corporate and shareholder levels; losses and deductions stay at the corporate level Limited Can be costly from a tax perspective but investor friendly
LIMITED-
LIABILITY COMPANY
Unlimited number of "members"; flexible membership arrangements, with voting rights and income divided as desired Pass-through federal tax entity* Limited Has lots of advantages but makes investors leery, which could make financing deal dicey. Cost of switching forms from S- or C-corporation status is generally prohibitive
PARTNERSHIP Two or more owners Pass-through federal tax entity*; flexibility about profit-and-loss allocations among partners Personal assets of any operating partner at risk from business creditors** Allows lots of room to play with tax benefits, but in a general partnership, that personal liability can be scary
LIMITED-
LIABILITY PARTNERSHIP
Two or more owners Pass-through federal tax entity*; some flexibility about ownership arrangements Limited As an alternative to traditional partnerships, has many advantages. Is easy enough for partnerships to switch to -- but is a new form and hasn't gained acceptance in all states

*In a pass-through tax entity, income and losses "pass through" to owners and are taxed by the IRS at the personal level. **In limited-partnership variation, limited partners' liability can be restricted to amount of original investment.


Now what? When Should I Switch?

There are times when a change in corporate structure can bring a growing company all kinds of advantages, such as a boost in the owner's income or greater ease in raising capital. Then again, there are times when a change isn't worth the hassle. Here's a list of factors that may help you decide:

  • The company needs capital. If you're simply contemplating raising your credit line or bringing in some informal investors, you can probably stay with whatever structure you've got. But if you're aiming for venture capital or a public stock offering, you'll need C- corporation status.
  • You're exploring incentive compensation. A deferred-compensation arrangement will likely mesh with whatever corporate structure you've got. But setting up a stock-option plan will be much easier if you switch to C status. The exception: you can use an S structure if the number of employees covered--plus the number of previous shareholders--doesn't exceed the new 75-owner limit for S corporations.
  • The company is profitable and no longer capital hungry, and you're looking to boost your personal income. One quick solution might be to switch from C- to S-corporation status, thus eliminating the double tax on all dividends paid out to shareholders. But don't go this route if you're also contemplating an IPO: you won't be able to revoke your decision for five years.
  • You've got great prospects, but the company is still losing money like crazy. Corporate losses, and the tax benefits they can provide, may be more valuable if you switch to a C corporation. That's because, in many cases, S-corporation owners can claim corporate losses only on their personal tax returns up to the amount of their total investment. With C corporations, most losses can be claimed (or carried forward into later tax years) at the corporate tax level.
  • You're thinking about adding fringe benefits but are looking for ways to control their costs. It's time to get your accountant to do a cost-benefit analysis. Many fringe benefits for owners turn out to be cheaper with C-corporation status. But don't switch before figuring out whether the cost of double taxation would wipe out any benefits you'd receive from a switch.
  • You're diversifying the company into a new business line. Wait! Although switching to an LLC structure is often too costly to make sense for an established business, you might be able to achieve real benefits by organizing your new venture from day one as a limited-liability company.

Did you know that ...

  • It's now easier than ever to choose LLC status, thanks to the IRS's new "check-the-box" guidelines. With them, to declare a corporate structure to the IRS, all you need to do is just that. (Before January 1997 companies ran the risk of the tax man stepping in later and reclassifying them as C corporations if they failed to meet key standards.)
  • You run a much higher risk of personal tax audits as the owner of an S corporation, especially by revenue-hungry states that audit your company.

Resources

Nobody ever said that corporate-status issues were simple. But here are two good sources of in-depth information: The Essential Corporation Handbook, by Carl R. J. Sniffen, and The Essential Limited Liability Company Handbook, by Corporate Agents Inc. Both are published by Oasis Press (800-228-2275) and cost $19.95 each. While not exactly fun reads, both are full of accessible answers to the kinds of questions business owners typically have. These books are good starting points that can help you prepare for a conversation with your accountant or lawyer.

Last updated: Dec 1, 1997




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