Updated: Feb 4, 2021
Forming a new business requires addressing numerous topics. From a legal standpoint, the key things to consider normally involve choice of entity, ownership structure, management structure and exit planning.
Choice of entity means what type of legal entity to form. If you are looking for limited liability protection, the business would usually be formed as a corporation, limited liability company or limited partnership. They offer limited liability protection for the owners, meaning they are not normally personally liable for the debts or obligations of the business. Tax planning is also an important factor in entity selection. S corporations, partnerships and limited liability companies taxed as partnerships provide for pass-through tax treatment. That basically means that the taxable income from the business flows through the business to its owners and is taxed at each owner’s applicable individual income tax rates (state and federal). C corporations pay income tax at the corporate level and, if a C corporation distributes profits to its shareholders by paying dividends, the shareholders then pay tax on the dividends they receive. Although there are two layers of tax for a C corporation, it may still be the most desirable entity structure in some situations.
Determining the ownership structure for a business requires deciding ownership percentages for each owner and whether each owner will have the same type of ownership interest. Sometimes it makes sense to have two or more forms of ownership interests. A common distinction between ownership interests is that there may be voting and non-voting interest, with the owners of non-voting interests having few or no rights to vote on matters related to running the business. Different types of ownership interests may also be created to provide different profit distribution rights.
Determining the management structure for a business typically involves deciding who will be the directors and officers (for a corporation or for any other type of business with a board of directors and officers) or its managers (if it will be a limited liability company managed by one or more managers). Determining the management structure also involves deciding who will have authority to change the management. In a corporation, the shareholders normally have the right to remove and elect the directors and the directors normally have the right to remove and elect the officers. In a limited liability company or a partnership, an Operating Agreement (for a limited liability company) or Partnership Agreement (for a partnership) would normally address such matters.
It may sound odd to think of exit planning when forming a new business, but in any business with multiple owners that should be a consideration. Such “exit planning” typically takes the form of a Buy-Sell Agreement (also known as a Shareholders’ Agreement) to address what may happen in the event one of the owners dies, becomes disabled or otherwise leaves (or wants to leave) the business.
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