Financial Issues for Choosing a Business Entity & Incorporation: Beyond the Basics
The average entrepreneur or business startup is aware of general differences between LLCs and corporations. When choosing a business entity type, most startups decide the LLC vs corporation question based on general business tax issues and considerations of corporate formalities. Others will simply choose to incorporate because they’ve been told that investors or venture capitalists prefer this business entity. Smart business owners seek advice from a business formation attorney to get advice that goes beyond the basics – including many often-overlooked financial issues.
Cash Method vs Accrual Accounting for LLC & C-Corp
An LLC is one of the most flexible business entities available. Generally, an LLC may use the cash method of accounting under Section 448, but may be required to use the accrual method of accounting if the non-managing members of a manager-managed LLC possess 35% or more of the profit-loss allocations, and where a C-corporation is one of the members (with some exceptions). In general, the cash method of accounting is not permitted for a C-corp unless certain exceptions apply, for example, if it is a farming business, personal service corporation, or if it does not exceed $5 million in gross receipts.
Revenue and Loss Cycles for Business Entities
Choice of business entity formation should also be calibrated to your foreseeable revenue cycles. If you’re starting a company that will show losses in its initial years, it’s often a good idea to form the company as an LLC at first, because business losses in the early years can offset the owners’ individual tax liability. Later on, it won’t be difficult to convert the LLC to a corporation (but it is difficult to convert a corporation into an LLC). Corporate shareholders cannot deduct the losses of the business from their personal taxes.
Future Asset Contributions & Entity Formation
After business startup, how do you plan to raise financing in years to come? If you want the owners to make additional cash contributions or asset contributions to the company, you need to think of the how your choice of company formation will affect future capital calls. In general, an LLC can receive property without being taxed (unless it is a sale or if the member receives debt relief for the contribution). However, contributions to a C-Corp are taxable, unless the persons transferring the property to the corporation pass the “80% control test” or otherwise satisfies the exceptions in 26 U.S.C. § 351.
Our Texas law firm regularly consults investors, entrepreneurs, and businesses in all aspects of business entity selection, company formation, investor agreements, financing, regulations, corporate governance, and other matters that are critical to business startup. Contact a Texas business attorney today to get advice that goes beyond the basics to give you the full protection you need.
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