Peacock Tales • Fall 2012


Starting a Business: Which Decisions Should Come First?

By: Donald B. Formoso

While starting a business involves a number of practical considerations, choosing the structure should be done at the outset. Many entrepreneurs do not take the time to consider forming a business entity. Instead, in the case of an individual owner, they start off as a sole proprietorship or as a general partnership in the event of multiple owners. These two types of businesses have a significant disadvantage: unlimited liability.  Creditors of the business can recover against the owner's personal assets for business liabilities. Their main advantage of pass-through tax treatment (meaning that profits are not taxed at the business level) can be achieved with entities that offer liability protection.

Subchapter S Corporations used to be the most common entities that provided the owner personal protection with pass-through tax treatment.  In contrast, in Subchapter C Corporations, profits are taxed at both the corporate and personal level. S Corps are limited to 100 shareholders. To create any corporation, Articles of Incorporation must be filed with the Department of State, bylaws adopted, and shareholders and directors meetings held. The corporation must make an election to be treated as an S Corp.  In comparison with other entities, start-up costs and administrative formalities are usually greater for corporations.

Limited Partnerships (LPs) and Limited Liability Companies (LLCs) usually offer a less burdensome alternative to S Corps. LLCs are relatively new to Pennsylvania. Both of these entities are formed by filing documents with the Department of State, and are largely governed by internal agreements between or among the owners. While at least one owner of a limited partnership must serve as General Partner and be subject to unlimited liability, all members of an LLC are afforded limited liability.  However, LLCs may be subject to Pennsylvania's capital stock tax; LPs are not.

In conjunction with structuring the business, the owners must also consider financing options unless they are able to contribute personal assets to fully fund the business.  Some common financing options include:

  • Commercial loans, which can fund a variety of operating needs, such as working capital and purchases of equipment or inventory.  These types of loans are usually secured by the asset it is used to purchase. The loan-to-value ratio can vary depending on the asset.  Terms on these types of loans typically range between three to seven years.
  • Commercial mortgages may be available to businesses seeking to purchase real estate.  In contrast to residential mortgages, most business borrowers can only secure financing in the amount of 75% of the property's value, and terms are limited to 15 years.
  • Commercial lines of credit may be available to businesses seeking a short term influx of working capital.  Renewed annually, interest only accrues on the outstanding balance, similar to a credit card.

For small businesses, personal guarantees of the shareholders, partners or members are frequently required by lending institutions, regardless of the entity type or type of loan.

While entrepreneurs may only initially focus upon the practical operation of the business, careful consideration of structure and financing, with the assistance of an attorney and an accountant, will prove instrumental to successful startup and smooth growth over time.  A later conversion to a different business entity may result in additional costs and expenses which could have been avoided by early planning.
 

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