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5 Questions for Businesses Changing Entity Type

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During your next financial planning meeting with business-owning clients, Nellie Akalp suggests ensuring their business entity type choice is still the right one. After all, companies are like anything else, and their needs change as they do. Here are five reasons switching might be the right decision.

Mar 11th 2021
CEO and Founder CorpNet
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At some point, your small business clients may find that the entity type they chose initially may no longer serve them well. As companies grow and evolve, their needs and priorities may change.

How can you help your clients assess their situation and determine whether their current business structure is still ideal or if it may be time to make some changes? In this article, I’ll share some information to give you a better understanding of what business owners should consider.

Of course, as in all decisions with legal and tax impacts, it's critical to stay cognizant of what advice you're legally allowed to give your clients. Only provide the guidance you're authorized to provide, and direct clients to other licensed professionals for advice in other matters.

5 Considerations for Business Owners Thinking About Changing Their Business Entity Type

The points below cover scenarios when it can be beneficial for clients to revisit their business structure and evaluate if it’s still the right choice for their current situation and long-term goals.

1.  Are they growing?

As owners of sole proprietorships or general partnerships expand their services or add employees, they potentially open the door to more legal issues. Sole proprietorships and general partnerships do not provide legal separation between their owners and the business. So, if someone sues the business, the owner is legally liable, which puts their personal assets—home, vehicles, retirement funds, etc.— at risk.

As your clients add headcount or more services and products to their portfolios, they may feel less comfortable with their sole proprietorship’s or partnership’s lack of personal liability protection. This may be a good time for them to explore the benefits of forming a Limited Liability Company or a corporation to gain peace of mind.

2. Is their business structure providing the optimal tax situation?

As I'm sure you've encountered with some clients, operating as a sole proprietorship, partnership or LLC can sometimes add up to a hefty self-employment tax burden for business owners. Clients who find themselves in that situation may want to consider incorporating or electing S Corporation status to reduce their self-employment tax liability. With those structures, owners' wages and salaries are subject to Social Security and Medicare tax obligations while other business profits (including those paid as distributions) are not.

Another consideration is how clients' individual income tax bracket compares to the corporate tax rate. If the business is a pass-through entity, is the personal income tax rate creating the best outcomes? Or would the overall financial situation improve by incorporating? This will involve some number crunching, but it's a worthwhile effort that can potentially lead to a decision that makes a significant bottom-line impact.

3. Are they bringing on new partners?

Some business entity types (S Corporations, for example) limit the number of owners a business may have and restrict who may own them. If clients are adding co-owners or partners to their business, they need an entity type that affords them the flexibility they require.

Another consideration when adding owners is personal liability. For example, in a general partnership, owners are responsible for their own actions AND those of their partners. Therefore, clients may want to talk to their attorney about business entity types that give individual partners liability protection.

4. Do they intend to expand operations into other states?

If clients are extending their operations into a state beyond their home (domicile) state, they may need to form a domestic business entity in the new state or "foreign qualify" there. (States require "out-of-state" businesses to register so consumers can be protected.)

Whether forming a new domestic entity or foreign qualification is needed depends on the client’s business structure and the state’s rules. Generally, most states consider the following criteria as indicators when a company is “doing business” in their jurisdiction and will need to either form an entity or foreign qualify there:

  • The business has a physical presence (office space, warehouse, or retail store) in the state.
  • The business is conducting in-person meetings with clients or customers in the state.
  • The business has employees living or working in the state.

5. Are they ready to sell their business or retire?

When owners of sole proprietorships or partnerships exit the business, retire or pass away, the business ends as well (exception is if a partnership agreement has provisions for remaining partners to continue the business). However, by forming a legal business entity, like an LLC or corporation, business owners have options for selling or transferring ownership of their companies. So, if business perpetuity is important for clients, they may wish to consider entity types that allow their company to carry on after they are no longer a part of it.

Final Food for Thought

Changing a business entity has financial and legal effects—and it affects ongoing compliance requirements. As you offer guidance within your realm of authority, also encourage your clients to talk with their attorneys to review their business entity type. The more informed they are about all of the potential impacts, the better able they will be to choose the business structure that delivers the most advantageous situation for their growing business.

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