New Opportunities Are Rising From The Covid-19 Ashes

In terms of business, the coronavirus giveth, and the coronavirus definitely taketh away.

For any service-based business that was deemed non-essential, Covid-19 tooketh away, and I mean big time. Government-mandated closings resulted in government-mandated total loss of income albeit with some well-intentioned but logistically-challenged federal rescue measures: EIDL and PPP.

Conversely, Covid-19 resulted in a boom for some businesses that most of us likely did not see coming: toilet paper producers, summer vacation rentals (due to summer camps closing), increase in demand for home pools, and the rise in sales and rentals of RVs, to name a few.

The point, I think, is that despite deflating stories in the news, e.g., unemployment rates, bankruptcies, federal bailouts, etc., new and unexpected opportunities will always rise from the ashes.

Individuals starting a new business will no doubt research whether they should invest in forming a legal entity such as an LLC or corporation. The answer to that question is similar to the answer to most business and legal-related questions.

“It depends.”

The first step in identifying whether spending money to form a legal entity is understanding the purpose of doing so. Overall, legal entities, whether corporations, LLCs, limited partnerships, etc., serve multiple purposes, the most common being (1) protecting the individuals who run the business from personal liability, (2) minimizing tax liabilities, and (3) making sure you’re set up to raise capital, if needed.

LIABILITY 

There are two key criteria to consider when it relates to an owner’s personal liability.

First, does the cost of forming a legal entity outweigh the potential liability a business owner and its partners may face in the event of legal action on behalf of clients or creditors?

Second, can the business can buy enough insurance that would protect the owners from that same liability?

With the majority of the country sheltered-in-place, coupled with astronomical unemployment rates, small service businesses are on the rise. For the sake of argument, let’s compare a swimming pool service to a business consultant working with corporate clients.

Applying the questions above, what are the potential costs of a pool service professional’s potential negligence compared to the consultant? Assuming both are insured, is the coverage sufficient to cover potential worse-case-scenario claims?

Even if the pool company services high-end commercial clients like hotels and resorts, could potential negligence incurring damages that would exceed a $1,000,000 liability policy? If the pool company’s insurance is likely to cover the worse-case-scenario claims, then the owner is unlikely to face personal liability for his business and, therefore, the cost of forming a legal entity may be unnecessary.

Conversely, the business consultant providing counsel to larger businesses may have more of a reason to form a legal entity designed to provide protection against personal liability. First, the consultant may not even think to investigate commercial liability insurance because his entry and overhead costs are so low. It may simply escape her mind when getting the business off the ground.

Moreover, she may even default to first thinking of forming a legal entity due to the nature of the services provided. Whereas a mishap by the pool company will likely lead to damages that are easily calculated based on the cost of repairs, identifying the cost of damages in the corporate world can be a more slippery task considering projects have multiple layers in terms of individuals, teams, products, policies, procedures, etc.

Accordingly, because it probably makes sense for the pool company to pay the insurance premiums year over year considering the nature of the business (and other factors beyond the scope of this writing), forming a legal entity may be unnecessary. On the other hand, it likely makes a lot more sense for the business consultant to incur the one time cost compared to ongoing insurance premiums.

TAX CONSEQUENCES

How profits are taxed is another major factor when considering whether a legal entity is needed for a business. The first thing to do? Talk to your accountant. Seriously, call a CPA now. Explain your business idea and get his or her opinion regarding what legal entity may be best suited for tax purposes.

Otherwise, in brief, entities such as partnerships and LLCs are considered pass-through or flow-through entities, meaning that the businesses profits pass down to the owner’s individual tax return and are taxed accordingly.

Conversely, subchapter C corporations experience double taxation in that income is taxed at the entity level and then taxed again when dividends are distributed to shareholders. However, note that profit paid as salaries is classified separately and not subject to double taxation.

RAISING MONEY

This is important and it’s not often discussed online.

If a business is unlikely to have to raise money and potential liabilities can be covered by insurance, then the cost of forming a corporation, especially a subchapter C corporation, is likely unnecessary. There are tax considerations, as well, but we’ll leave that out of it for now.

Even if a small business needs money to cover costs such as new equipment, short-term cashflow gaps, etc., then credit or small business loans may suffice.

However, if the business contemplates the kind of growth that requires raising money from venture capitalists, then a C corporation may be the way to go because some VCs are prohibited from investing in C corporations for different reasons, i.e., tax exemptions of some partners involved in VCs 

That said, if the vision for your business is to raise capital to help get the motors running, then the default LLC thinking may not be for you.

Overall, the thinking here represents the tip of the iceberg when it comes to forming a legal entity for a new or existing business. If you want to discuss in greater detail, let us know.