Falling for fall.
Fall is wonderful. Harvest time. The afterglow of summer travels and the excitement of the first snowfall knowing the holidays and ski season are right around the corner. It is also a time when we audit our corporate clients to review strategic plans, make sure their corporate structure is appropriate and assure their corporate records are up to date.
Year-end strategy review.
Most of the year is behind us and we generally know how the year is going to wind up. Take time to meet with your tax advisor, review financials and determine whether there are any actions you can take before the end of the year to minimize your tax obligations or capitalize on industry opportunities. Recent devaluations may allow you to unwind an unfavorable transaction or make plans for the coming year. Also, take this time to reflect on the past year and re-evaluate your one year, five year and long-term strategic objectives. All too often small business owners get wrapped up in day-to-day operations and lose sight of their long-term goals.
A corporate structure can vary from one entity to hundreds of entities. All structures have the goal of minimizing liability exposure, but at what cost? Hundreds of entities with hundreds of bank accounts, financial statements, tax returns and inter-company transaction documents creates an administrative headache. So, what is the best structure for your business? Generally, we advise to start out simple and try to keep it that way until there is a business or tax reason for adding complexity.
Most businesses start with an operating entity, usually a C-corporation or an S-Corporation. The choice between the two tax classifications is beyond the scope of this post, but is based on the capitalization, minimizing self-employment taxes and the expected exit strategy. Disregarded entities and partnership classifications can be used in certain circumstances but are not favored for operating entities where the principals are working in the business. This allows the principals to determine whether the business is truly viable, without spending a lot of time or expense explaining a more complex structure to lenders, vendors and other parties.
Real Estate Holding Company.
The next step is for the owners to add a real estate holding company to purchase real estate and then lease it back to the operating entity. There are several reasons for this separation. First, liability protection. By separating the business assets from the real estate, a liability incurred by the operating business in excess of insurance limits will not impact the equity in the real estate and vice versa. Second, capitalization. Real estate requires a lot of capital which impacts financial ratios and sale multiples of the operating business. Keeping the real estate off the operating company’s books makes those calculations easier. Lastly, holding the real estate in a separate entity from the business assists the owner in minimizing employment and income taxes by separating out income attributable to the real estate. This corporate structure works across industries and professions and is a good starting structure for growing businesses.
Adding entities to your corporate structure entities may be appropriate under certain circumstances, though should be done with thoughtful planning. Creating separate holding companies for individual business lines, territories, products, equipment, intellectual property, or real estate properties can further enhance credit protection and simultaneously reduce the overall income taxes. However, these benefits must be weighed against the costs of creating and maintaining the structure and their impact on other aspects of the business such as raising capital, obtaining insurance or satisfying financial ratios in loan covenants. When considering bifurcating your business operations it is imperative for the business owner to review and analyze whether the corporate changes will negatively impact these other items. Areas to consider before creating additional entities include:
- Raising Capital. Determining the exit strategy for the company must be factored into the analysis. Creating a complex structure of unrelated entities may be fantastic asset protection, but a well-informed investor is not going to invest in a subsidiary that holds no assets and whose business model is dependent on other businesses to succeed.
- Lending. Lenders are usually looking for collateral and income streams to attach if a loan goes into default. By segregating these items into different entities, it may be difficult to find financing at reasonable rates, especially if the lender is looking to sell the loan or it is guaranteed by the government such as an SBA loan.
- Insurance. Construction companies usually have minimum capital requirements to qualify for bonding and insurance at competitive rates. If the company’s capital is tied up in assets such as equipment that is being separated out from the business, is there sufficient capital retained in the business to satisfy the insurer?
- Accounting and Administration. To be effective, each entity should have its own bank accounts and financial statements. For maximum protection, each entity should also have its own tax return. Does the owner have staff with sufficient accounting knowledge to keep and reconcile the books of each entity and properly account for the inter-company transactions? Does the structure save enough in taxes to offset the additional costs associated with the preparation of another income tax return each year?
These questions should be asked, and the responses reviewed to be sure the corporate structure is appropriate under the circumstances. Often, we find owners are not using entities or wind up collapsing complex structures because of one or more of the above items. It is easy to create entities but it can be difficult to maintain them in order to achieve the desired results.
Updating Corporate Records.
Regardless of your corporate structure, properly maintaining each entity is required. For corporations, this means at least holding annual meetings of shareholders and directors and documenting those meetings in minutes or consents. Corporations are also required to file annual reports with the Arizona Corporation Commission. Lastly, preparing and filing tax returns for the entities is imperative.
Limited liability companies (LLCs) are easier to maintain. In Arizona, they have no annual reporting requirement with the Arizona Corporation Commission, but corporate records should be checked to ensure the information is correct and updated and the members and manager are complying with the terms of the operating agreement.
Limited Liability Partnerships require annual reports to be filed with the Secretary of State’s office. And similar to LLCs, partnership records should be reviewed to ensure the information is correct and updated and the partners are complying with the terms of the partnership agreement.
For more details of what to review, see Corporate Records Update
Spending the time to review your strategic plan, determine the appropriate corporate structure and update your corporate records will save time, energy and expense. For a review of your business structure or an analysis of whether a new structure is appropriate, please give us a call.