A Guide to Entity Selection When Buying a Small Business
Most searchers organize a Limited Liability Company (LLC) early on in their search. This act permits them to put forward a professional outward persona. Instead of signing non-disclosure agreements and letters of intent in their individual capacity, they get to sign as the president of a company.
Yet above and beyond mere optics, there are other benefits to forming a legal entity. Let’s take a look at those benefits and answer the broader questions: Why should I form a legal entity, and what type of legal entity should I form?
Why Choose a Legal Entity?
Most legal entities offer limited liability protection—the liabilities of the business remain the liabilities of the business, not yours.
Put differently, if you own a haulage company and one of your drivers falls asleep at the wheel killing a surgeon and her children, the surgeon’s family can sue the company but not you personally.
Your personal assets, including your home, are safe.
This veil of limited liability is a cornerstone of modern U.S. capitalism. It limits an investor’s risk of loss to her investment, nothing more.
Yet there’s no opting out of this game. If you don’t select a legal entity, the state will select one for you. And almost always, this will be a sole proprietorship (if acting alone) or a general partnership (if acting with others).
Here’s the kicker: With a sole proprietorship, you are the company; there is no distinction between your personal assets and the assets of the business. There are no limitations on liability.
Your home is not safe.
The same is true with a general partnership. The debts of the partnership are the debts of the partners, and the partners are joint and severally liable for those debts.
Joint and severally means that all partners are equally liable for the entirety of the partnership’s debts. The surgeon’s family in our example can recover 100% of their damages from any single partner, irrespective of who is to blame (did your partner fall asleep at the wheel?).
Suffice to say, a sole proprietorship or a general partnership is rarely the right choice. The state is offering you this wonderful thing—limited liability. Take advantage of it.
Choosing the Right Legal Entity.
What Legal Entity Should You Choose?
A limited liability company.
Usually, the answer is: a limited liability company.
In addition to limited liability protections, LLCs offer unparalleled flexibility. They have few ongoing administrative requirements. And there is no need to separate ownership from management (owners can directly manage the business).
It’s as simple as it gets.
In contrast, in the ETA-searcher context at least, the alternative is a corporation. But now, you have greater administrative requirements. For example, you have to hold annual meetings. You also have to elect certain officers (normally, a president, treasurer, and secretary).
Finally, LLCs offer greater flexibility when it comes to income tax elections. LLCs can be taxed as C-corporations, S-corporations, partnerships, or disregarded entities (depending on the circumstances), while corporations can only be taxed as C-corporations or S-corporations.
So unless you have a reason to choose differently, organize an LLC. It’s often the best choice.
Two additional notes before we move on:
For the avoidance of doubt: You do not need to incorporate (form a state law corporation) to elect to be taxed as an S-corporation. The law makes a distinction between a legal entity for the purposes of state law and for the purposes of tax. I’ve written about this before.
Corporate formalities matter: Failing to follow them could result in the loss of limited liability protections (i.e., the surgeon’s family can still sue you personally). For those interested in legal terminology, this is called corporate veil piercing. The corporate veil doctrine is, in my opinion, largely incoherent. There is no logical reason why the failure to follow corporate formalities should result in the loss of limited liability protections. But in most states, this is the rule.
When Should You Form a Legal Entity?
It’s best practice to form a legal entity early in your search.
Even during the early stages of your search, you’ll be signing non-disclosure agreements and, eventually, letters of intent.
You’re unlikely to incur meaningful liabilities in the process. But why take the chance?
The LLC you use for your search may not end up being your acquisition vehicle. But LLCs are low cost and simple to organize (in most states).
Again, the state is offering you this wonderful thing—limited liability. Take advantage of it. If it turns out that you need to form a different legal entity for the acquisition, so be it; cross that bridge when you come to it.
Reasons to Incorporate.
When it comes to an acquisition vehicle, there are two main reasons why searchers may want to incorporate rather than organize an LLC:
Qualified Small Business Stock (QSBS)
Equity compensation plans.
1. Qualified Small Business Stock
This is one of the greatest tax breaks currently in existence.
Upon the sale of QSBS, federal capital gains tax is excluded:
50% if the stock is held for at least three years
75% if held for at least four years
100% if held for at least five years.
The total amount of capital gains you can exclude is currently the greater of $15,000,000 or 10x your basis in the stock (Note: The rules governing QSBS recently changed as a result of the One Big Beautiful Bill Act. Make sure you seek legal counsel if considering issuing QSBS).
But there are requirements. And one of them is that the issuing company must be a C-corporation.
I know, I know.
I’ve just stated that LLCs can elect to be taxed as C-corporations. And, yes, LLCs that are taxed as C-corporations can issue QSBS. But things start to get murky.
If you know that you want to issue QSBS and therefore need to be taxed as a C-corporation, the prevailing advice is that you incorporate.
This keeps things standard. For instance, it prevents your lawyer from having to create a bespoke operating agreement that marries LLC requirements with C-corporation language.
Save yourself that legal headache.
As an aside, if you are 100% committed to electing S-corporation status, you should also incorporate. There are reasons why you should avoid LLCs taxed as S-corporations (there are reasons why you may want to avoid S-corporations altogether, but I’ll leave that for another post).
2. Equity Compensation Plans
Some searchers want to set up an equity compensation plan to grant employees equity post-close as a means to attract and retain talent. And depending on the desired structure of that plan, the searcher may have to incorporate rather than organize an LLC.
Yes, an LLC taxed as a C-corporation could adopt a similar equity compensation plan as a corporation. But the same reasoning applies. Save yourself that legal headache.
Your lawyers will have battle-tested documents that they can use to establish and implement an equity compensation plan for a corporation. Don’t ask them to create non-standard forms.
Reasons to Form a Limited Partnership.
In the context of self-funded search, there are none (there are limited exceptions—seek legal counsel).
If you want to raise a fund, you may use a limited partnership. But even then, your fund’s acquisition vehicle will likely be an LLC.
Proceeding Without a Legal Entity.
Buying Stock as an Individual.
If you agree to a stock purchase, you may not need an acquisition vehicle.
The stock in many small businesses is held by an individual (the owner). If you are looking to step into the shoes of the owner, you can also purchase the stock as an individual.
Do not worry. So long as the business is formed as an LLC or a corporation (or even a limited partnership, as unlikely as that will be), you will benefit from limited liability protections.
You may still want to form a legal entity to complete the purchase. For example, if the purchase is one of many and you intend to pursue a holding company strategy. But if your plan is to buy one enduringly profitable business and grow it, it is not necessary.
Having two legal entities between you and the product or service sold, standing alone, does not increase your legal protection; it only increases your complexity and costs.
Forgoing the Benefits of an LLC as Your Search Vehicle.
Some searchers forgo forming an LLC to conduct their search. I’ve made my case for doing so above, but it is not mandated by law.
You do you (after, hopefully, seeking legal counsel).