Business structure and entity choice: Keys to a complex decision

Forward-looking owners of private companies continually ask themselves, “Is my business structured effectively?”

It’s a common question because of the cash and tax implications. For owners, cash flow must support personal and business priorities, while taxes, as one of the largest expense items, must be minimized.

In addition, economic conditions, market forces and tax policy change constantly, driving strategic shifts that may alter how owners organize their businesses.

For a long time, business structure wasn’t much of a question at all. Before the Tax Cuts and Jobs Act of 2017 introduced some variability and uncertainty in business tax rates, owners usually realized a more favorable tax outcome from a flow-through entity (S corporation or partnership) than a C corporation.

But since that legislation lowered the corporate tax rate, entity choice for private company owners has not been so clear-cut. Effective structuring now requires an understanding of:

• Owners’ priorities
• Company growth strategies
• The effects of potential transactions
• The effects of changing tax laws

Below we take a closer look at these components, demonstrate how they fit together strategically and highlight some examples.

Owners’ priorities

For a private company with multiple owners, aligning their own priorities to business goals can be challenging. After all, different owners run their businesses for different reasons, ranging from funding their lifestyle to building equity and growth for themselves and future generations. Each objective may call for a distinct business strategy or structure, and various strategies may not coexist effectively.

For example, an owner focused on funding their lifestyle usually works to create free cash flow within the business and an easy, low-cost mechanism to access that cash. Generally, those priorities align better with a flow-through structure instead of a C corporation, partly because the latter may raise concerns about double taxation.

Growth and transition can also be competing priorities, and they’re in the spotlight as a generation of private company owners leaves the workforce during a cycle of economic expansion.

Allocating all available cash for growth lends itself to the C corporation structure; however, an acquisition often requires distributions to new owners in order to finance that transaction. This can mean slowing the pursuit of growth while not moving immediately to the best long-term structure for the enterprise.

Aligning ownership and business priorities usually facilitates effective structural choices. Start by asking what is most important to all stakeholders. By determining priorities—an exercise in which the long-term viability of the business usually lands at the top—you can contemplate a plan that supports owners’ objectives.

Company growth strategies

For high-growth or rapidly changing companies, understanding how a new tax structure might relieve common problems can help owners weigh their options.

Many businesses form without a focus on certain elements of long-term success, such as future investors, acquisitions or employee retention. Understandably, they instead focus on turning an idea into reality and financial viability.

But as companies grow, so do the complexities of the business. Although not all issues are tax-driven, many elements of growth have tax ramifications, which must be understood when assessing the choice of entity and business structure.

For example, business structure can affect strategies for attracting and retaining talented employees and executives. Strategies may include equity plans, deferred compensation arrangements and other approaches to compensation and benefits.

In one scenario, certain employees may become owners of the business but share in future appreciation only above a certain amount. In that case, a partnership may make sense and provide tax benefits, while other structures may not allow this form of compensation.

Another common issue for growing private companies is increased debt load. Maybe they benefited previously from easy distributions of cash or losses, but their new focus might be on easy ways to retain cash and extinguish debt. A C corporation, with its lack of distributions and lower tax rates, may be a great fit.

The effects of potential transactions

Significant changes in ownership and business operations—such as estate plan provisions, acquisitions, divestitures, mergers and new investors—can affect tax outcomes and warrant a reexamination of structural choices.

Estate planning is a prime example, particularly given the aging population of private company owners, the forward-looking nature of younger owners and the fluid nature of tax laws.

An effective estate plan often requires cash flow to pay annuity streams or acquisition indebtedness—and business structure plays a role. 

For example, a flow-through entity will commonly make tax distributions to the owners, and they, not the business, pay income tax. In turn, the tax distributions can be utilized to pay a note or annuity stream, increasing the effectiveness of estate planning tools. 

On the other hand, if an owner’s objectives are centered more on charitable giving instead of estate planning, flow-through status can take certain techniques off the table and severely limit the planning options available.

Acquisitions or divestitures are two other types of events that could dramatically change operations of an organization.

Consider, for example, a private company that operates a heavy equipment rental and manufacturing business. Increases in interest rates and competition have eaten into rental margins, so the company is considering a divestiture of the rental business.

This business change would decrease debt load and geographic footprint—changes significant enough to merit a fresh analysis of the company’s tax structure. Although cash retention may have been key under the old model, a different structure that allows for tax-advantaged distributions may be a better fit.

The effects of changing tax laws

Tax laws change frequently enough that private company owners may assume some risk if they base their tax structure decisions solely on current laws. By also considering scenarios and outcomes under potential future tax rules, they can identify key factors that affect their tax position, evaluate the trade-offs between tax and nontax considerations, and be prepared to adapt to any policy or law changes.

Given the long-term nature of a tax structuring decision, any subsequent tax law change can fundamentally alter the outcome of any modeling. The easiest two ways to combat that risk are running scenarios under different potential tax rules and planning early to react quickly.

Through a modeling exercise, a private company can usually pinpoint policy variables that would heavily affect the company’s credit utilization, tax rates, deduction availability and other elements of finance and operations.

Even though tax laws are uncertain, their effects on a private company will usually fall within a specific range and time span. Examining the possible outcomes can help owners decide on structural changes with resilience in mind.

Modeling and scenario planning also prepare private company owners to respond quickly to tax law changes. Those exercises help owners identify law changes that would heavily affect the company and nontax factors that may outweigh their impact.

There is always a chance that something could occur outside of the projected range, but foundational knowledge enables a faster response and a strategic advantage.

Entity choice: Opportunity within complexity

Answering questions of business structure and entity choice is more complex than it once was, but it provides opportunities to be intentional about articulating and pursuing personal and business priorities.

An experienced advisor can help determine priorities and align them between ownership and your private company. An advisor with technical knowledge of business structures and transactions, experience managing business issues common to growing private companies, and a command of policy developments and mechanics can help you model scenarios to identify the most effective entity choice.