Governance of the Business Entity

The corporate governance model is the most effective business governance model because of the recognition of the interest of the three discrete groups, ownership, management, and policy. Moreover, the control adjustments available between the groups allows fine-tuning for a particular business needing a certain mix of boundary definition and control. In entities such as limited liability companies, where there is no formal policy-making group provided for in the typical entity creation, a provision for such a group can be added to the legal documentation of the entity.

The bylaws of a corporation and the statutes of the state of incorporation control the relationship between the board of directors and the president of a corporation. Typically, the shareholders (owners) elect the directors on the board. In addition to setting business policy, the board of directors appoints the officers of the corporation including the president. The board of directors sets compensation for and reviews the executives it appoints, including the president. In a closely held corporation, the shareholders, directors and executive officers are often the same people. Some states have statutory provisions which allow simplification of the typical corporate structure in the case of a closely held corporation. Many owner-managed businesses use limited liability companies or other business entities where the roles of owner, executive and employee are not so sharply defined. It is not unusual for the ownership, management, and policy roles to be confused and duties (especially review of the president or CEO) overlooked.

To make the best decision-making process in the business planning process, a small group of diversely informed individuals should aggregate their judgments and provide that wisdom to the decision-makers charged with determining and setting forth the policy. This group should be formed to include the elements of diversity, independence, and decentralization. In a corporation generally this group will involve the board of directors, sometimes supplemented by a board of advisors. But in a closely-held business or a limited liability company or other entity, the ownership and policy-making roles will not be with separate individuals and the boundaries of ownership, management, and policy may not be defined. In these situations advisory boards with members outside the business may help keep the proper perspective in the policy or planning process. Advisory positions may be informal and usually will not involve the liability of a director’s position on a board of directors.

The business planning process may be viewed as a series of decisions. These decisions are best made when the decision-makers have the input of policy group members exhibiting diversity, independence, and decentralization and articulating written judgments concerning planning problems. A collection of these written judgments will constitute a plan. The plan will be executed by the executive officers of the business.

Choice of Business Entity

There are a number of variables that will suggest appropriate entity selection. Three factors are most considered: limited liability, governance (including control and compensation), and tax treatment.

The primary factor is limited liability. An individual should not do business unless it is through a limited liability entity. Limited liability protects the business owner from the claims of outside creditors of the entity and also protects from the liability that could accrue to an owner from the actions of another owner. Generally the choice of limited liability entities is between a corporation and a limited liability company (“LLC”).

The next factor is governance. With respect to the number of owners, recent court decisions suggest that a single owner of an LLC will not have as much liability protection as the single owner of a corporation. Moreover, the governance and compensation issues are different between an LLC and a corporation. For example, in a corporation each owner would vote shares of stock on ownership issues (electing a board of directors and officers) and typically an owner would exercise one vote as a director on the board of directors (setting compensation) and receive compensation as an officer (employee) of the corporation. With a limited liability company, the member is not an employee of the company and profits of the company are allocated to the capital accounts of the owners (members) in the proportion of their capital contributions. A member will not have control unless the member is designated a manager by the member or members contributing the most capital. The number of owners and the amount they invest will influence control and compensation issues of the entity.

Tax treatment generally involves three choices: corporate (“C corporation”), S corporation, and LLC. A C corporation is taxed as a separate taxpayer on the money it earns (filing a form 1120). Money in a corporation can be transferred to a shareholder in three ways: compensation (salary and bonus), dividends, and loans. Often the warning is given that the C corporation shareholder will incur “double taxation.” While this can happen, well-run C corporations are able to utilize the deduction for wages and bonuses, along with other benefits regarding fringe benefits and retirement planning to reduce or eliminate this effect. The shareholder of an S corporation is liable for tax on the income of the S corporation but the S corporation does not have to pay tax (filing an informational form 1120S with a K-1 to the form 1040 of the shareholder). Since much of the profit of the S corporation can come to the shareholder as a dividend without additional tax, advisors frequently recommend that S corporations pay small salaries to shareholders who are employees to limit amounts paid to withholding and government trust accounts. The owner (member) of an LLC receives in the member’s capital account an amount from LLC earnings in proportion to the balance of that owner’s capital account to all other owner’s capital accounts. (An LLC files a partnership form 1065 with a K-1 to the manager’s form 1040.) This entire amount will be subject to self employment taxes. S corporations and LLCs can “pass through” losses incurred by the entities to the extent of basis (the money invested).

Entity selection involves a complex decision tree. Do a thorough analysis involving all the owners with accounting and legal advice before the selection is made.