By Derek Larsen-Chaney and Jason Pill
Because most gyms trace their business roots back to humble beginnings as a small start-up company rather than a federally-regulated, large corporate entity, it’s not uncommon for gyms to overlook basic corporate formation issues.
Gym owners typically race to form a corporate entity to protect themselves from corporate debts and other liabilities and then focus on more exciting pursuits such as collecting capital, designing their walls, and picking out holds. However, choosing a corporate formation structure, whether it be a corporation (“S Corp” or “C Corp”), partnership, limited liability company (“LLC”), or other vehicle, is a critical decision at the beginning of any climbing gym’s business life that impacts how the gym will be governed, managed, owned, and possibly acquired.
As summed up by Hal Thureson, co-owner of Vertical Ventures of Tampa and St. Petersburg, Florida: “It’s easy to focus on what’s in front of you and the immediate concerns when you’re starting up a gym. As a result, it’s even easier to overlook the tax and legal ramifications of your initial decisions when you start the business. However, if you plan on being around for the long run, these decisions are critical to the success and longevity of your gym.”
For all of those reasons, and a few more explained below, corporate formation is a key issue for both new and established gyms.
These important decisions regarding corporate structure also impact the ways in which gyms can be acquired or expand in the event they aspire to have more than one location. As a result, this article is the first of two articles to address corporate formation and expansion. This article sets the table by discussing the basics of corporate formation (and why they matter), and the second article will discuss options for gyms to consider when expanding, or planning to expand, to additional locations. For purposes of this article, we’ll address the two basic—and most common—corporate structures: LLCs and corporations.
Protecting Yourself From Debts: The Primary Benefit
One of the hallmarks of forming an LLC or corporation is the creation of a new legal entity. Under long-standing legal notions, business entities are treated separately from their associated owners, in what is often referred to as “corporate personhood.” The law bestows upon the business entity certain legal rights and responsibilities, including the right to enter into contracts with other parties, to sue or be sued in court the same way a natural person would, and to have and maintain debts.
As a result of this corporate personhood, corporation shareholders and LLC members are not personally liable for the debts of the company (as long as there are multiple legitimate members, the company is adequately capitalized, and the company is not a mere shell setup solely to protect members). With the exception of “shell” or “dummy” entities, individual owners and members will be shielded from the debts of the business, which allows for much greater entrepreneurism. Although this benefit is common to both corporations and LLCs, each structure has unique pros and cons to consider when selecting the proper business entity for formation purposes.
Benefits of Limited Liability Companies
The word used most often when discussing the virtues of LLCs is “flexibility.” The LLC, which is a creature of statute, allows remarkable flexibility in structure, management, profit distribution, and taxation. As such, an LLC is often the entity of choice for smaller businesses with few stakeholders. LLCs can elect to be taxed as a sole proprietor, partnership, or corporation (as long as it would otherwise qualify for such tax treatment). Under the default provisions provided by most state statutes, LLCs are not subject to the “double taxation” of a C Corp (we’ll explain the difference between S Corps and C Corps below, along with the differences in taxation between the entities). Generally, the LLC is “disregarded” for tax purposes and profits are taxed only at the member level.
Moreover, an LLC with multiple members that elects to be taxed as a partnership may specially allocate the members’ distributive share of income, gain, loss, deduction, or credit via the company operating agreement on a basis other than the ownership percentage of each member, provided that certain federal rules are met.
Additionally, as a practical matter, the formal administrative requirements for an LLC are far less onerous than for a corporation. This allows for more efficient management with less paperwork and fewer required meetings.
Because LLCs are creatures of statute, and most statutes have detailed statutory schemes to govern LLCs, the statutes are “default” laws, which means that generally speaking, absent a provision to the contrary in the governing documents of the LLC (i.e., the articles of organization or the operating agreement), the statutes will govern the business and affairs of the LLC and the relationships among the managers, members, and LLC. Outside of a few mandatory statutory provisions, the members will have the ability to draft an operating agreement to provide the restrictions and arrangements they desire, thus providing a great deal of flexibility to the LLC.
Benefits of a Corporation
For-profit corporations can form under IRS subchapter S or subchapter C (“S Corps” and “C Corps”). With both of these structures, the primary benefit (in addition to limiting personal liability) is predictability and formality. The corporate structure—whether it be a C Corp or S Corp—is well accepted and understood by financial advisors, lenders, lawyers, and, perhaps most importantly, investors. The recognized ownership and voting structure of corporations may be very appealing to investors who seek the certainty of established corporate laws and governances. Although an LLC may provide great customization, not every investor may want to deal with the nuances and quirks of your gym’s particular LLC, and may prefer the formalities and familiarities of a corporation.
C Corps vs. S Corps
C Corps offer greater flexibility than S Corps with respect to ownership structure. For example, a C Corp can issue multiple classes of stock, each providing different voting and dividend rights. Additionally, there is no limit to the number of stockholders in a C Corp. Some of these issues may seem too ambitious for starting gym owners looking to quickly protect themselves from liability, but these considerations may impact longer term growth and expansion options of the business, especially if it will seek outside investment.
S Corps, on the other hand, have limited membership and are restricted to no more than 100 shareholders, and can only have one class of stock (disregarding voting rights). Also, unlike C Corps, S Corps cannot have non-US citizens and residents as shareholders. Moreover, S Corps cannot be owned by C Corps, LLCs, partnerships, or other S Corps.
There are several factors that may make a corporation attractive when it comes to the corporation versus LLC decision. Many of these factors relate to the taxation of the company, including deductions for the costs of providing health insurance to employees and shareholders.
As mentioned above, an LLC has complete flexibility, which includes flexibility on how it wants to be taxed. A C Corp, however, does not have such flexibility. A major disadvantage to the corporate designation is its double taxation implications. The corporation’s profits are taxed once at the corporate level (corporate tax), and any dividends to the corporation’s shareholders are taxed again at the individual level (individual tax).
Alternatively, an S Corp allows for pass-through taxation (no corporate tax), similar to an LLC. Unlike an LLC, an S Corp’s dividends are not subject to an employment tax, whereas an LLC’s are. As noted above, there are certain requirements to qualify as an S Corp that may limit its utility to a gym, especially a larger gym looking to expand. Depending upon the circumstances of the gym, it may have no choice but to be a C Corp and face double taxation.
An LLC, on the other hand, can elect how it wants to be taxed. By default, an LLC is treated as a “pass-through” entity (meaning single taxation), but, if it qualifies, an LLC may elect to be taxed as a S Corp or an C Corp. While it may seem counter-intuitive for a start-up business to volunteer to be taxed twice, there are some circumstances in which this situation may be beneficial, but you’ll need to confirm with an accountant. For most LLCs, double taxation will not be beneficial and the members will not select this option. Again, though, the beauty of the LLC is its flexibility.
All of this talk of taxation demonstrates the various financial implications associated with corporate formation, and these issues will vary for each gym. For those reasons, you should always consult a proper tax professional or accountant to make sure your gym is set up in the most tax-advantageous structure.
Employment Law Issues
Many climbing gyms assume (or hope) that state and federal employment laws do not apply to them because they are too small. And while there is some truth to that, it is a risky and complicated assessment that will depend on corporate formation. For reference, many federal laws, including Title VII—the federal anti-discrimination statute—require a gym to have more than 15 employees to be covered.
Similarly, the Family Medical Leave Act requires a gym to have at least 50 employees before periods of up to 12-weeks’ leave can become required for qualifying employees. As such, it becomes critical to know when and how these laws apply (for more background, refer to the prior CBJ article “Spotting Employment Discrimination“).
Because the first step to determining coverage under most employment laws requires a simple count of employees, it is critical to know the precise number of employees to include and which individuals, such as owners or LLC members, to exclude. Frequently, under most state and federal laws, owners are not included in the count of employees when determining coverage.
For example, if your gym has 14 employees and 2 owners, the gym likely would not be covered by Title VII (triggered at 15 employees), meaning that an employee could not bring a lawsuit under Title VII against the gym. This determination, though, is very fact-intensive and depends on the structure of the entity and its actual operations. Thus, the corporate formation and corresponding designation of owners may impact whether a gym is subject to and must comply with various employment laws.
Another question arises when a gym owns multiple locations, each registered and established as a separate corporate entity, with multiple employees at each location. Are all of these employees counted when determining whether the gym is subject to various state and federal laws, even though the employees technically work for different companies, e.g., Climbing Gym 1, Inc., Climbing Gym 2, Inc., and Climbing Gym 3, Inc.? Once again, it depends. Generally, courts apply an “integrated enterprise” test to determine whether all the employees of various companies are operating under a “single enterprise” or employer.
The test for establishing whether the multiple companies are operating jointly varies by jurisdiction, but the factors typically considered include: (1) the interrelation of the operations; (2) the presence of common management; (3) centralized control of human resources or workforce management; and (4) common ownership or financial control.
Put simply, courts and federal enforcement agencies, like the Equal Employment Opportunity Commission (the “EEOC”), will look past the veneer of corporate formalities to determine whether multiple companies are operating as a single enterprises with a common management structure. This means that a gym system that has created separate companies for each of its locations may still be subject to certain state and federal employment laws because the number of employees at each location can be aggregated to determine if coverage exists under these laws. This issue is of critical importance because it determines whether gyms are subject to, and can be sued under, various employment laws.
For larger gym systems looking to expand and operate multiple locations, whether they are under the same parent company or not, these formation issues may have a significant impact on a gym’s coverage under state and federal employment laws. This is yet another consideration that must be discussed at the corporate formation level, and certainly when evaluating expansion of a gym.
So What’s the Best Entity for My Gym?
In sum, there are advantages and disadvantages associated with each entity discussed. Each offers the individual owners of a gym protection from the liabilities of the company. The flexible and less formal LLC rules also allow for more efficient management, especially in the earlier stages of a gym’s development. Corporations, especially C Corps, are by design easier to expand as the gym grows, and incorporating additional investors is a more straightforward process. Of course, there are starkly different tax treatments that will impact the gym’s finances and ability to expand. Lastly, there are various employment laws that get triggered based on the size of a gym’s workforce, which are affected directly by management structure and corporate organization.
These decisions will have a lasting impact on your gym, and require attention as your gym grows and expands. As explained by Thureson when looking back on the beginnings of Vertical Ventures, “it’s easy to say that we should have given some corporate decisions more focus.” Elaborating on that point, Thureson further explained that, “after owning the business for more than a decade, we’ve had to make adjustments to our corporate and tax structure along the way. . . . if we had the right relationships in place for legal and tax advice at the outset, we could have handled those issues earlier, as opposed to switching certain things midstream, and avoided some headaches.”
So, there’s no one-size-fits-all answer when choosing between LLC, S Corp, and C Corp, but there are a lot of possibilities to consider based on where your gym is and where you want it to go.
It is important to note that while the initial determination of which entity is appropriate for your gym is likely to have a profound effect on your operations, you are not permanently tethered to that decision. State laws provide procedures by which you can convert your gym from an LLC to a corporation or vice versa. Of course, there may be implications to that decision as well, so it is wise to fully consider your options and your business plan before moving on to focus on the more exciting elements of owning a climbing gym.
The authors, Derek Larsen-Chaney and Jason Pill are labor, employment, finance and business attorneys with Phelps Dunbar, LLP in Tampa, Florida.