Business Entities - Limiting your Personal Liability While Operating your Small Business

When you look to start your business, there are certain protections that every entrepreneur needs to set up. One of the most basic protections that a business owner can take is setting up a separate entity to run their business under. The goal of these entities is to separate business owners, personally, from the business, and thus limit their own personal liability for business debts.

THE ENTITIES

As a business owner, there are several ways to own and operate your business. This guide is a general overview of the different entities and how to decide which is best for you. Sole proprietorships, partnerships, limited partnership, corporations, and limited liability companies are all governed by state law, and thus the specifics will vary by state to state. Entrepreneurs are advised to look at their specific state’s rules and consult an attorney with experience working with business attorneys in their state.

The simplest is the sole proprietorship. In a sole proprietorship, the business and the owner is inseparable, and considered to be the same, and is the default when a person starts a business. Everything is done and owned in the owner’s name, and all business debts similarly belong to the owner. While it may work out for a short time, a sole proprietorship is not recommended, and business owners should look to establish a separate business entity as soon as possible.

Many prospective entrepreneurs probably have heard of partnerships, and possibly have used it to refer to their businesses. A partnership is an agreement between two or more individuals (or entities) that have agreed to operate a business together. This agreement may be either written or oral. Prospective entrepreneurs should note, however, that a partnership does not impart any separations between the partners and the business. Each partner in a partnership, either separately or jointly, are presumed to be liable for the entirety of any debt of the partnership or business. In some ways, a partnership is even more undesirable than a sole proprietorship. In addition to not being personally protected from business debts, you may also be liable for the actions or mistakes of your business partners.

Corporations and LLCs

Now that we have gone through the business entities that you should avoid, let us get into the meat and discuss the two most popular entities: the Corporation and the Limited Liability Company (LLC).

Both corporations and LLCs are considered separate entities. This means that, notwithstanding fraud or illegality, the owners of the corporation or LLC are not liable for the debts of the company, even if the debts exceed the company’s assets.

Before we go into the differences between a corporation and an LLC, lets first discuss the other similarities. Both corporations and LLCs must be registered with their respective States. The State that you register your business will generally decide the laws that apply to the company. In many cases, the State that the business is principally located does not need to align with the State that the company is registered with. For example, many companies decide to incorporate in Delaware due to their robust and their executive-friendly laws, and their courts which are very experienced with adjudicating corporate cases quickly. Please note that while you generally can choose to establish your entity with any State that you choose, you may also be required to register the company with the State or States that you are doing business in. For example, a business located in California may be incorporated under the laws of Delaware. The structure, requirements, and obligations of the corporation will be governed by the laws of Delaware, but in order to do business in California, the corporation will need to register in California as a foreign business entity. The operations business would still need to abide by the laws of California or any other state that the corporation was doing business in.

From a practical standpoint, an LLC and a corporation are quite similar. Both LLCs and corporations separate the business from their owners. Additionally, both LLCs and corporations issue ownership units to the owners which can convey certain management rights and interests to the profits of the company. LLCs, however, are generally more flexible than corporations. Where the internal operations of a corporation are heavily governed by the laws in of the Corporation’s state, an LLC’s internal operations are governed through an Operating Agreement, a contract between the members. For example, an LLC operating agreement may dictate that each member has an equal right to the management of the company, regardless of their actual ownership percentage, or vice verse.

In addition to the flexibility of LLCs, LLCs legal requirements are generally more relaxed. Many states require that corporations have annual shareholder meetings and report certain statistics and events to the state. LLCs generally are not required by state law to do this.

Lastly, LLCs and corporations are taxed differently. Corporation and owners of corporations undergo what is known as double taxation. Because corporations are regarded as separate legal entities, the profits of the corporation are taxed against the corporation. Later, however, if the individual shareholders receive dividends from the corporation, the income the shareholder receives is taxed again, this time against the shareholder. LLCs, on the other hand, are not recognized as a separate entity by the IRS, and the management of the LLC decides on how the LLC is taxed. LLC owners are required to elect for their company to pay taxes as either a corporation or a partnership. Generally, LLCs will elect to be treated as a partnership, as this would avoid double taxation.

On a short note, small corporations that meet specific size and ownership requirements may choose to become S-Corporations. An S-corp is taxed by the IRS in a similar manner to an LLC. Additionally, S-corp shareholders who also act as employees of the S-corp no not need to pay self-employment taxes on their share of the s-corp’s profits. Business owners looking to convert to an S-corporation should speak with a tax attorney or CPA to determine whether they apply and what tax benefits they would be able to take advantage of.

Based on the above, it would appear that an LLC would be the optimal choice for many business owners. So why would you ever choose a corporation? One way to view the decision is that LLCs are very owner and management friendly. It gives the founder and the management wide leeway in structuring the company and, in some cases, ways to shield their decisions from the scrutiny of the shareholders. On the other hand, state law generally requires that shareholders have some say in the management of the corporations. Additionally, the reporting and disclosure requirements of corporations allow shareholders greater transparency into the operation of the company. The decision really comes down to the business owner’s goals. While a small business owner is afforded greater flexibility with an LLC, the lack of a set structure may turn away potential investors.  Some larger investors will want more say and transparency into the operations of the company, and because state requirements for corporations are more or less universal, investing in a corporation has a degree of predictability to it.

Sticking points

·       When starting a new business, entrepreneurs are advised to form a separate entity to run the business as soon as it becomes financially reasonable.

·       Corporations and LLCs are highly recommended over partnerships.

·       The business entity you choose will have tax implications that entrepreneurs should consider when choosing their entity.

·       LLCs give the management of the business a higher degree of freedom than a corporation, but some investors may want the structure inherent in a corporation.