Of all the different choices you have to make when starting a new business, arguably none is more critical or has a more significant impact on your success or failure than your choice of business entity structure. The entity you choose will affect everything from the amount of taxes you pay and the type of records you are required to keep, to how vulnerable your personal assets are to the legal and financial liabilities incurred by your company, and even your ability to finance your venture.
When choosing between the different entity types, you will be considering one of the following structures: a sole proprietorship or partnership (the default choices if you do nothing), a corporation, or limited liability company (LLC). You may notice that we did not mention an S-corporation, B-corporation, public-benefit corporation, or nonprofit, or even a trust here. And that’s because S-corporations, B-corporations, public-benefit corporations and nonprofits are all types of corporations, and while a trust can be an owner of an entity, it is not the entity itself.
You can think of the legal entity you choose for your business as the container for your business, which is distinct from how that container is owned (which could be through a trust), and it is also distinct from how that entity is taxed (which could be as an S-corporation or as a nonprofit).
In this two part series, we’ll discuss several key questions you should ask yourself when choosing the right legal entity for your particular business venture.
1. How Many Owners Does Your Company Have?
The number of owners your business has is one factor that affects the entity structures available to you. For example, if you own the business by yourself, you can operate as a sole proprietorship, an LLC, or a corporation. If you choose an LLC, its owners are called “members,” and you would operate as a single-member LLC. If you choose a corporation, the owners are “shareholders,” and you would be the sole shareholder of your corporation.
If your business has more than one owner, your choices of entity include a partnership, an LLC, or a corporation. If you have multiple owners as an LLC, your company would be considered a multi-member LLC. One highly important note: If your business has multiple owners, it is critical that you have a lawyer prepare your operating agreement (as an LLC) or corporate bylaws (as a corporation), and that you do not rely on an online document service like LegalZoom and Rocket Lawyer to create these vital governing documents. There are simply too many factors that go into multi-owner business entities that you will overlook if you try to handle this yourself; and even worse, you will not discover the cost of having done it wrong until you are in a conflict, the sale of your business, or the incapacity or death of one of the members, and it’s too late to unwind the mess.
Navigating major business issues, such as ownership terms, transfer rights, what happens when a member or shareholder wants out, and what happens upon the death of an owner, all require serious consideration and involve decisions that simply cannot be addressed with a one-size-fits-all template document. If you try to wing it by creating your own business agreements without the assistance of a lawyer experienced in this area, you are likely to face extremely expensive and potentially ruinous surprises down the road when you sell the business, when one of the owners dies or wants to get out of the business, or when you go to raise capital.
2. How Much Personal Liability Are You Willing To Face?
The second factor in your entity choice is protecting yourself from legal liability. In today’s highly litigious society, all businesses should expect (and be prepared) to face some type of legal dispute or conflict at some point. This could be something as minor as a refund request from a customer, or something as serious as an employee or vendor suing your company, or it could be something much worse. And if your business does get sued, unless you have the right entity set up and the corporate formalities properly maintained, you could lose what you’ve worked so hard to build up, just to satisfy a judgment.
You could face a similar situation if your company ever experiences a significant financial loss or goes out of business. Without the proper entity in place, your company’s creditors could seize your personal assets to satisfy your business debt. This risk comes from the fact that unless you have the correct entity in place, there’s no separation between your business and personal assets, so your personal assets could be up for grabs in the event your company ever gets sued or goes into serious debt.
For example, let's say your company is a sole proprietorship or a partnership. In either case, you and the other owners are legally inseparable from your business—in the eyes of the law, your business and its owners are one in the same. For this reason, you and the other owners would be personally liable for any debt or court judgment incurred by your company.
However, if you set up your business as an LLC or a corporation and maintain the corporate formalities of these entities, you can shield your personal assets from your company’s legal liabilities, including lawsuits and debt. These two structures establish your company as a separate legal entity that’s distinct from you and the other owners as individuals, keeping you safe from being held personally liable for the company’s debt or legal judgments as long as they are properly maintained.
At Davidek Law Firm, PLLC, we will not only help you choose the correct entity for your business, but we will also support you in setting up and maintaining your entity to ensure you have maximum personal liability protection during the life of your business.
Next week, in part two, we’ll discuss the remaining risks you should consider when choosing your business entity.
This article is a service of Davidek Law Firm, PLLC. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business.