Are you confident that your personal assets are protected from your business liabilities?
One of the biggest dangers you face as a business owner is that your personal and business assets aren’t properly separated. We can help you set up a legal entity to protect your personal assets in the event of a business dispute – or to review your existing entity to make sure it’s set up properly and in good standing.
Starting a business is exciting – the ability to innovate and see your ideas come to fruition is what drives a lot of people to become entrepreneurs in the first place. But it also comes with headaches and stressors: thinking about protecting your investments, shielding yourself from liability, and setting your company up for success can keep you up at night.
Forming an entity is the first step to protecting both yourself and your new business. Operating without an entity in place is a risky proposition, especially as your business grows – it exposes you to personal liability, meaning that any aggrieved customer or third party can sue you directly, potentially collecting against your personal assets.
But choosing the right entity can be a daunting task even for the best-educated founder. Luckily, we’ve seen this movie before, and we’re here to help entrepreneurs pick the right structure for their business – and make sure it’s set up properly.
Let’s talk a bit about why forming an entity is so important, the different options available, and what you need to do to keep your entity in good standing once it’s up and running.
Why Entity Formation Matters
Choosing the right legal entity for your business is not just a technicality; it’s a strategic decision that impacts your long-term growth, tax liability, and legal protection. Here are some key reasons why entity formation is essential:
- Limited liability: When you structure your business as a separate entity, like a corporation or LLC, your personal assets are shielded from business liabilities. This protection is invaluable in protecting you from debts and lawsuits.
- Tax advantages: Your choice of entity can have significant tax implications. Proper planning can lead to tax savings and greater profits for your business.
- Credibility: A well-structured entity can boost your business’s credibility in the eyes of customers, investors, and partners.
- Ease of ownership transfer: Having an entity in place ensures that your business owns its most critical assets, increasing its value and salability down the line. And each type of entity offers unique advantages when you’re ready to sell.
Types of Entities
There are a number of ways to structure a new entity, but the most popular types are the corporation, S-corporation, and LLC. Here’s a primer on each:
A corporation is a well-established entity that provides strong liability protection. It’s ideal for businesses that plan to expand or go public. The main advantages and disadvantages of a corporation are:
- Limited liability: Shareholders are typically not personally liable for the company’s debts.
- Tax options: Corporations can choose between a C-corporation or an S-corporation tax structure (more on the S-corporation below), offering flexibility in managing tax liabilities.
- Attracting investors: Corporations are often preferred by investors, making it easier to raise capital.
- Potential for lower tax rates: C-corps may qualify for certain deductions and credits, which can result in lower effective tax rates, especially for businesses that reinvest profits.
- Employee benefits: C-corps can offer tax-deductible employee benefits such as health insurance, retirement plans, and stock options.
- Fringe benefits for owners: C-corps can provide various fringe benefits to owners without those benefits being subject to self-employment tax.
- Double taxation: C-corps are subject to double taxation. The corporation pays corporate income tax on its profits, and then when dividends are distributed to shareholders, they are subject to individual income tax.
The term “S-corporation” causes a good amount of confusion for founders. An S-corp is not actually its own structure, but rather a standard corporation that elects “S-corporation” tax status (because it is taxed through Subchapter S of the Internal Revenue Code).
An S-corp is an excellent choice for small to mid-sized businesses. It combines the limited liability of a corporation with pass-through taxation. The tax treatment is often a key reason that new businesses choose an S-corp. The main advantages and disadvantages of this structure are:
- Pass-through taxation: S-corps pass profits and losses directly to shareholders, avoiding the double taxation applicable to C-corps described above.
- Limited liability: Shareholders are protected from personal liability, just as they are in a C-corp.
- Ideal for small businesses: This structure is suitable for businesses with a limited number of shareholders.
- No self-employment tax on distributions: Unlike LLCs, S-corp owners may be able to avoid self-employment tax on their share of the company’s profits distributed as dividends.
- Ownership and eligibility restrictions: S-corps have restrictions on ownership, such as a limit on the number and type of shareholders; additionally, all shareholders must be U.S. residents or citizens.
- Limited flexibility: S-corps have stricter ownership and operational requirements compared to LLCs.
Limited Liability Company (LLC)
Limited liability companies, or LLCs, provide a balance of liability protection and tax advantages, making them popular among startups and small businesses. Key advantages and disadvantages include:
- Flexibility: LLCs offer flexibility in management structure and profit allocation.
- Pass-through taxation: Like S-corps, LLCs pass profits and losses through to members, avoiding double taxation.
- Limited liability: Members are generally not personally liable for the company’s debts.
- No restrictions on ownership: LLCs have no restrictions on the number or type of owners, and they can have both domestic and foreign investors.
- Self-employment tax: Members of an LLC are generally subject to self-employment tax on their share of the business income, which includes both the employer and employee portions of Social Security and Medicare taxes.
A Word on Tax Implications (tldr: Talk to Your Accountant!)
It’s important to note that the specific tax implications for an entity can vary depending on factors like state laws, business size, and individual circumstances. Choosing the right business structure involves considering not only tax implications but also legal, operational, and financial considerations. It is critical to consult with a tax advisor or CPA to determine the best way to structure for your business.
Maintaining Your Entity
Once your entity is up and running, it’s critical to keep the business in good standing to maintain its legal and operational status. Failing to keep your business entity in good standing can lead to penalties, legal complications, and even the dissolution of your business. It’s advisable to create a calendar or other system to track deadlines and requirements to ensure that your business remains compliant with state regulations and tax laws.
The exact steps needed to do this vary depending on your business structure and your state’s regulations, but here are some general steps that business owners typically need to take:
- Annual filings and fees: In many states, entities are required to file an annual report and pay a fee. This report typically includes information about the business, its members or managers, and its address.
- Registered agent: Most businesses will need to appoint and maintain a registered agent who is responsible for receiving legal documents and official notifications on behalf of the business. The registered agent’s information must be kept up to date with the state.
- Business licenses and permits: It’s important to ensure that you have all the necessary business licenses and permits required by your state, county, and city or municipality. The licenses and permits needed typically depend on the type of work that your business does and may need to be renewed periodically.
- Tax compliance: It is critical to fulfill all federal, state, and local tax obligations, including income taxes, sales taxes, employment taxes, and any other applicable taxes. This includes filing tax returns and making timely payments.
- Meeting minutes and records: Corporations are required to hold regular meetings of the board of directors and shareholders, and maintain minutes of these meetings. This is also a best practice for LLCs, even though it is not always required. Also be sure to keep all your corporate records, including bylaws, shareholder agreements, and financial statements.
- Changes in business information: Promptly update the state’s records if there are any changes in business information, such as changes in ownership, management, or the business’s address.
- Compliance with governing documents: Be sure to follow all requirements outlined in your governing documents, including the Certificate of Incorporation and Operating Agreement (for LLCs) or Bylaws and Shareholder Agreement (for corporations).
- Maintain good financial records: It’s important to keep accurate and up-to-date financial records for your business. This is not only necessary for tax purposes but also for assessing your business’s financial health and for preparing for investments or a future sale of your business. You should also be sure to keep copies of all important documents related to your business, including formation documents, tax returns, licenses, and permits, in an organized and easily accessible manner.
Starting a new business is full of opportunities and pitfalls – and choosing an entity falls squarely into both of those categories. But don’t fret, we’re here to help. Book an exploratory call with us and let us help you get off on the right foot.