There are many benefits you derive from forming a company, corporation or limited partnership; however, not all benefits apply equally to all entity types. For example, if you plan to sell shares in your business in the future – that is, you plan to take your company public - you will choose to form a corporation instead of a limited liability company because LLCs cannot have publicly traded shares. However, an LLC has better asset protection than a corporation does, which may cause you concern if you hold intellectual property in your business. In this instance, you may decide that going public without changing structures is more important to you than having superior asset protection, so you will form the corporation; but you will place your intellectual property into another entity where it will have better protection. By understanding what is most important for you in each situation, you can weight the pros and cons and choose your structures wisely. That having been said, be aware that the law is constantly changing. What is best for you today may change tomorrow; so review your structures frequently with your professional team.
The most frequently cited reasons for forming an entity are:
- Liability protection
- Asset protection
- Tax benefits
- Privacy
- Credibility
- Separation of personal and business life
- Going public
Liability Protection
A liability is a debt or obligation that you owe. If you are a sole proprietor, you are responsible not only for your own acts, but also for the acts of your employees. If you give your car to an employee to run an errand, you are liable for the damages if the employee hits someone on the way to the store, even though you were not driving the car. If the business is sued and the insurance company does not cover the full extent of the judgment, you may have to make up the difference out of your business and ultimately your personal resources.
When a business is contained inside a company or corporation, a lawsuit against the company usually stays inside the company, provided the entity has been created and maintained properly and the company is run like a business separate from the owner. That means the correct paperwork has been filed with the state and kept up-to-date by means of the required filings; the company has a separate bank account used for business purposes only; if a Resident Agent is required, the one chosen actually stays in business long enough to receive any legal papers served on the company; resolutions are created to note anything of legal, financial or tax significance and to memorialize the annual election of officers and directors or managers of the company; the company maintains separate accounting books and files the required tax returns; companies and individuals are given proper notice that the owner is acting as a manager or officer of the company and not as a private individual. If the company is sued, a plaintiff may be able to get everything inside the company, but the owner’s individual assets should be separate and safe. If you neglect to do all the things mentioned above, it is possible that an opposing attorney will be able to pierce your corporate veil and reach through the wall separating you the business and you the individual to get to your personal assets. It is easier to pierce the corporate veil in some states than in others, particularly in single member LLCs.
Asset Protection
No one likes to think that someone else might sue them just to get to their assets; however, targeting someone based on their perceived wealth is fairly common. You have probably heard of situations where a driver in an expensive car is targeted and maneuvered into an automobile accident. If that driver is sued personally and a judgment is awarded greater than the insurance company will pay, the driver now has to sell his personal assets to make up the difference.
However, if the owner’s assets are in a limited liability company, the situation might be different. In thirteen states[1] in the US, all the plaintiff may be able to get is a charging order against the company in order to get anything that would be distributed from the company to the owner; but he or she will not be able to force management to dissolve the company in order to collect the owner’s portion of the proceeds. In all other states, a charging order is only one remedy available to the courts, and may be used if a third party would be harmed if the LLC was dissolved. One thing to remember: for asset protection to work, the structure must be put in place ahead of time. Flipping a property into an LLC after a lawsuit has been launched will not save anything.
Tax Benefits
There are many tax benefits available to business owners: Some are available only inside specific entities. For example, if you wish to split your income between a W2, on which you pay payroll and income taxes, and a distribution, on which you pay only income tax, then you must run your business in a corporation or company with a small business (S) tax election. If you want specific benefits, such as a 105 medical reimbursement plan, then you need to run your business inside a C corporation.
When structuring you business, make sure that you know which benefits and deductions are important to you so you choose the appropriate entity.
Privacy
When you are serious about wealth building, the last thing you want is anyone to connect you with numerous assets. Placing those assets into companies not only affords asset protection, but also may permit the owner to remain invisible if the companies are in a state that allows nominee managers to file public records.
Having a company behind you, and signing as the manager for the company, can also permit you to insert distance between yourself and a tenant, for example.
Credibility / Public Offerings
In many areas, having a company gives you credibility in front of your target market, vendors and potential business partners. Setting up an entity to house your business shows you are serious about staying around. To take a company public, you must be a corporation.
Separate business and personal life Putting your revenue generating business into an entity with separate bank account, accounting books and identity is a good way to separate it from your personal life and bring order and focus to your business. It also creates the psychology that you are serious about what you are doing: This is a business, not a hobby. You will feel more driven to make a success of what you are doing, rather than allow it to flow along at its own pace.
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[1] The thirteen states are AZ, AR, CT, DE, ID, IL, LA, MD, MN, NV, OK, RI, VI