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What Entrepreneurs Need to Know About Legal Entities: LLCs, S Corps, Corporations, & More

Leo Manzione

C Corporations. S Corporations. Limited Liability Companies. Partnerships. Sole Proprietorships.

Goodness, those sound like some major buzz words! But what are they really? And how can I know which one is right for me and my business??

As business owners, there’s so much we already need to worry about…

  • What product or service should I create?
  • How will I market and sell it?
  • How can I deliver to my customers so they want to come back and/or recommend me to others?
  • How do I manage the resources of my business effectively?

…and so many more. These questions are truly just the tip of the iceberg.

Being a business owner is complex enough without having to decipher endless legal jargon and analyze a ton of business entity structures to find the right fit.

So I called upon a colleague of mine – Doug Bend, Legal Counsel to Entrepreneurs at Bend Law Group – to provide some much-needed clarity.

“One of the biggest benefits of having legal entities in place is that they create this legal backstop - this barrier, if you will - a shield - that at the worst-case scenario, blocks off your personal individual assets from what occurred inside the business. And for a lot of clients, that provides them peace of mind.” - Doug Bend


Sole Proprietorship

A sole proprietorship is the default if you do nothing at all.

    • Advantage: Simple to set up and simple to maintain.
    • Drawback: No protection against liability exposure – in the event of a lawsuit, you can be found personally liable. While you should have insurance, there are insurance limits and many exceptions in insurance policies that aren’t covered.
    • What should we be aware of?
        • Look into your city/county requirements – you may still need a business license, a fictitious business name statement, etc.


Partnership

This is the default if you have more than one business owner and start doing business without forming a legal entity.

    • Advantage: Simple to set up and simple to maintain.
    • Drawback: No protection against liability exposure – in the event of a lawsuit, you can be found personally liable. While you should have insurance, there are insurance limits and many exceptions in insurance policies that aren’t covered.
    • What should we be aware of?
        • Look into your city/county requirements – you may still need a business license, a fictitious business name statement, etc.
        • You will still want a partnership agreement that outlines what the expectations are for all parties.
            • How are you going to split profits?
            • How will decisions be made?
            • What if there’s a deadlock?


What usually causes someone to transition from a partnership/sole proprietorship to a legal entity?

    • A big scare (someone threatens them with a lawsuit) or a big contract and they want to reduce their risk exposure
    • Taxes – sometimes taxes will be higher without being a legal entity
    • Bringing people on to the business and wanting to give equity in the business


Key questions to ask:

    1. Does it make sense to be a legal entity at all?
    2. If so, what type of legal entity?


Conduct a cost-benefit analysis: 

    1. What are the upfront/ongoing costs of forming a legal entity and what are the benefits?
    2. At what point does that scale tip?In summary, what are common overall reasons to create a legal entity?
    • Creates opportunities to optimize tax situations for owners
    • Protects individual assets through limited liability
    • Allows transfer of ongoing equity interest in the company to an employee, partner, etc.
    • Facilitates raising investment capital (investors aren’t generally looking to write checks to sole proprietorships)


What legal entities will we be reviewing today? C Corporations and Limited Liability Companies. (S Corporations are a tax election, NOT a legal entity.)

C Corporation

C Corporations are the most common type of corporation. Be aware that if you form a C Corporation, among other things, you will need annual shareholder meeting minutes, annual board of director meeting minutes, and you will need to file a Statement of Information every year.

A C Corporation also runs the risk of double taxation – you can be taxed at the entity level and at the individual level if/when the corporation makes distribution payments to shareholders.  According to Investopedia, “Although double taxation is an unfavorable outcome, the ability to reinvest profits in the company at a lower corporate tax rate is an advantage.

Limited Liability Company (LLC)

According to Investopedia, LLCs are “hybrid entities that combine the characteristics of a corporation with those of a partnership or sole proprietorship. While the limited liability feature is similar to that of a corporation, the availability of flow-through taxation to the members of an LLC is a feature of partnerships.

Keep in mind that the regulations surrounding LLCs vary by state. In general, however, an LLC is a bit easier to maintain than a C Corporation with no shareholder meeting required, no board of director meeting required, etc.

Tax election: S Corporation

An S Corporation is a tax election you file with the IRS. It helps prevent the double layer of taxation experienced in C Corporations.

    • Who can make an S Corp election?
        • LLCs
        • C Corporations
    • When should you consider filing as an S Corporation?
        • If you’re netting $70,000+ a year, it may be worth talking to your CPA about potentially becoming an S Corp to see if it’s a good fit for your business. It’s around the net $70K mark that the tax benefits start outstripping the costs of S Corp formation/maintenance.
        • If you have a strong Q3 and Q4 that you feel are more representative of what your business will look like the next year, again speak with your CPA. It might be worth making an S Corp tax election starting January 1st for the next tax year.


Lastly, what is “piercing the corporate veil?”

When an entity is sued and the plaintiff also names you as an individual in the suit, the judge may let them “pierce the corporate veil” and go after you as an individual as well if…

    • The entity wasn’t properly set up
    • You haven’t been maintaining the entity (no Statements of Information, etc.) – this can lead to suspension which removes any protections of your entity
    • You’ve been co-mingling funds – if there is no separation between your funds and those of the business (no business checking account, no business credit card, etc.)


Whew! This was a long one today but I hope it got you thinking about what structure might work best for you and your business. 

We’d encourage you to talk to professionals like Doug and your CPA to advise you on your unique situation.

It’s important to protect your assets and your business’ future with the right legal entity so you can go back to doing what you do best.

Talk soon, 

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