Clients often ask me why a separate legal entity is a good idea for their business. There are many advantages to setting up a separate legal entity, specifically liability protection. For example, consider a small retail business that is structured as a sole proprietor. The business has some initial success so the owner decides to expand the business. They move to a larger location, increase staff, and expand product lines. However, the expansion results in significantly higher operating costs, so the owner decides to take out a loan to cover some of the costs.
Unfortunately, the business gets behind paying the bills and becomes unable to make loan payments. As a result, the owner defaults on the loan and the lender files a collection action to recover the remaining debt. Because the owner held the business a sole proprietor the lender was able to file the action against the owner, personally, rather than just against the business itself. This meant that the lender could seek recovery from personal assets as well as any business assets. Most of the assets and inventory of the business were already purchased on credit so the creditor looks to personal assets to collect on the judgment. This could result in a judgment which encumbers a personal home and can take a significant amount of time to free personal assets from the judgment. If the business had established the business as a corporation, or other separate entity, the owner could have avoided entangling a personal home with business debt.
Consider Your Business Entity Structure
If you own a small business and want to avoid some of these issues, consider structuring your business as a separate business entity such as a corporation or limited liability company (LLC), limited liability partnership (LLP), or other legal entity. For purposes of this article I use “corporation” or “incorporation” to generally discuss how forming a separate entity can be advantageous to your business. However, the decision about the specific legal structure for your business will impact your tax liability, ownership rights, and business operations. Making the right decision about the legal and corporate structure of your business is critical to your long-term success, so discuss your options with your tax advisor and business attorney to determine what is right for your specific business.
Advantages of Incorporating
Regardless of the specific entity type there are some very compelling advantages to incorporating, or otherwise creating a separate entity for your small business. Among the advantages these include:
- Protection of Your Personal Assets
Perhaps the most persuasive reason for incorporating your small business is protection of your personal assets. A corporation is a separate legal entity which means it can own, buy and sell property; enter into contracts; sue and be sued; and be separately taxed. Moreover, a corporation is responsible for it’s own debts and liabilities.
This separate structure protects the owners, or shareholders, as well as directors and officers from personal liability for corporate debts and obligations so long as corporate formalities are properly followed (as discussed below). This means that creditors of a corporation may only seek payment from assets of the corporation and not the shareholders or directors. Without a separate entity structure such as a corporation, business creditors may be able to pursue the owner’s personal home, car, or bank accounts as Mary’s creditors did.
- Ease of Transfer
Ownership interests in a corporation are held in corporate stock. Corporate stockholders can readily sell or transfer their stock. This also means that shareholders can transfer or even give shares of stock to their family members. The ease of transferability allows business owners to transfer a family business to the next generation in a more seamless fashion. It also increases the ability for the business to add new owners or investors.
Alternatively, transferring ownership in a sole proprietorship or partnership can be an expensive and time consuming process that involves transferring title to property, assigning contracts and often setting up entirely new accounts.
- Perpetual Existence
A corporation is a separate legal entity so it is not dependent on the life of any one individual owner. This allows a business to continue indefinitely despite changes in ownership without disruption. This also provides additional stability for owners and investors and avoids the need for an extensive process to transfer or liquidate the business upon the death of an owner.
- Attracting Investors & Raising Capital
When you incorporate your business it is often taken more seriously by lenders or outside investors. If you have taken the step to incorporate it indicates that you may be more willing to invest time, energy and resources in the business to ensure the long-term success in the business. The willingness to invest in the long-term success of the business makes corporations more attractive to lenders and investors.
In addition, corporations can easily raise capital and transfer ownership by selling shares of stock. This makes it easier for outside investors in invest in corporations, and provides the additional piece of mind associated with the limitation on personal liability.
- Potential Tax Advantages
Corporations may provide certain tax advantages over a sole proprietorship or partnership. It is typically easier for corporations to write off expenses such as pension plans, health insurance premiums and other fringe benefits as tax-deductible expenses. Some corporations are also able to structure the business in a manner to save on self-employment taxes. There are numerous ways in which a corporation may reduce its overall tax liability. It is important that any business discuss these issues with its tax advisors prior to incorporating, or otherwise creating a separate entity for the business.
Maintain Corporate Formalities
The advantages of incorporating a small business are numerous. However to enjoy the benefits, especially the benefit of limited liability protection, the entity must act as a corporation. This means maintaining certain corporate formalities such as using the corporate name, holding annual and special meetings, maintaining meeting minutes and filing annual reports. Furthermore, it is essential not to mix corporate and personal assets or accounts or otherwise use corporate assets to pay for personal debts and obligations.
If you incorporate your business, it is critical to know when to seek legal advice to assist you in maintaining a separate entity structure. Legal advice may be especially beneficial when taking actions such as issuing or purchasing stock, performing business in other states, amending corporate documents, or merging, dissolving or otherwise restructuring the business.
A business attorney can advise you how to incorporate your business, as well as discuss the benefits and drawbacks of specific types of legal entities for your particular business. While incorporating your business will not ensure that your business will always be successful, it can enable you to protect your personal assets.