Congratulations, you’ve decided to start a business! Just taking the first step is the hardest part. But now you’re probably overwhelmed with questions about how you need to set up your business.
The question I get asked all the time by business owners if they need to set up an LLC or corporation for their company.
The answer is: it depends.
You can absolutely run your business without doing any corporate formation, which is the easiest and simplest way to get started. If you’re solo, it’s called a “sole proprietorship,” and if you have partners it’s called a “common law partnership”. This just means that you are holding yourself out as a business, but you don’t have any personal legal protection from your business’s creditors.
There are two things to think about when deciding whether to form an LLC or corporation: liability and taxes.
An LLC (Limited Liability Company) or corporation can protect your personal assets from being taken if someone sues you for something you do in your business, or if you don’t pay a business debt.
If you don’t form an LLC or corporation for your company, you’re treated as one and the same as your business. So, if you get sued, a court could take your personal assets (house, car, bank accounts) to pay damages for things that went wrong in your business. No one wants to lose their savings because of a business deal going south!
If you have an LLC or corporation, then the court would only be able to take any business assets or bank accounts to pay the damages.
In my opinion, the liability protection is the most important reason to form a corporate entity.
Some businesses have higher risks of being sued than others – a graphic designer, for example, is very unlikely to damage a client while doing her work (although she could be on the hook for copyright infringement if she doesn’t use properly licensed images and fonts). A company that takes people skydiving will have a much higher risk of getting sued if something goes wrong while working with a client.
Forming and keeping up an LLC or corporation can cost anywhere from a few hundred to several thousand dollars a year, depending on the state where the business is located. It’s important to weigh how much protection you need against the cost.
Second issue, taxes.
An LLC or corporation may (but may not) save you money on your income taxes.
This will be different in every state so it’s well worth finding a local accountant who works with small businesses. She can run the numbers walk you through the tax pros and cons for the different corporate forms.
If I decide to form an entity, what’s the difference between an LLC and a corporation?
An LLC and a corporation will both provide liability protection for your personal assets. The biggest differences are 1) how much paperwork you have to file each year to maintain them, 2) how they are taxed, and 3) management and ownership structure.
Every state has different rules about LLCs and corporations, but in general, corporations require more formalities and paperwork to be filed with the state every year. Usually a corporation must hold an annual meeting and file minutes from the meeting, saying what happened, with the state, and may have to follow other state or federal regulations.
LLCs generally only have to file an annual report, which in many states can be filled in quickly and easily on the state’s Secretary of State website.
These differences are important, because if you don’t follow all of your state’s rules to a T, you can lose your liability protection! So it’s important to think about whether you will actually follow all of these rules every year, and how expensive it is to do so.
On the tax issue, an LLC is basically taxed the same as a sole proprietorship — the company doesn’t pay taxes, the individual LLC members pay taxes on their share of the company’s revenues after deduction of expenses, called “pass through” taxation. A “C Corp.”(a type of corporation commonly used by big businesses) will be taxed on its profits, and then the owners will be taxed on any salary or distributions that they receive — this can result in double taxation and a higher total tax bill. An “S Corp.” (a type of corporation commonly used by smaller businesses) avoids this double taxation because the company is not taxed on its profits, its owners are only taxed on their salary and any distributions. Again, you should discuss which form makes sense for your business with your local accountant who works with small businesses.
The third issue will not have much of an impact for most small business owners, but corporations generally offer more flexibility in ownership and management structure. For example, in some states an LLC cannot be owned by a person outside the U.S. Only a corporation can issue stock certificates; it sometimes can be more difficult to sell your ownership of an LLC than if you owned part of a corporation and can simply sell your stock.
What about liability insurance?
My clients often ask me whether they can just buy liability insurance instead of forming an LLC or corporation.
Liability insurance offers different protection than the liability protection that forming an LLC or corporation does.
One of the benefits to insurance is that a policy will often pay to hire a lawyer and pay for your legal fees and costs if you are sued for a claim that falls within the policy. If you form an LLC or corporation and are sued, without insurance, you are on your own to pay those fees.
However, an insurance policy will have a limit — so if you’re sued by someone who gets a judgment against your business for $1 million, but your insurance policy limit is $100,000, and you don’t have an LLC or corporation, then you would be personally liable for the $900,000 above the policy limit. That means the plaintiff can come after your personal assets (personal bank account, house, cars, etc.) to recover the $900,000 the insurance company did not pay. If you have an LLC or corporation, the plaintiff could take any of your business’s assets, but not your personal assets, to recover any amount over the policy limit.
And, all insurance policies will have rules about what kind of lawsuits against the business are included in the policy and what are not covered, so you could be sued for something having to do with your business that’s not covered by your policy. In that case, if you don’t have a business entity, you are personally liable for the full amount of any judgment. If you have formed an LLC or corporation, your personal assets generally cannot be seized for any claims relating to the business’s activities, as long as you followed all of your state’s rules for maintaining an LLC or corporation.
Have questions about how to set up your business? If you’re located in Tennessee I’d love to chat — click here to set up a Legal Road Map® session.
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