How to know you if you need an LLC, Corporation or Something Else
This blog post contains a transcript from a video presentation. This content is for informational purposes only and should not be considered legal advice. No attorney-client privilege is created.
In this post we’re going to be talking about our business formations. A lot of people have been reaching out and asking questions such as: What’s the best way to set up my business? What kind of entity do I need? Do I need a corporation, or an S Corp, or an LLC. The purpose of this post is to break down these entitles so that you can decide what is best for you and your business.
When setting up your business online there are four things that I believe that you need to be concerned with. Those four things are:
1) Liability – if your business owes money or it gets sued, who is going to be liable? Is it going to be you personally or is it going to be your business? A major benefit of setting up a separate business entity is that it helps protect your personal and your family assets. For example: if your business goes under, if it owes some people money, you don’t want those people to have a legal recourse to go after your personal property like your home. So, number one is always Liability. The business entity that you set up must have a way of shielding you and your family’s personal assets.
- Taxation – you should never pay more taxes that you are required to pay. There are certain legal entities that require you to pay taxes on a corporate level, and then also on a personal level as income tax. So, essentially the money that your business is making is getting taxed on two separate levels. Having a business that is set up to minimize tax payments is important. A properly organized business entity will ensrure that you’re not paying more taxes than you are required to do so.
3.Continutiy – Will the business survive if there are ownership changes? This is especially relevant if you have a business with multiple owners. Sometimes partnerships don’t work out, and sometimes somebody else comes in. Therefore, you want to have strong continuity in place. There are some legal entities that once one partner leaves or once one founding member leaves the whole business needs to be dissolved. It’s really important that we avoid this issue because you want your business to be set up for the long term.
- Legal Formalities – This refers to the ease of formation, cost-effectiveness, and business maintenance. You don’t want to be spending thousands of dollars just to get your business set up. In addition, some business entitles require complex “corporate formalities” just to keep it registered.
There are four different business types that we are going to go over here. The one that we’re not going to go is C-Corporations. These are public companies that you can buy stocks in. If you are thinking about setting up a C-Corporation then one of two things are likely going on. 1. You were mistaken about the nature of C-Corporations as tey are not proper for small online businesses, or; 2. Your business is so far advanced that you have no real knowledge to gain by coming here. This type of structure is where double taxation is going to come in. So, we’re not really going to discuss that too much at all now.
Sole Proprietorship and Partnerships
The most common business entity is a sole proprietorship. If you set up a business but you do not go through any legal formalities: you don’t set anything up with the government, you don’t file any papers, etc. – then that’s called a sole proprietorship. For example: if I’m out mowing lawns every Saturday I technically have a sole proprietorship. At some point most people are going to have a sole proprietorship for at least a short period of time. If you have a business, the key is to get out of that sole proprietorship phase as quickly as possible because it fails the first three tests.
Liability: If you’re a sole proprietorship then you are going to be personally liable for everything. If you mess up mowing somebody’s lawn and they want to sue you, they’re going to sue you personally and come after your own personal assets, your personal bank account. If you don’t have enough money they’ll come after your car, or your house or whatever else you have that they can get their hands on.
The second most common entity is a partnership. Essentially, a partnership without any formal documents in place is basically a sole proprietorship with multiple people. You want to get out of this partnership phase as quickly as possible. Even if you have a business partnership agreement in place, you’re still technically failing the first three tests because your liability is going to be personal, just split between multiple people. In some ways this is more dangerous because your now liable for the actions of your partners as well as yourself. There also isn’t any continuity for a sole proprietorship or a partnership because business typically ends if the founding members leave
Therefore, sole proprietorships and partnerships are not a good idea if you want your business to be set up for success in the long term. If you’re in one right now it’s okay, we’ve all been there before. Its simple and easy to upgrade your business entity. You’re going want to set up either an LLC or an S Corp. There are some slight differences between the two, but for the purposes of an online business, especially in your early stages, there is not a huge difference. It comes down to whatever is easiest for you, or maybe you have an accountant that you’re working who prefers to work with an LLC or an S Corp.
LLC and S. Corp.
Now, I just want to go through why LLC’s and S. Corps pass all four tests.
- Members are shielded from personal liability. As long as the LLC and S. Corp. are set up properly. The entity must have its own bank account and you must not mix business and personal funds. As long as you operate the business properly you cannot be held accountable, personally, for things that happen through your business. What this means is that, if my business were to get sued, or if my business were to owe some people money, then only the business assets are at risk. For example, if somebody sues me for a million dollars and I only have five thousand dollars worth of assets in my business bank account, then they can get that five thousand dollars but they can’t come past that business into my personal life and collect money from my house, my personal bank accounts, my car, my college kid’s tuition fund, etc.
It is essential to make sure that you separate business and personal assets. For example, the money in the business bank account must only be used to pay for business expenses. You should not use that money to go grocery shopping or to buy new shoes. Before using any business money for personal reasons, you must transfer the money to your personal account and mark it as income. Once you start commingling business and personal assets then you start blurring the line between the business and yourself. That means that somebody who your business owes money to has an opportunity now to try to get in through the back door to your personal assets. This is called piercing the corporate veil.
- LLCs and S. Corps are known as “pass-through” entitles for tax purposes. This means that taxes earned by the business can be passed on directly to the owners without having to first pay a corporate tax. You will still have to pay personal income tax on whatever money is passed through to you as an individual. This is a major distinction from C-Corps. Which require a corporate tax to be paid before any profits can be distributed, which are then taxed at the personal income level. This results in double taxation. LLCs and S. Corps allow you to avoid this.
- These legal entities will exist outside of its members for continuity purposes. What I mean is if I have an LLC and I pass away, but I really want to leave this business to my family, then the LLC doesn’t dissolve just because I’m not around anymore. The same goes for S. Corps. The business can still exist without me, whereas with a sole proprietorship or partnership if I pass away then that business is basically over. Having an LLC or an S. Corp is a great way to set up a business that will last for a long time and can be passed on to your family.
- Finally, both an LLC and an S corporation are incredibly easy and inexpensive to create and to maintain. There are a few formalities that you need to follow throughout the year, such as filing earning statements and meeting minutes every few months just to prove that your business is operating and regularly holding meetings.
That does for our discussion on business formations. If you guys have any other questions about setting up your business or if there are any other topics that you’re interested in us discussing shoot us an email at email@example.com. Thanks for stopping by!