Email this page

Publications

Formation Options for Small Businesses

Q: I run a small business, but haven't taken steps to create a formal entity in my State. Is this a problem?  

A: It is certainly possible to run a successful small business without creating a legal entity to conduct business; however it carries with it inherent risks. 

Some people may run a "business" out of their home, or turn a hobby into a profit-making side job.  If a business owner does not form an entity to own and operate the business, and instead conducts business in his/her own name or through an assumed name such as "Acme Painting", the business is considered a sole proprietorship. 

A major issue for business owners who are operating as a sole proprietorship is that there is no liability shield.  This means that if you enter into a contract or transaction on behalf of a business as sole proprietor, you will be sued personally if there is a problem and your personal assets will be at risk.  My advice to clients who are running a business is to seriously consider creating and utilizing a limited liability vehicle.  Using a limited liability entity is especially important if you employ others in the business.

Q: As a small business, what are my options in forming a business entity?

A: Most small business owners will elect one of two entity types, a corporation or a limited liability company.

The most important thing to understand is that creating and maintaining a proper business entity IS NOT HARD!  Although the alphabet soup of entity choices (GP, LLP, LP, LLC) may seem overwhelming, there are typically only three types of entities used in general commerce, especially for small to medium sized businesses:

1)      Sole Proprietorship: As discussed above, a sole proprietorship exists when a business is owned and operated by a single individual without use of a separate entity.  While running a business as a sole proprietor, the assets of the owner and the business are commingled, and the owner files a single tax return.  As the commingling of assets suggests, the owner is personally liable for all obligations and liabilities of the business. 

2)      Corporation: A corporation is the type of entity that most people recognize.  A corporation generally is managed under the oversight of the Board of Directors. The owners of a corporation are its shareholders. In order to take advantage of the limited liability protection, it is important that certain so-called corporate formalities be maintained. For example, the finances of the corporation must be kept completely separate from that of its shareholder/owners. Separate bank accounts and books must be maintained, and there can be no commingling of assets.  Properly managed and maintained, use of a corporate entity for conduct of your business will generally protect the shareholders, directors and officers from liability for acts or omissions of the business. 

3)      Limited Liability Company (LLC): A limited liability company is a newer entity option, but one which is increasingly common as it offers the same limited liability protection as a corporation, with greater flexibility for business owners.  The terminology is sometimes confusing, but an LLC has "members" instead of shareholders, and "managers" instead of directors.   

To determine which entity is right for your business I suggest that you consult a business attorney who fully understands your business goals.  You will also want to have a discussion with your accountant as there are various tax considerations involved.

Q: What are the benefits of business formation to me or the business?

A:  A major benefit is limited liability, in addition to creating a more formal structure with which to conduct your business.

To illustrate, let's consider a situation in which Business Owner runs Business, sells Product to Customer, Product injures Customer, and Customer sues Business:

Business Run as a Sole Proprietorship: If Customer is awarded a judgment against Business, it can collect damages from Business Owner. This means that Business Owner's home, bank accounts, and other assets are at stake! 

Business Run as a Corporation or LLC: If Customer is awarded a judgment against Business, and the Corporation conducting the business has been properly run and corporate formalities maintained, Customer will be entitled to payment of the damages only from the Business assets held by the Corporation or LLC.  Customer generally will not be entitled to look to the Business Owner to pay for this liability of the Business. Therefore, Business Owner's personal assets—that home, bank account and other personal assets—are generally safe!

As you can see, utilizing a limited liability vehicle can be very important in protecting your personal assets.  Setting up an entity as a "separate person" goes above and beyond the protection insurance can give you, and is a quick and cost-effective way to protect yourself and your family. 

Q: How do I form an entity?  

A: Once you and your attorney have chosen a business entity structure that best fits yours needs, she will then assist you in forming your the entity through a filing with the Secretary of State. If your business is already operating, she can also assist in moving assets into the new limited liability vehicle. She can also assist in obtaining necessary tax identification numbers and any required licenses.  To maintain limited liability, each state requires both a corporation and LLC to make annual filings, as well as to maintain certain corporate formalities (such as making and recording business decisions properly, maintaining separate bank accounts, keeping the business separate from individual assets, etc.).  However, you can see that these formalities are a small trade-off for the major benefit of limited liability that a business owner receives when the business becomes a separate legal identity. 

Next Steps

Since both a corporation and LLC offer limited liability, other considerations in determining what type of entity makes the most sense include: 

• tax treatment
• desired management and compensation structure
• size of the company and plans for growth
• expected avenues of capitalization

If you are running a business of any size, and have not yet set up an entity, discuss your goals and options with a business attorney.  She can advise you on your options, and assist you through the simple process of setting up a business entity, to protect your assets and help your business grow!  I welcome your questions on this, or other business-related legal matters. Feel free to reach me at cfournier@preti.com.