BUSINESS STRUCTURES: Using Corp., LLC, or General Partnership to Gain Credibility

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1 BUSINESS STRUCTURES: Using Corp., LLC, or General Partnership to Gain Credibility

2 If you have ever tried to obtain a credit card, a mortgage loan to buy a home, or a car loan, then you know how important it is to have good personal credit. It is just as important to establish credit for your business. Strong business credit is important to help obtain business loans, better insurance premiums and leases. One of the great benefits of starting a business is that it is possible to establish a new and separate credit profile that is distinct from your personal credit profile. This means that you can structure your new business in a manner that allows you to build a pristine credit profile for your company, enabling the business to receive loans, credit cards, lines of credit, etc. that you would not be able to obtain as an individual (and often at better interest rates). You can start building business credit even before opening your doors for business. The first step is to establish your business as a separate entity.

3 How you can benefit from a corporation or LLC? There are many reasons why an owner should consider forming a business entity, the best being the myriad of financial and tax advantages that are available to a corporation or other similar types of legal structures. Business entity formation creates the basis of long-term stability, which in turn helps establish credibility. There are also many risks inherent in operating a business outside of a formal entity structure, such as a sole proprietorship. By definition, the owner of a sole proprietorship is inseparable from his business. There is no legal distinction between the owner s personal and business assets. That means a sole proprietorship puts the owner s personal assets in jeopardy from potential business risks, and puts the business at risk due to the owner s potential liabilities. Many sole proprietors find it difficult to obtain the financing necessary to fuel growth since lenders find them to be a high risk. Before weighing the pros and cons of each legal structure, it is important to understand the benefits of forming a separate business entity. Each business entity has its own unique set of benefits and risks. However, regardless of which legal structure is adopted, each form of business entity has advantages over sole proprietorships for the following reasons: Separating business and personal assets: A separate business allows for the easy delineation of personal and business assets. For example, it is much easier to maintain records and manage operations when an owner has a separate bank account for his or her business. Blurring the lines between personal and business items can make it much more difficult to perform activities such as preparing taxes or obtaining a business loan. Covering your assets: A common reason for forming a business entity that operates separately from the owner as a person is to limit personal liability. Even something as simple such as driving a car creates is a considerable degree of liability in day-to-day operational activities that can put a company at risk. One serious car crash can result in a major civil suit and a judgment costing millions. If one has not protected the business from the owner s personal liability, then a significant judgment against the owner can often mean the end of the business and a person s means for making a living. Establishing business credibility: An owner is announcing the intention to create a longstanding legitimate business by structuring it as a legal entity that is separate and apart from any one individual. By creating a business entity, banks will be more apt to provide funding, and vendors are more likely to offer lines of credit and better payment terms. Obtaining debt capital: Setting up a business as a separate legal entity takes work and money. However, a legal entity also provides stability and credibility. In addition to establishing and maintaining business credit, operating under a legitimate business entity is a necessity when trying to obtain a business loan or credit line. Raising equity capital: If a company grows significantly, an owner may want to hedge risk or fuel business expansion by adding business partners or raising equity capital. However, investors cannot provide capital to a sole proprietorship in exchange for equity. In order to do so, the sole proprietorship must be reorganized into another legal entity, such as a corporation.

4 A greater array of tax benefits: A business earns money, spends, and then pays tax on the difference, while individuals earn money, pay taxes, and then spend what is left over. Although the U.S. Government, in an attempt to spur small business growth, has made great strides in increasing the business deductions for sole proprietorships, separate business entities will often have many more deductions and potential tax reduction strategies available to them than sole proprietorships. One large tax issue for anyone with 1099 income (various types of income other than wages), is the cost of self-employment and FICA taxes. These taxes apply to anyone who engages in a business or trade to earn his or her livelihood and has not created a business entity under which to do so. This 15.3% additional tax is just one of the many costs that can be avoided by creating a separate business entity. Owners should consult a tax professional before executing any tax based strategies. Promote legitimacy and longevity: Corporate entities that create a market identity for themselves and their products through name recognition and brand building often find it easier to build legitimacy than independent contractors. Moreover, unlike a sole proprietorship, a legally formed business entity can continue to operate after the original owner retires or decides to leave the company, which makes it more able to establish longevity. Supporting an exit strategy: Naively, many owners start their businesses without an exit strategy. They underestimate the growth potential of the business and do not choose a legal structure that will support the eventual sale or transfer of ownership. If necessary, the transfer of all items like customer accounts, bank accounts, receivables, business vehicles, intellectual property, and other assets and liabilities, can be made to a new entity. However, this type of transfer will inevitably cost money and a tremendous amount of time. Forming an entity properly in the beginning makes maintaining and eventually exiting a successful business a lot easier.

5 Choosing a business structure Structuring a business as a corporation or limited liability company (LLC) establishes it as a separate legal entity from its owners. That legal entity is responsible for all the operations of the business while the personal liability of the shareholders is limited to their capital contribution or investment in the business. In many cases, the type of business being performed will dictate the legal structure that best supports its operations. In other cases, business owners determine their firm s structure based on tax and liability mitigation. Ultimately, the decision as to which type of legal structure is best suited for a particular business should be made by an experienced attorney or legal authority with detailed knowledge of the specific company and business. The Business Structure Comparison Chart shows the benefits of forming the most common types of business structures. BUSINESS STRUCTURE COMPARISON CHART General Sole Business Structure Advantages C Corp S Corp LLC Partnership Proprietor Owners have limited liability for business debts and obligations Created by state level registration that usually protects the company name Perpetual business duration Owners do not need to be U.S. citizens May be owned by another business, rather than an individual May issue shares of stock to attract investors Owners can report business profit and loss on their person tax return Owners can split profit and loss with the business for a lower overall tax rate Permitted to distribute special allocations, under certain guidelines Not required to hold annual meeting or record meeting minutes

6 What business structure is right for you? Whatever business structure you choose isn t set in stone. It can be changed as your business matures. For example, many small business owners start out as sole proprietorships or partnerships, with formal business incorporation taking place at a later date. Of the many business structures that business owners consider, LLCs and Subchapter S Corporations (S-Corps) are two of the most popular because, unlike sole proprietorships and partnerships, both offer liability protection. This means that the owner of a company cannot be held personally responsible for the company s debts. The personal assets of an owner are shielded from company liabilities. S-Corps and LLCs are similar in that they are both passthrough entities for tax purposes; the income of these companies is passed through to their owners and reported on the owners personal income tax returns, thereby eliminating the double taxation incurred by owners of a standard corporation, or C corporation. (With a C corporation, the net business income is subject to corporate income tax, and the monies remaining after the corporate income tax are taxed a second time when they are distributed as dividends to its owners, who must then pay personal income tax.) The answer as to what type of business structure is best for you depends on your own unique situation. If operational ease and flexibility are important to you, an LLC is a good choice. If you are looking to save on employment tax and your situation warrants it, an S corporation could work for you. Because the needs of every business are different, and the law varies from state to state, you may want to seek out the services of a business incorporation service provider such as LegalZoom.com to help navigate through the most common issues related to structuring a business. Our education center provides a valuable legal resource to help you make the right decision, says John Suh, CEO of LegalZoom. In addition, if you form your business at LegalZoom, you receive complimentary 30-day access to a business attorney licensed in your state who can give you legal advice based on your specific needs. Get started on your Incorporation today! Establishing Your Business Credibility Once you determine your business structure, the next step in the process is to establish your business credibility, which can affect the way your business stakeholders, including customers, lenders, investors, and employees, perceive you. You can enhance your business credibility by doing the following: Secure a federal Employer ID Number (EIN) for your business. This is essential. Without an EIN, you cannot separate your personal financial information from your business finances. Even worse, if you are taking out personal credit for business purposes (using your Social Security Number), you are staking your personal credit on the success of the business. Additionally, your business is not building a credit history of its own, which can greatly diminish its chances of obtaining funding in the future. Obtain all the necessary business licenses, permits, etc. that are required in your jurisdiction. Make sure your business is listed in the phone directory and the phone line is in the business name, not in your personal name. Make sure the exact same business address is used for your D&B D-U-N-S number, the yellow pages listing and phone number, and on any business licenses and company credit cards that you apply for. Your home address is acceptable; however, private mailboxes and P.O. boxes may not be. Publish full business addresses and contact information on your website. Also, provide information about your business history and the owners or officers of your business.

7 Establishing Your Business Credit File Any business that has had to raise working capital or to fund growth realizes the importance of establishing business credit. Before providing loans or other sources of debt capital, lenders require small business owners to demonstrate their willingness and ability to repay credit obligations. Although the underwriting process is mainly focused on the financial standing of the business, lenders also look to the relationships the business maintains with customers and vendors to make a final determination on processing loans. For this reason, savvy business owners establish and manage their business credit to ensure access to capital. Determine whether you have a business credit file. The first step for a company looking to build a strong credit rating is to determine if they have an existing business credit file with a credit reporting agency such as Dun & Bradstreet Credibility Corp. (DBCC). If your company already has a credit file, examine it thoroughly for accuracy and don t hesitate to ask a DBCC Credit Advisor for advice or clarification. If your company does not have a credit file, contact DBCC to apply for a unique business identification number called a D-U-N-S number. With a D-U-N-S number, a business can easily track and evaluate its credit profile. GET A D&B D-U-N-S NUMBER FAST! Get a D-U-N-S number in just 5 business days with the D-U-N-S File Creator from Dun & Bradstreet Credibility Corp. Call to learn more. It is important to note that requesting a D-U-N-S number is only the beginning of the process of building a business credit profile. Create a business credit history. Far too many small business owners make the mistake of using personal credit to secure financing for their company. In fact, many small business owners falsely believe that a personal credit profile automatically creates a business credit profile. The dangers of using personal credit are substantial. If a small business owner uses personal credit to secure loans made to a company, then the owner s assets could be claimed by a lender if the company is unable to service the loan. An individual s personal credit rating may also suffer if the business fails to repay a loan. It is crucial to establish business credit by allocating business expenses to the company and establishing a payment history using a commercial bank account.

8 Pay On Time. It is essential to make timely payments. Once a profile is established, a business can begin building a strong credit history by making timely, regular payments on debts owed. This is the key component in building a strong credit profile. Although many other factors play a part in determining business credit rating, including revenues, total debt, and the type of business, payment history is of the utmost importance. Monitor Your Credit Profile. Companies should meticulously manage their credit profile. The process of monitoring a business s credit profile also includes checking for errors, omissions, and other reporting mistakes. Clerical errors are one of the most common ways a credit rating can be damaged. If such an error occurs, a company should first verify the mistake and then contact their respective credit bureau. Monitoring your business credit profile with CreditBuilder by Dun & Bradstreet Credibility Corp. will alert you to any changes in your company s credit rating or profile that could affect your company s standing with vendors, clients, and lenders. Another simple error that can damage a company s credit rating is the omission of payment history, which may occur either intentionally or unintentionally. If a business is trying to establish good credit, omissions of payment history can slow the process. Companies should verify that vendors and suppliers are promptly reporting payments received. This process would be an arduous task if not for the services provided by a credit bureau. Here are a few important scores provided in a credit report by Dun & Bradstreet Credibility Corp. that small businesses should monitor in order to maintain or improve their credit score: Overall Rating Financial Stress Score Commercial Credit Score PAYDEX Score Credit Limit Recommendation Supplier Evaluation Risk Rating Monitor Customer and Vendor Credit. By monitoring the credit of customers and vendors, companies can make more informed decisions on business partners. Better information can improve cash flow and risk management, and potentially result in a higher credit rating. When choosing suppliers, a company should consider whether they report transactions to credit bureaus. Also, small businesses should always monitor the credit of customers to whom they choose to extend credit, using that information to determine how much credit to extend as well as the terms of that credit.

9 Conclusion The advantages offered from forming a business entity are usually greater than that of a sole proprietorship. In addition to the tax and liability mitigation benefits, business entity formation allows small business owners to establish greater legitimacy, which is difficult to do as a sole proprietor. Establishing market credibility is the foundation required for business growth. However, building business credibility is achieved not only by building trust with customers, but also by building the necessary relationships with vendors and other sources of capital. Therefore, incorporating one s business and managing one s business credit can potentially boost business growth, which is much more difficult to achieve without good credit. In fact, the most important time to build credit is during a company s early stages in order to increase a company s chances of obtaining funding and favorable credit lines and terms when the company needs it the most. DISCLAIMER: This publication and the information contained herein are for your noncommercial, personal use on an as-is, as available basis and may be used by you for informational purposes only. Dun & Bradstreet Credibility Corp. makes no representations or warranties, express or implied, with respect to the information contained in this publication and the results of the use of such information, including but not limited to implied warranty of merchantability, fitness for a particular purpose, and non-infringement. The information contained in this publication may include technical inaccuracies or typographical errors. Neither Dun & Bradstreet Credibility Corp. nor any of its parents, subsidiaries, affiliates, or their respective partners, officers, directors, employees, or agents shall be held liable for any damages, whether direct, incidental, indirect, special, or consequential, including without limitation lost revenues or lost profits, arising from or in connection with your use or reliance on the information presented in this publication.