COMPREHENSIVE GUIDE TO CHOOSING A NEW BUSINESS STRUCTURE

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1 COMPREHENSIVE GUIDE TO CHOOSING A NEW BUSINESS STRUCTURE 1. Corporations and LLCs: The most common entities 2. Comparing corporations and LLCs 3. Things to consider when forming a business entity 4. Which entity keeps my assets the safest 5. How to find a lawyer who knows business entities

2 Disclaimer: The material on this web site is for informational purposes only. This information is not legal advice. The law changes constantly, and the information may not be correct on the date you read it, and it may not apply to your particular legal problem. Each legal problem depends on its own facts, and the law is different in each state and country. Because of this, you should not rely on any information in this web site without first obtaining advice from a licensed, competent attorney about your particular problem. For more information, visit sandiegolawfirm.com/terms Now that you ve decided to start a new business, you may have discovered there are many ways you can structure it. Incorporating, creating an LLC, or functioning as a Sole Proprietor are just a few. The most important question now is this: Which structure will best protect your personal assets if your business gets sued or has financial difficulty? Each entity has advantages and disadvantages, depending on your situation. There are many factors to consider. Let s discuss. 1. Corporations and LLCs: The most commonly compared entities The entities that are compared most frequently are corporations and Limited Liability Companies (LLCs). LLCs combine the personal liability protection of a corporation, while also offering the tax advantages and minimal formalities of sole proprietorship and partnership. When starting your new business, you ll want to know the differences between the two, including the rules and benefits of each entity that could affect your business. Corporations Protect your personal assets. If the corporation is properly formed and maintained, the owner is generally protected from any personal liability for the company s debts. In addition, if the corporation obtains sufficient insurance and/or assets to satisfy potential liabilities, the owner is further protected from any personal liability for the company s debts. Employee fringe benefits. Once incorporated, business owners who work in the business can receive certain tax-free or tax-advantaged fringe benefits, including company-paid health insurance and pension plans.

3 Tax advantages. Depending on your business situation, it may be possible to maintain the benefits of corporate status but be taxed as individual owners, by electing to be an S-Corporation for federal income tax purposes. While a C-Corporation pays taxes on any profits remaining in the company after salaries and benefits are paid, all income will pass through an S-Corporation and be taxed only individually to the corporation s owners. Keep in mind that an S-Corporation cannot retain profits. Whether this is desirable or not depends on your particular business goals and the potential future needs of the business. Perpetual existence. If your business is a corporation, it will continue to exist, even if you die or decide to leave the business, so it can be sold as a separate entity. Financial incentives. Incorporating can make it easier for you to secure financing, raise capital, and sell part or all of the business. LLCs Protect your personal assets. As with owners of a corporation, the personal assets of LLC owners can be limited from liability for business debts, including lawsuits. Tax advantages. An LLC automatically avoids the double taxation that occurs when a corporation pays taxes on income and then pays taxable dividends to the shareholders. Generally, all profits and losses to the LLC are instead reported by LLC owners on their individual income tax returns. Additionally, profits and losses do not have to be tied to ownership percentage, and they can instead be allocated by agreement. This may be helpful if you are selling a portion of the business to a new owner and wish to allocate a gradually increasing share of the profits to that person. Flexible management options. An LLC offers greater flexibility in management than a corporation. This can create more business efficiency.

4 Avoid many corporate formalities. LLCs require fewer ongoing corporate legal formalities, such as annual meetings and the keeping of minutes of board meetings. 2. Comparing corporations and LLCs As we ve discussed, corporations and LLCs both serve up a variety of advantages and disadvantages. Knowing what these mean for your business is very helpful in deciding what type of entity to form. Here are some additional things to keep in mind. Business ownership. A corporation is owned by its shareholders. Stock issued by the corporation is subject to securities laws, although most small business corporations qualify for a strict exemption. An LLC s owners are referred to as members, and ownership interests are generally not subject to securities laws as long as all members are active in the business. Decision making. In a corporation, management decisions are made by the Board of Directors. In an LLC, members have decision-making authority, unless the LLC has chosen to be run by one or more managers. A manager may be an outside hire or can be one of the owners. Transferability of ownership interest. With corporations, your ability to transfer your stock may be limited by securities laws or by possible restrictions in the Articles of Incorporation or Bylaws. S-Corporations are further limited due to tax qualification requirements. In contrast, to transfer your ownership interest in an LLC, state law or the Operating Agreement may require the unanimous consent of the remaining owners - or consent of a substantial percentage of those owners. Taxation. A corporation pays taxes on its profits at the corporate tax rate, and owners pay taxes on profits paid to them as dividends, salaries, and bonuses, for example. The profits of an S-Corporation or LLC are generally taxed only at individual income tax rates. In a C-Corporation, owners who also work as employees can receive tax deductible fringe benefits and deduct all medical insurance premiums. If S-Corporation

5 status has been elected, owners are often limited regarding corporate fringe benefits. If an LLC has been formed, the benefits an owner receives depend on whether the LLC is treated as a partnership or corporation for tax purposes. Business debts. Generally, a corporation incurs liability for its business debts by the actions of its directors and officers. An LLC s business debts are incurred by any of its members or by its managers, if the LLC is run by managers. Business formalities. A corporation requires annual meetings and minutes of its meetings. An LLC usually does not require meetings, although an operating agreement is required. Startup investments. A corporation is financed by its initial shareholders, and S- Corporations are subject to limitations on their classes of stock. An LLC is financed by its members, and a promise to perform services for the business or contribute cash in the future can be considered an investment. Sources for raising capital. A corporation can raise capital from several sources, including outside investors and can possibly become a publicly traded corporation. An LLC s members may contribute capital, or obtain bank loans which may be secured by the member s personal assets, depending on the LLC s credit history. Legal History of Entities. While Corporations have been a part of the American landscape for nearly 200 years, LLC s are a relatively new business structure, emerging as recently as the 1990 s. This means there is less gray area with regard to what will happen if a corporation s shareholders are sued, as opposed to an LLC s members, simply because there is a greater volume of case law and statutory code to rely on. 3. Things to consider when forming a business entity

6 Forming a business entity is different for each individual. As you ve learned, there are many types of entities, and they all serve different needs. Here are a few questions you ll want to ask yourself when deciding which entity is right for you. What administrative tasks are you comfortable taking on? An LLC has few administrative requirements. If your business operates as an LLC, you do not have to elect a board of directors, elect officers, hold annual meetings, or make annual filings, and the LLC can be owned by just one person. LLCs are therefore very popular with beginning entrepreneurs. Who will be involved in your business? LLCs and Subchapter S Corporations both pass through their income to their owners tax returns, avoiding corporate income tax. A Subchapter S Corporation is often formed by family-run businesses that need more access to credit than LLCs usually qualify for. Likewise, if there is a need to continue uninterrupted if one family member/owner dies or becomes incapacitated, a Subchapter S Corporation is often what people decide to form. What tax benefits are important to you? A Subchapter C Corporation is the only type that can provide extensive, tax-free fringe benefits to the owners. A C Corporation also permits the owners to leave profits in the corporation, where they are taxed at a low corporate rate, and keep them there until the business is sold. If you set up and then sell a C Corporation, your total profit on the sale of your small business stock may qualify for the low capital gains tax rate. The disadvantage of a Subchapter C Corporation is that profits that are distributed to the owners as dividends (rather than salaries) are taxed twice: once on the corporation s return and once on the owners returns. Do you plan to, or already, have employees? Sooner or later, you may find your business needs one or more employees. As a California employer, you must follow all employment and labor laws in hiring employees, setting their schedules, providing a safe workplace, and more.

7 You will also want an employee handbook, specific to your business, which explains your business policies and procedures to your employees. A carefully prepared and enforced handbook can help you communicate all the information you are legally required to provide to your employees, list out the other material (such as a brochure on worker s compensation) that all new employees are legally required to receive, and avoid later lawsuits for discrimination, harassment, or labor law violations. 4. Which entity keeps my assets the safest? Setting up your business as a Subchapter C corporation, a Subchapter S corporation, or a Limited Liability Corporation ( LLC ) can protect your personal assets from business creditors in almost all situations, so long as you did not defraud or intentionally harm someone else. Without a properly formed and maintained business entity, your personal assets, including those you may gain in the future, are at risk to creditors. Both a corporation and an LLC can provide equal protection for your personal assets in the event your business gets sued. Whether you already have personal assets you want to protect, or you plan to grow your assets in the years to come, a properly formed and maintained business entity is the best way to minimize your risk. There are many factors to consider, and your decision will be based on the things that will best protect you and what will fit best with your business model. An attorney who specializes in creating business entities to protect assets can guide you through the decision process and ensure your entity is formed correctly. 5. Factors to consider when looking for a business lawyer Not all business law firms are created equally. When you begin your search for a business lawyer, keep in mind that a good business lawyer should: Assess the needs of your business and help you prioritize those needs. Work within your budget. Although it s rare, there are firms that offer fixed fees, on a one-time or monthly basis. This fee structure can make it much easier

8 for you to take care of the legal work you can afford, without interfering with your business cash-flow. Be an expert on business entities. Your lawyer should not only know which business structure is right for you, but he should have experience in forming business entities for a variety of clients. Be interested in helping your business succeed. Your lawyer should be sure to assess your big-picture business goals and budget, not rushing to perform services. Understand your business. Your legal needs are more than just filing the entity or creating a document. Ready for the next step? If you would like to meet with one our skilled business attorneys to see if we re a good fit to work together, please let us know. We offer fixed fees for all of our services, and there is no cost for the first meeting. We d love to get to know you and learn your business needs.