Are you ready to form a corporation or LLC?
When deciding whether to form a business entity, there are many factors you should analyze. A few of those factors are (1) formation and formalities, (2) liability, (3) tax consequences, and (4) potential funding.
Formation and Formalities
Forming a corporation or an LLC and complying with the formalities can be expensive and time consuming. First, business owners should hire an attorney to form the entity. Then, all accounts and contracts must be transferred over to the entity. This usually means time at the bank and communicating/negotiating the changes with any vendors, customers, and/or partners. Once the entity is formed, a corporation or LLC must follow certain formalities. For example, shareholders and members must avoid commingling personal funds with the entity funds and treat their personal bank account as separate from the business’ bank account. In addition, decisions must be made in accordance with the corporate bylaws or the operating agreement, which may include consent of members/shareholders or special meetings for major decisions. For corporations, meetings are also required on at least an annual basis. These are just some of the formalities necessary when operating a corporation or LLC.
Liability
Operating as a sole proprietor comes with risks and you need to assess the potential liability that comes with operating the business and the personal assets that you are putting at risk. If your net worth is low and the risk associated with the business is low, it might make sense to remain a sole proprietor. On the other hand, the potential for judgments against you as a sole proprietor may be a reason to form an entity. These judgments can extend beyond the business and affect your credit and ability to take out loans as an individual. If you form an entity and the entity incurs debts and judgments against it, the liability should not extend you as an individual shareholder or member, as long as you operated the entity properly. Forming an entity helps reduce liability but an entity may not be necessary if potential liability is so minimal.
Tax Consequences
Forming a corporation or LLC will change and complicate any business owner’s tax situation. First, the state of CA charges an $800 minimum tax to each corporation or LLC, regardless of its revenue. In addition, LLCs are taxed by California on their income based on a tiered system. For corporations, taxes will be different based on the choice of a C-corporation or S-corporation. Before forming an entity, a CPA should be consulted to discuss the tax consequences of staying a sole proprietorship or forming an entity.
Potential Funding
If you plan on pursuing funding for your business, you should analyze the types of funding available to each business type. For sole proprietors, your funding options are loans, lines of credit, and basic forms of investors. These all require you to put your own credit on the line, which opens you up personal liability. Forming an entity protects your personal assets from creditors in most situations. For LLCs, the operating agreement, as well as the tax consequences, may tend to scare off some investors who are looking to gain equity in a young company. Corporations usually gain the most investor interest and have the ability operate with many shareholders.
Every business owner’s situation is different and there are many factors beyond the four listed above. Thus, it is important to consult with an attorney when considering forming a business entity. Choosing the correct business entity will influence many aspects of your business as it grows.
Feel free to contact the Toomey Law Firm with any business entity related questions!