Business Entities for a Recovering Economy
Small business owners oftentimes are perplexed by the various options they have for operating their business. In many instances, a business starts out as a very simple endeavor, perhaps run out of a garage or as a sole proprietorship. As a business grows, not only does it add employees, but it also adds on risks that need coverage through insurance. The simple steps that need to be taken in order to formulate entities to protect important assets and operations are sometimes overlooked.
There are basically three ways to operate your business. One of these options is a sole proprietorship, which is nothing more than operating your business with your own social security number. This is usually a default position for a start-up business, particularly when there are no employees. For example, a lot of start-up internet companies are without employees and are sole proprietorships. As long as your business operation is simple and not the major source of your support, this is not the worst method of running your business. However, if your business liabilities—in regard to the product or services you are producing—are not extraordinarily limited, you must look into an entity that protects your personal assets as your business grows.
Since you are operating essentially as your own person, a sole proprietorship does not allow any protections or asset management. Also, if you begin to hire employees or develop a more complex way of operating, a sole proprietorship does not lend itself to a strong operational base; it actually has a tendency to lend itself to a more casual operating style. Although this type of culture may be favorable (particularly in an internet business), as a business grows, it may become counterproductive.
Another form of operating is a limited liability company. This concept has been discussed by me—both in articles in this newsletter and also on Karen Ellenbecker’s “Money Sense” radio program—as a way to hold real estate, but it can also be used to operate a business. A limited liability company is a good vehicle for pass-through income. In other words, a limited liability company can operate in a more formal manner and is also a separate legal entity, thereby protecting its owner from personal liability. By running a “check the box” limited liability company, you can actually use your own employer identification number (your social security number) for purposes of filing your income tax return. This allows you to have a less complicated tax return but still have the benefit of the liability limitations for a limited liability company.
Limited liability companies work best when there are fewer employees, a large amount of cash flow, and a strong desire to maintain an informal operational base. Always check with your accountant before picking an entity within which to operate your business to make sure your tax benefits are maximized (however, the purpose of this article is not to deal with tax issues, but operational issues and ensuring that liabilities of your business do not attach to your personal assets).
The third form, a popular way of operating a business, is a corporation. A formal corporation has annual minutes, meetings, and a board of directors. If you have multiple shareholders, particularly shareholders who do not regularly participate in the operation of the business, this option is the best. The formality that it creates and requires in operating the business means that there has to be an appointed board of directors, annual minutes and meetings, and reports to non-participating shareholders. This ensures that there can be no lawsuits by shareholders against the officers of the business, as the formalities require that rules and protocols be followed that lend themselves to full disclosure of business operations. Additionally, you can operate a corporation as what is known as a statutory close corporation. I have also opined in regard to this, and it is my favorite way of operating for small family-run businesses. A statutory close corporation allows you all of the benefits of a corporation without the formalities. You can operate without a board of directors, annual minutes, or meetings. Actually, the statute specifically states that personal liability cannot go to the shareholders by the mere fact that they do not follow corporate formalities.
After the economic downturn we have been through, the benefit of separating out an operating business from your personal assets has been clearly demonstrated to any of you who struggled with refinancing with banks or who wanted to walk away due to difficulties on the path to reviving a business that has been successful and ongoing for years. Operating with the right corporate entity out of the gate gives you options down the road that do not exist if you just run your business as a sole proprietorship.
Consult an attorney regarding your specific situation.
This article first appeared in the Ellenbecker Investment Group In Touch quarterly newsletter, the 3rd Quarter 2011 issue. Past newsletters can be viewed at Ellenbecker.com.