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Why You Need A Business Entity
By Richard A. Chapo, Esq.

When starting or expanding a business, many owners wonder if there is any advantage to forming an entity for their business. There is a wide variety of information and "pitches" being made regarding the benefits of certain entities versus others. When you cut through the flak, however, the primary reason for forming a business entity is to create protection from personal liability arising from the business.

Why Incorporate?

Is incorporation an unnecessary expense or task to be put high on your "to do" list? Depending on the source, it is well established that up to eighty percent of businesses will fail in their first two years. Many of these businesses, and probably yours, are created in such a way as to create a high level of personal risk in our litigious society. The simple fact is that without corporate protection, you are personally liable if the business fails. Do you want to expose your home? Your car? How about your paycheck from your regular job? By conducting your business through a corporation, you create a legal shield between potential liability and your personal property. More importantly, you can sleep at night knowing that the worst thing that can happen in a lawsuit is that you lose your investment in the business, not your home.

Business Structures

There are a number of business options that exist in the modern corporate world. Following is a short explanation of the most common business structures.

Limited Liability Company

A limited liability company, or "LLC" as it is better known, was a very popular entity choice in the early 1990s. A LLC is similar to a corporation, but can be taxed as a partnership. Depending on the state you are in, the LLC can have either one owner or two. These owners carry the legal title of "member", which is the functional equivalent of a shareholder in a corporation. The LLC provides a shield for your personal assets. Of significance, not all states recognize LLCs as legal business structures.

You should note the "was" qualifier in the first sentence of the previous paragraph discussing the popularity of LLCs. Although LLCs are a flexible way to create protection from personal liability, the cost associated with the companies is less attractive. Many states have enacted a fee or tax known loosely as the "gross revenues tax" for LLCs. In California, for instance, an LLC is required to pay an annual "fee" based on its gross revenues. If you made $250,000 in gross revenues in 2000, the fee would be approximately $1,040. This fee is in addition to an $800 fee for "the privilege" of doing business in California. In short, the fees can pile up with an LLC. Before forming an LLC, you are encouraged to speak with an accountant or attorney regarding the requirements in your state.

Corporations

Corporations come in two basic forms, a "C" corporation and an "S" corporation. There are a variety of differences, but the central difference is a tax issue. Briefly put, a "C" corporation will be taxed on its revenue and you will then be taxed on any money you take out of the corporation. An "S" corporation is taxed one time for the money earned with most of the gain being passed through to the shareholders personal tax returns. The double taxation issue with a "C" corporation is typically wiped out by expensing legitimate costs of doing business, including paying expenses in advance. It is vital that you speak with a tax expert to determine the best choice for you in light of your financial position.

Regardless of the tax classification, a corporation is considered to be an independent entity from a legal standpoint. The owners of corporations are known as shareholders with some states allowing one owner while others require a minimum of two. In most states, the shareholders are listed in a database that is available to the public.

The advantage of both corporations and LLCs is that they are recognized as an independent legal entity for liability purposes. What does this mean? Essentially, the companies will be treated as though they are an independent person. As a result, the liabilities of the company do not pass through to you if the business is sued by a third party or runs into financial difficulty. As a practical example, Kmart recently filed bankruptcy. The individual shareholders were not required to file bankruptcy and they will lose nothing more than their investment if the company is liquidated. Your use of an LLC or corporation as a business structure will have the same effect. You will be risking only your time and investment in the business, not your personal assets. In short, you should select either a corporation or LLC for your business.

Partnerships

In my opinion, it is better to have died a small child then to be in a partnership. Unfortunately, many business owners create partnerships intentionally or unintentionally. The folly of doing so is significant for one primary reason: a partnership does not provide any protection from liability! In many ways, it is worse. Under well-established law, most partnerships are classified as "general". This simply means that all the partners are contributing to the administration and running of the partnership business. This classification has a grisly result. In a general partnership, each partner is jointly liable for the debts of any other partner arising from the business. For instance, you and your partner go to a business dinner with a client. Your partner has a drink and then a few more. They then get into an accident on the way home. Each of the partners is liable for the damages claimed by the injured people. That means YOU! Even if you were not in the car, did not rent the car, never saw the car and don't drink! In short, the dangers of a partnership are extreme.

Limited Partnerships

Limited Partnerships ["LP"] are perhaps the most misunderstood business entity. A limited partnership is similar to a general partnership. The difference, however, is that a number of the partners can limit their liability by being designated as limited partners. It is critical to note that these limited partners are restricted to simply making a capital [cash, content, equipment] contribution to the partnership. They cannot actively be involved in the running of the business. If they are, they lose any protection from partnership debts. Many limited partnerships end disastrously. If you are married to the idea of pursuing a limited partnership, you must do so in combination with corporations. This strategy is well beyond the scope of this article, but feel free to contact me if you wish to pursue a limited partnership.

Each business is unique and requires a different business entity solution. Whether you are starting a business or moving your current business to the next level, make sure you obtain competent advice regarding the best entity for you.

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Richard Chapo is the lead attorney for SanDiegoEsquire.com, based in San Diego, California. He can be contacted at Richard@SanDiegoEsquire.com. or 619-992-1867. This article is for general education purposes and does not address every facet of the laws surrounding the subject. Nothing in this article creates an attorney-client relationship.