Under most circumstances, the experienced Business Lawyers at Revision Legal deem it prudent for clients to operate their businesses through a corporate entity like a standard corporation or a limited liability company. Of course, there are some circumstances where a partnership of some type might be the better option, but it would be a rare circumstance where operating as a sole proprietorship would be better than operating under the framework of a corporate entity.
The key reason for this conclusion is the “shield” that a corporate entity provides to protect the personal assets of the owners from business-related creditors. When created, a distinct legal entity comes into existence with many of the same rights and obligations as a natural person. The rights include the right to enter into contracts, open financial accounts, sue and be sued, buy, sell, and own property, etc. Obligations include paying taxes and obeying laws.
Since a corporate entity is a distinct legal “thing,” it is thereby deemed distinct from its natural-person owners. Thus, when a corporate entity signs a contract, only the corporate entity is liable for the obligations made under the contract. In this manner, the corporate form “shields” the owners of the corporate entity from being held liable for any debt default related to that hypothetical contract. Likewise, if the corporate entity violates a law or regulation and is assessed a civil money penalty, only the corporate entity is liable for the fines; the owners are shielded. There are, of course, cases where the shield can be pierced by judicial action. But, as long as corporate formalities are honored and there are no attempts to defraud creditors, personal assets are protected from business-related obligations.
There are several other reasons to operate your business under a corporate form. One involves what we might call “prestige” or “marketing value.” This is particularly true for new and smaller businesses. Generally, for consumers, it is more impressive that a company is operating as a corporation than as a sole proprietorship. Part of this is simple economics. It costs a certain amount of money to create and maintain a corporation. Thus, a corporate entity can be seen as a sign of success.
Another reason relates to practical things like the ability to obtain a business tax ID number and to obtain a business credit rating. Again, these things can be very important for a new business. Consider the value of a distinct business credit rating if the owner (or owners) have had financial setbacks that have diminished their own personal credit ratings.
A couple of other important reasons for operating your business as a corporate entity involve financing, investors, and the ability to transfer the business (in whole or part). Generally, financiers and investors will require the existence of a corporate entity for any amount of significant funding. This is partly because ownership of a business is much easier to transfer if it is a corporate entity and because the corporate entity has a continuity of existence beyond the lives of its owners. These corporate features are essential for funding and financing decisions.
Contact the Business Attorneys at Revision Legal
For more information, contact the experienced Business Lawyers at Revision Legal. You can contact us through the form on this page or call (855) 473-8474.
Choosing Between a Corporation and an LLC: Key Differences
The two most commonly chosen corporate forms are the traditional corporation (C-corp or S-corp) and the limited liability company (LLC). Both provide the liability shield described above, but they differ in important respects that affect which structure is right for a particular business. Owners in Northern Michigan can compare these options with our Traverse City business attorneys.
A C-corporation is taxed as a separate entity — it pays corporate income tax on its profits, and shareholders pay individual income tax again when those profits are distributed as dividends. This “double taxation” is a disadvantage for small businesses that intend to distribute profits to owners regularly. However, C-corporations are the required form for businesses that plan to accept venture capital or institutional investment, issue multiple classes of stock, or eventually pursue an IPO.
An S-corporation avoids double taxation through pass-through taxation: profits and losses flow through to shareholders’ personal tax returns. However, S-corporations are subject to significant restrictions: they cannot have more than 100 shareholders, cannot have non-U.S. citizen shareholders, and can issue only one class of stock. These restrictions make S-corps unsuitable for many growth-oriented businesses.
An LLC combines the liability shield of a corporation with maximum flexibility in ownership structure, management, and tax treatment. LLC members can choose to have the LLC taxed as a sole proprietorship (single-member LLC), partnership, S-corporation, or C-corporation. The LLC’s operating agreement — the foundational governing document — can be customized to allocate profits, losses, management authority, and voting rights in virtually any way the members choose. For most small and medium-sized businesses, the LLC is the optimal structure.
Piercing the Corporate Veil: How Owners Lose the Shield
The liability shield provided by a corporate entity is not absolute. Courts can “pierce the corporate veil” — holding owners personally liable for corporate obligations — where owners fail to respect the separation between themselves and the entity. Common grounds for piercing include:
- Commingling of funds. Using a single bank account for both personal and business transactions, or transferring money between personal and business accounts without documented justification, is the most common basis for piercing claims. Separate bank accounts, maintained exclusively for business use, are essential.
- Failure to maintain corporate formalities. Corporations must hold regular meetings, keep minutes, elect officers and directors, maintain proper corporate records, and follow the procedures set out in their governing documents. LLCs have fewer statutory formalities but should still maintain current operating agreements, hold documented member meetings, and keep adequate records.
- Undercapitalization. An entity that is formed with inadequate capital to meet reasonably anticipated obligations may be found to be a sham. While there is no bright-line capitalization requirement, owners should ensure the entity has sufficient assets or insurance to meet its reasonably expected liabilities.
- Fraud or injustice. Courts pierce the corporate veil where honoring the legal separation would sanction fraud, promote injustice, or allow an equitable wrong to go unaddressed.
The Operating Agreement or Bylaws: The Most Important Document You Will Draft
The operating agreement (for an LLC) or the bylaws and shareholder agreement (for a corporation) define the internal governance of the entity. These documents are far more important than most new business owners understand. A generic, off-the-internet form operating agreement may create significant problems down the road:
- Ownership and capital contributions. The agreement should clearly document each member’s ownership percentage and the capital each member has contributed or is obligated to contribute. Vague or missing contribution provisions are a leading cause of owner disputes.
- Profit and loss allocation. How are profits distributed? Are distributions discretionary or mandatory when the LLC generates profit? Is profit distributed proportionally to ownership, or differently? These questions must be answered clearly in the operating agreement.
- Management authority. Who has authority to enter into contracts on behalf of the entity? Who can open and close bank accounts? Who can hire and fire employees? Undefined management authority leads to disputes and can expose the entity to unauthorized contracts.
- Buy-sell provisions. What happens when an owner wants to leave? What happens if an owner dies, becomes disabled, or files for bankruptcy? A well-drafted buy-sell provision provides a mechanism for the remaining owners to purchase the departing owner’s interest at a defined price, using a defined process, within a defined time period. Without this provision, a departing owner can effectively hold the business hostage, or worse, an unwanted third party (an heir, a creditor) can end up owning an interest in the business.
Federal and State Compliance Obligations After Formation
Forming the entity is only the beginning. New corporate entities face a range of initial and ongoing compliance obligations:
- EIN registration. Every business entity — even a single-member LLC — should obtain an Employer Identification Number (EIN) from the IRS for tax and banking purposes.
- Beneficial Ownership Information reporting. Under the Corporate Transparency Act (CTA), most small business entities formed or registered in the United States must report information about their “beneficial owners” — individuals who own 25% or more of the entity or who exercise substantial control — to FinCEN. Deadlines and penalties for noncompliance apply.
- Annual reports and registered agent requirements. States require corporations and LLCs to file annual or biennial reports and to maintain a registered agent — a person or entity in the state of formation who can receive legal process on the entity’s behalf.
- Business licenses and permits. Depending on the type of business and the jurisdictions in which it operates, various local, state, and federal licenses and permits may be required before the business can legally operate.
Federal beneficial ownership reporting under the Corporate Transparency Act has changed several times since it took effect, so check whether it applies to your entity; our Corporate Transparency Act attorneys can help.
Contact the Business Formation Attorneys at Revision Legal
Forming a corporate entity is one of the most important decisions a business owner makes, and getting it right from the start avoids costly problems later. The Business Formation Attorneys at Revision Legal help entrepreneurs select the right entity type, draft customized operating agreements and governance documents, and establish the compliance framework for a new business. Contact us through the form on this page or call (855) 473-8474.
