Last week, we talked about what a business entity is and whether you should use one for your business, ..
the short answer? Yes, if you want to grow your business and shield your personal assets from your business activities.
This week, we'll cover what kind of entity you should use and where you should set that entity up.
You'll recall, we are really talking about either an LLC (Limited Liability Company) or an S-Corp (Corporation filing an election for special taxation with the IRS).
You can form a C-Corporation or a Limited Partnership, but if you are considering that, make sure you are talking to a lawyer who is familiar with the specifics of your specific situation and is advising you personally.
With both LLCs and S-Corps, you are taxed only once on the income of the entity , meaning that all of the income and expenses will be reported on an information return filed with the IRS, but the actual taxes are paid by the shareholders or members of the entity.
This is called pass-through taxation.
You'll recall from last week, that I said the purpose of your business entity is to limit your liability as a business owner.
This is to encourage business owners to take risks that they would not take if they had unlimited personal liability.
Here's the thing though, the shield is only intact if certain formalities are maintained, such as proper filings with the State, annual meetings of the shareholders (for corporations), and separation of all financial activities between you and the entity.
Far too often, I've come across business owners who used an incorporation service, a shoddy lawyer, or a CPA to incorporate their business and when I asked these business owners where their operating agreements, bylaws, annual meeting minutes and state filings were kept, they couldn't tell me.
Why is that? Because they didn't realize that merely filing articles of incorporation with the State does not provide liability protection.
Your corporate entity must be established correctly from the beginning with governing documents and then maintained on a yearly basis.
If you don't do that, you may come to find out too late that your business entity doesn't provide the protection you thought it did.
So, make sure that once you decide what kind of an entity to use, you set it up right and then maintain that entity.
Now, before we talk about the type of entity, let's talk about one additional kind of asset protection that you need to take into account.
Up until now, we've been talking about what I call "inside asset protection" or protection against liabilities that are incurred by the corporation, within the bubble that I described in last week's post.
There's another kind of protection that is often overlooked and that's "outside asset protection".
Outside asset protection protects your business from your potential personal liabilities.
For example, if you are in a car accident, file for personal bankruptcy, or are sued by a business partner or colleague or personally guarantee a debt.
These are all personal risks that are happening outside your business entity.
In most cases, your business entity is not protected from your personal risks.
That means if you are sued personally and a judgment is obtained against you, the judgment creditor could take your business entity from you in satisfaction of the judgment.
But, not always.
In certain States, notably Nevada, there is something called "charging order" protection.
What this means is that if you are sued personally and a judgment is entered against you, your judgment creditor cannot take away your Nevada business entity, they can merely take a charging order against it.
This means that they have a right to distributions from the entity, but cannot force those distributions in satisfaction of the judgment.
This can be a big deal if you are concerned about your potential personal liabilities.
In that case, you will want to establish either a Nevada LLC or a Nevada S-Corporation.
If you could care less about charging order protection, you can form an entity in any State of the Union, but in most cases you will want to form it in your own home State where you will be doing business because no matter what if you use a foreign corporate form, you will need to qualify to do business in your State, which means you pay state income taxes there no matter what.
Yes, there are people who will tell you that you can avoid income taxes by setting up your entity in Nevada, but that is very rare.
Like if your business is totally virtual and can actually have its principal place of business in Nevada.
Or, if you live there, of course.
Again, if this is something you are considering, talk to your lawyer.
Ok, so LLC or S-Corporation? Well, there are pros and cons to both and I'm going to lawyer out on you at this point and tell you that this is really a decision you should be reaching with the guidance of your own lawyer and your own CPA working together to advise you.
Your decision will have tax consequences that cannot be considered based on what you read in a general article that does not take into account the specifics of your situation.
So before you incorporate any sort of entity, make sure to consult with your own personal lawyer and your CPA to make the decision about an LLC or an S-Corporation for your business structure.