Making it Official: Should You Create a Legal Entity for Your Business?
small business
Oh hi friends! I'm taking a seat and getting comfy for today's blog. One of the most common questions I get with my clients is whether or not they should form a legal entity and, if so, which one. So, if you’re reading this right now with that same question, guess what, you’re amongst good people.
Now there’s a ton of information about this topic and it could easily be broken down into five different posts, but I’m going to do my best to condense this into short, but sweet, answers and hit as many of the common questions I usually get. But just know that if your situation doesn’t fit into this exactly, or if you still have more questions, I am totally here for you and to answer all of your questions (more on that below).
Ready to dive in? Let’s do this!
Below are the first three questions you should be asking yourself. We’re going to work through them together:
→ Who should own the business? You (sole proprietorship) or form a separate legal entity to own the business?
→ If you decide to form a separate entity, what entity should you pick: corporation or a limited liability company (LLC)?
→ How do you want the corporation or LLC to be taxed?
Who Owns the Business: You or An Entity?
If you’re on the fence about who should own the business, ask yourself a few questions:
1. Do you have a lot of assets—a car, house, 401K, savings account, insane shoe collection, prized vintage guitars, anything of value?
2. Is this something you plan to do as a career or is this business a hobby that you’ll participate in a few hours a week?
3. Would you be open to accepting financial contribution/investment to help get this off the ground?
4. Will you have substantial startup or operational expenses?
5. Do you eventually want to hire employees or contractors?
6. Will you make money (now or eventually) and profit from this, and if so, will you want to pay yourself?
The main, and most important reason to form a Corporation (Corp for short here) or LLC, is to limit your personal liability.
What is Personal Liability?
Simply put: it’s what you’re on the hook for. If something goes wrong in the business, you want to contain that problem to the business and make sure your personal assets—your house, car, savings accounts, and personal belongings—are completely off-limits.
Corps and LLCs are their own entities, like their own artificial person. The Corp or LLC owns the business, not you. But you would own the Corp or LLC. You’re creating an extra step of protection between the outside world and you. Still with me?
The Corp or LLC will have its own bank account, email address, enter into contracts, can be sued, and is liable for its own debt and obligations. Not you. Because your Corp/LLC is its own ‘person,’ any expenses, debts, lawsuits or problems are limited to that ‘person’ and not you. Have you ever heard of a business going bankrupt but the CEO still comes away with millions? Yup, that’s how.
For the rest of us, we want to limit our personal liability as we work our way through these exciting new ventures.
Why would you not want to form a Corp or LLC?
→ You’re doing something as a hobby and not focused on profit.
→ You’re just starting a business idea and there isn’t significant risk or liability associated
(ex: you’re starting a blog, or starting off as a freelancer).
→ You have ZERO personal assets
→ You can’t yet afford the formation and registration fees.
Even if you chose not to form an entity but still run a business, it’s no less official. It’s called a Sole Proprietorship and is still just as legitimate of business. You can still open a business bank account for your SP and run it just as any other business.
But What Entity to Pick: Corporation or LLC?
To pick which one is best for you, it’s best, off the bat, that you understand neither is the ‘cheaper’ alternative. How each is formed, governed, operated, and taxed is different, and will accommodate the business you’re growing.
And guess what? If it doesn’t, it’s actually quite simple to convert entities down the line.
Big picture details to consider:
LLCs are considered the more ‘lax’ entity. They require less administrative work and filings. There is no specific management structures. You can chose to be an LLC, but be taxed as the super beneficial S-Corp. For 90% of businesses, this might be the way you want to go.
Corporations require stricter annual record keeping and reporting. There are more restrictions on shareholders (ex: only US citizens can be shareholders, LLCs cannot be shareholders). However, if you foresee your company taking money from outside investors, or having numerous shareholders who each financially contribute, a corporation is your answer. Also—if you are like me and an attorney, or a medical doctor—you are legally required to be a corporation and not an LLC.
I find it helpful to look at the chart below and compare the two structures side by side:
Ugh taxes... There’s no avoiding them, and no matter what anyone says, don’t try to. Because I’m not a tax attorney or advisor, CPA, bookkeeper, or even someone who knows their own local sales tax, I’m going to keep this short but sweet. Pay your taxes, but only pay what you absolutely must.
This means:
- Maximize your business expenses to minimize your taxable income, and
- 90% of my small business clients should chose to be taxed as a PASS-THROUGH entity.
To best explain pass-through taxation, let’s take this scenario: your business makes money throughout the year, and that money is used to pay for operational expenses, salaries, all that good stuff. At the end of the year, there’s a profit of $100 left. (Just pretend, ok!?) The business won’t be taxed that $100, but instead that $100 will be passed off to you, the sole owner. You will pay personal income taxes on that $100, at your tax rate. If there are four owners, each will be passed $25 and pay income taxes on that $25. Make sense?
LLC’s are not automatically taxed as pass-through entities and instead have to chose to in their registration forms. Corporations have the choice of how they want to be taxed. A C-Corp is taxed ‘double’ and for most of our purposes, we can ignore this right now. A S-Corp is taxed as pass-through entity, and again, as you’re forming your corporation you can make the election to be taxed as such. Easy enough!
And last but not least - don't be afraid to maximize your operational expenses. Yes, I'm telling you write off legitimate business expenses—educational opportunities, memberships, supplies, preparation for photoshoots/marketting materials—anything that your business needs to run. When deciding if something is a business expense, I ask myself: "How does this expense better my business, or better me in running the business?" If I can justify it, it goes on the business credit card. (This is a hot topic right now, and I think definitely warrants it's own post down the road).
Remember: operational expenses are subtracted from the business' profits. Less profits at the end of the year mean less taxable income that's passed to you.
~phew~
That was a ton of information guys. And I could go on and on about entities, requirements, pros and cons, but this has already been a lot to process.
Feel free to leave the questions below, or email me at Danielle@DSB-Legal.com, message me on Instagram @Danielle.Stead or carrier owl me with your questions.
Can’t wait to connect with you all as your start to build + grow your dreams.
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