In another article, Joshua Kelly wrote about establishing a Sole Proprietorship when starting your own business. Today, I will discuss two other entities, specifically Corporations and Limited Liability Companies (LLCs). Please note that this article is not legal advice. So should you decide to start your own business, please consult a qualified attorney and certified public accountant for advice on selecting the best entity for your needs.
There is a lot of confusion out there when it comes to the purposes of various entities and the legal consequences for each type. To clear up that confusion, the easiest way to think about the issue is from two perspectives: legal and tax. Importantly, think of these two perspectives separately, and do not intermingle them with each other.
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The purpose of a Corporation and LLC from a legal perspective is to protect you, as the owner, from exposure to personal liability for claims made against the business. In other words, these entities are designed to help prevent plaintiffs from going after your personal property (such as your house and car) should your business accrue a liability. This is a protection that a Sole Proprietorship does not provide to you.
For example, say you own a convenience store and it purchased $120,000.00 worth of inventory to sell to customers. Furthermore, the supplier of that inventory agreed to a $10,000.00 payment per month for the next year, until the debt is paid off. Now suppose over that year, the convenience store did not make enough sales to pay the supplier.
If the convenience store is under a Corporation or LLC, and importantly you did not personally guarantee the $120,000.00 loan, the supplier can normally only go after the assets of the Corporation or LLC to satisfy that debt. However, if the convenience store is under a Sole Proprietorship, the supplier can also go after your personal assets to recover the money. You could be in a position where your prized sports car is being auctioned off (involuntarily) and the money turned over to the supplier.
So the general idea of a Corporation and LLC is to shield you from personal liability for the debts of those entities. Of course, there are numerous exceptions and rules to follow, which is why it is imperative to obtain quality legal and accounting advice on an ongoing basis when running your Corporation or LLC.
From a legal liability sense, a Corporation and LLC provide generally the same protection. The difference between the two becomes clear when thinking about the issue from a tax (accounting) perspective. For tax purposes, net income from the LLC is added to your personal income. In this regard, if the LLC makes a lot of money, your personal income tax filing will reflect that profit. The LLC will issue to you, the owner, a form K-1 that states how much net income was earned. From there, that form K-1 is then enclosed with your personal income tax filing, and the profit (or loss) is declared to the IRS.
For a Corporation (specifically a “C” Corporation), net income (and losses) remain with the Corporation. The Corporation is essentially its own “living person”, which means that the owners (i.e. shareholders) are not responsible for declaring corporate profit and losses on personal income taxes. Instead, the Corporation itself is taxed on its income by the IRS.
Shareholders are responsible for declaring income when the Corporation issues a dividend. Dividends are payments made to shareholders when the Corporation has excess money and can afford to turn that money over to its owners. When a Corporation declares a dividend, the pool of money is taxed twice. The first time, the money is taxed when the Corporation declares the dividend money as corporate income. The second time, the money is taxed when the shareholders declare the dividend money as personal income. This is known in accounting circles as “Double Taxation”. Remember, Double Taxation applies when corporate profits are turned over to shareholders, and not when the Corporation keeps the money in its own accounts.
There is no right answer to this question. Many lawyers generally steer their clients away from Sole Proprietorships because of the discomfort with mixing personal and business liabilities. On the other hand, the work to maintain Corporations and LLCs as legal entities can be time consuming. There are annual filing requirements with the state, board and shareholder meeting requirements, and record keeping rules (to name a few). Many of the details you will need to know in order to make the best decision are outside the scope of this article. Your accountant and attorney can each assess your business and personal situation to make a calculated recommendation.