Running a business involves risk – the risk that the business may either succeed brilliantly or fail miserably. Or neither. The upside is high — financial and (perhaps) time freedom; independence; unlimited earning capacity.
The downside is equally steep, just in the wrong direction — potential financial ruin if you’ve staked everything you own on your business’s ultimate success and thrown your career down the proverbial to boot. If you’re running your business as a sole proprietorship or a general partnership, make no mistake — everything you own is on the line.
There’s a lot that can go right and wrong in a business. A lot of it out of your control. But the extent of your personal financial liability for what goes wrong is one thing you can and should control.
The answer is to form an entity separate from yourself to run the business.
WHICH BUSINESS ENTITY?
As you probably already know, you have several choices when it comes to your business entity. The most basic is a sole proprietorship, followed by a partnership (general or limited), a limited liability company (“LLC”) and a corporation (either a general “C” corporation or an “S” corporation – more about these later).
Although sole proprietorships and general partnerships are relatively straightforward and inexpensive business entities to establish and maintain, hence their popularity, neither of them protects you from personal liability.
If you’re a sole proprietor, you’ve probably made this election by default – by doing nothing other than starting a part-time Internet business out of your spare bedroom, most likely.
A limited partnership will protect the limited partners from personal liability beyond the extent of their capital contribution to the partnership, but limited partners cannot participate in the management and control of the business so that’s not a good option for most of you reading this article. Needing to control and manage your own business is most likely non-negotiable.
As an attorney, I generally recommend that small business owners, including (especially!) home-based and Internet entrepreneurs, incorporate at least as soon as they are generating sufficient profits from the business that the amount of tax payable on such profits equals or exceeds the minimum franchise tax payable in the state in which the business is being conducted. In California, for example, one of the most onerous states in the U.S. when it comes to taxes, the annual minimum franchise tax is $800 per year. Therefore, as soon as you’re generating profits the tax on which is $800 or more in a year, there is no tax disadvantage to incorporation and every advantage.
HOW DOES INCORPORATION PROTECT AGAINST PERSONAL LIABILITY?
Quite simply, when you form a corporation (or an LLC), you’re forming a separate legal entity. This separate legal entity has the power to enter into contracts, own and dispose of assets, hire and fire employees and generally do anything that a sole proprietor could do. The difference between the corporation and the sole proprietorship, however, is that only the corporation’s assets are at risk, not the owner/shareholder’s (beyond the shareholder’s contribution to share capital, that is).
Let’s take an example. You run a part-time Internet business. You’re still working a day job and this is really just a way to make a little money on the side to save for your annual Hawaiian vacation and even more expensive spa stay for your dog while you’re away. To you, this is only a pocket-money venture and so you don’t really think of it as a business at all, really. So you don’t give a second’s thought to the fact that you’re running a business as a sole proprietor.
You register a domain name that, unbeknown to you, violates a Macrohard trademark. You create a website for that domain and, lo and behold, overnight (of course, because this is the Internet) your business becomes successful beyond your wildest dreams due, in no small part, to site visitors mistakenly believing they are doing business with Microsoft’s arch-rival.
Macrohard, meanwhile, sees all of this and figures your gain is its loss and sues you for an account of profits based on your misuse of its trademark. And wins. It gets a judgment for $100,000. Then it executes on its judgment. And you lose your house, your savings and your business.
Now let’s look at a slightly different scenario. You’re fortunate enough to have read this article before you established your business and formed an S-corporation, Hawaii Here We Come, Inc. The only asset of HHWC, Inc. is the domain name and website. So, when MarcoHard gets its judgment against HHWC, Inc., the only asset it can touch is the domain name and website. That’s bad enough, of course, but you did, after all, violate their trademark. But get this. Because they’re in your name, not HHWC, Inc.’s, you still have your house and your savings.
HOW LIMITED PERSONAL LIABILITY CAN BE LOST
Merely incorporating is not enough to avoid personal liability, however. As a director and shareholder, you must run your corporation or company (if an LLC) as a separate legal entity, NOT your alter ego! This means you can’t just siphon off cash from the corporation’s bank account to pay your house mortgage.
Do that, and the court will “pierce the corporate veil” in a heartbeat, thereby exposing you to full personal liability on the grounds that the corporate structure is nothing but a sham designed to unfairly protect you from personal liability.
It is also particularly important that you follow all corporate formalities such as those set out in the by-laws, passing board and/or shareholder resolutions for major decisions and holding annual meetings of the shareholder(s) to elect the directors and directors’ meetings to elect the officers.
Also, don’t think the “corporate veil” will protect you from criminal acts such as filing a false income tax return, because it won’t.
SO HOW DO I GET MONEY OUT OF THE BUSINESS?
You are paid by the corporation as an owner/shareholder in the form of dividends and/or as an employee in the form of a salary.
CORPORATION OR LLC?
While both corporations and LLCs limit your personal liability, there are differences between states when it comes to how other states’ LLCs are treated in this regard. By contrast, corporations are treated uniformly when it comes to personal liability. Especially if you’re operating an Internet-based business where you can be transacting with people from pretty much anywhere, for the greatest certainty concerning your personal liability, a corporation is preferable to an LLC.
One of the advantages of an LLC as a business entity is that the profits and losses of the LLC “flow through” to the personal income tax return of the members. However, if you make a “subchapter S” election when forming the corporation (thereby forming an S-corporation), you can achieve the same result.
S-CORPORATION or C-CORPORATION?
Although the S-corporation’s profits and losses flow through to the shareholders (rather than the S-corporation being taxed as a separate entity as in the case of a C-corporation), S-corporations are limited to 75 shareholders and, generally, those shareholders must be U.S. citizens or resident aliens.
You would therefore not be able to have foreign shareholders with an S-corporation (but you can with a C-corp), which may be an issue, particularly for Internet-based businesses with shareholders from various countries.
Also, you cannot have multiple classes of shares with an S- corporation so this will not work if you want to issue preferred shares, for example. You’d need to form a C-corporation instead.
Forming a corporation is a relatively straightforward matter (at least for an attorney) and shouldn’t cost you more than a few hundred dollars depending on the complexity of the corporate structure. Most attorneys would charge between $500 and $1,000 for a straight C or S-corporation.
At its simplest, a corporation can have a single director and shareholder with that same individual holding each of the three required offices (president, secretary and treasurer). (If a corporation has three or more shareholders it must have a minimum of three directors but if it has fewer than three shareholders, it may have the same number of directors.)
Your attorney will prepare and file articles of incorporation with your State’s Secretary of State, and then prepare by-laws and organizational minutes. You’ll need a Federal Employer Identification Number (SS-4) from the IRS and, if you have more than one shareholder, a buy-sell agreement to ensure that the shares do not pass to shareholders unacceptable to the other shareholders.
Your attorney will also attend to annual filings with the state (a statement of officers and directors is usually required to be filed every one or two years) and make sure you stay in compliance with state corporate requirements (such as annual minutes etc.).
Taking the time and trouble to think about the legal structure of your business may seem like overkill when all you’re doing is running a fun little business out of your spare bedroom in your spare time. But fun little businesses have a way of becoming very unfunny major headaches when things go wrong. No matter how small or fledgling your business is, do yourself and your family a big favor and at least think about incorporating. What may seem like a pleasant past-time today could be anything but tomorrow.
2003 Elena Fawkner
Elena Fawkner is editor of A Home-Based Business Online … practical business ideas, opportunities and solutions for the work-from-home entrepreneur. http://www.ahbbo.com/