Don’t Expose Your Assets!
There you are. You just finished reading Rich and Jeff Sloan’s book and you are fired up! You have an idea that you are certain will make make the invention of those small yellow sticky notes look like small potatoes.
Not only that, but you are so proud of yourself, because you have done exhaustive market research, completed a fabulous and no-fail business plan and are already taking orders from your home office.
WAIT! Step away from that business loan application and listen.
While a great majority of new businesses start as sole-proprietorships, most of them should not. While there are ease-of-use and tax advantages to a sole-proprietorship, the ever-present exposure to liability can render those benefits useless. I would venture to guess that most small start-ups could benefit from becoming an LLC as soon as possible. Here is why:
- Operating as a sole-proprietorship exposes you to all the debts and liabilities incurred by your company. That means that your personal assets (your house, your car, that collection of vintage Barry Manilow LPs that you secretly love) are all vulnerable to creditors and potentially injured customers, suppliers or third-parties if you end up in a dispute or are unable to pay your company’s debts.
- An LLC generally (see below) protects the business owner from business debts and liabilities, while also providing pass-through tax benefits (consult your friendly neighborhood CPA for more information on what entity form provides the right tax treatment for your business).
- A single-member LLC will be treated by the IRS as a sole proprietorship, so you haven’t lost that benefit by forming an LLC.
- Like the simplicity of a sole-proprietorship, an LLC does not require the maintenance of corporate formalities or certain corporate activities to maintain its status. It is a relatively maintenance free way to operate…aside from the business of running the business, that is.
- An LLC also allows you to grow and add additional members as needed by your company. Of course, if that happens, you will be treated by the IRS as a partnership and no longer as a sole-proprietorship. But that would happen even if you were moving from a sole-proprietorship to having more than one owner.
Now for the big but…
Not all debts and liabilities will belong to the LLC, even if you go through the trouble of forming one to house your new business. That is because many new businesses are only able to obtain credit/loans by providing a personal guarantee for that debt. If you provide your social security number or personal financial information to obtain financing or credit, you can bet that you will be personally liable for that debt, even if your LLC is unable to pay it back.
Also, even under a properly formed LLC, a member still faces personal liability for damages or injury resulting from his or her negligent or tortious behavior. And the issue of “limited liability” is more intricate to fully discuss in an entry such as this one, but is an important one to understand fully as you move into your new venture.
That is why I strongly encourage you to consult a reputable small business attorney before you form your entity. I have nothing against the low cost and efficiency of the internet-based entity-formation services out there, but as a lawyer who has spent many years cleaning up or working to resolve disputes for small businesses on the back-end, I’d rather see a small business owner spend a few hundred dollars for proper and customized legal advice before making such irreversible decisions about their companies.
It will be worth the peace-of-mind to know you set your business up properly, and you can get on with doing the work you love.
Now you ask, “How do I find a good small business lawyer?” That, my friend, is a different topic for a different time. Stay tuned!
June 1st, 2008 at 8:42 am
very much staying tuned, jessica! thanks for the great post.
one question we get here a lot on this topic, though: does what state you’re in impact which kind of entity/structure to chooose? and relating to that “one question,” can a “sub S” corporation provide some of these benefits and actually be preferred in some cases?
June 1st, 2008 at 1:00 pm
Thanks for those great questions, Rich! You are absolutely correct that LLCs are creatures of state statutes, and what state you are in will definitely affect which entity you should choose. That is one big reason why consulting with a local small business attorney is critical. However, I will also get into more detail about that in a future post.
As for the S-Corp question, there are definitely times that an S-Corp is the right choice over an LLC or another entity. It is more difficult to obtain and maintain S-Corp status, though, and so it isn’t for the uninformed or faint of heart. The beauty of an LLC is that if the business owner decides that the business would benefit from S-Corp status, it is easy to convert from an LLC to an S-Corp. Not so the other way around, so you want to be sure S-Corp status is the right one for your business before you pull the trigger. Another great topic for a future post, so stay tuned!
June 5th, 2008 at 2:12 pm
If it was just a few hundred bucks like you say then I guess more people would actually see lawyers and not use online services instead.
June 5th, 2008 at 5:22 pm
Jessica,
As you have pointed out toward the end of your post, many LLC members will have to personally guarantee business debts, so the business structure won’t provide any “limited liability.” I find that many small business owners completely misunderstand the concept of limited liability and I always recommend that they talk to a reputable independent insurance agent who can educate them about things like Errors & Omissions and Product Liability insurance.
“Protecting you assets” is only one factor to be considered when selecting a business structure. One’s personal and family situation also come into play. Age, health, retirement goals, dependents, and college funding are a few that come quickly to mind.
The regulations covering payroll and fringe benefits differ significantly among the various entities. As do the tax consequences. For those reasons, I recommend that small business owners spend a few hundred dollars with a competent CPA to obtain proper tax advice before consulting their attorney and making a decision about how to organize a new venture.
Respectfully,
Sheryl