What Exactly Are Entities?
If you speak with an attorney, an accountant, or any other financial professional, or pick up any business book, you will see the term “entity”. In the business world, an entity is nothing more than a form of business. C corporations, S corporations and LLCs are all entities.
There are numerous forms of business out there for you to choose from. These include the sole proprietorship, the C corporation, the S corporation, the limited liability company (LLC), the general partnership, the limited partnership (LP), the limited liability partnership (LLP) and the limited liability limited partnership (LLLP). If you look at that list, you will see why it is often referred to as “alphabet soup”.
The best way for the business owner to think about a business entity is as a separate legal “person”. Your business is separate from you. You are not your business and your business is not you; though at times it will feel like it. As you will see, a business has many of the same rights that you do. A business can sue and be sued. A business is separate from you for tax reporting purposes and in most instances has an employer identification number (EIN). An EIN can be thought of as your business’ social security number. Your business will also receive a certificate of incorporation or organization that can be likened to its birth certificate.
Why You Need a Business Entity for Your Business
There are two big reasons for choosing to do business through a business entity rather than without one: 1) Limited liability; and 2) Tax savings.
Limited Liability. A properly set up and maintained business entity will protect your personal assets from business creditors. Think of this as the ultimate insurance policy. If you choose to operate a business without the use of a business entity, you are risking your home, your car, your retirement accounts, accounts established to save for your kids’ college, the list goes on. Whatever you own, you risk losing to creditors of your business.
Let’s face it, we live in a highly litigious society. It is estimated that nearly fifty-percent of us will be involved in a lawsuit in our lifetimes. And not only are the number of lawsuits increasing, they are becoming more expensive. Over the last 50 years, the cost of our civil justice system has increased over 100 fold, from less than $2 billion to more than $205 billion as of 2001. As a business owner, your likelihood of being involved in a lawsuit increases. So you need all the protection you can get.
Without a business entity, creditors can attach your personal assets to satisfy a judgment. However, with a properly set up and maintained business entity, business creditors can only go after business assets. They cannot go after your personal assets. Now, notice that there are two requirements to that protection: 1) The business entity must be properly set up; and 2) The business entity must be properly maintained.
Tax Savings. Choosing the proper business entity for your business can provide you with significant tax savings. The wrong business entity choice can cost you significantly.
I once had business owners visit my office with a question about a former employee who was violating the terms of a non-compete. Part of the paperwork they brought with them to the meeting showed their annual revenues. I asked why, based on their revenues, they had made the entity choice that they had. They told me a friend had the same entity for their business so that is what they chose. I informed them that based on the type of business they had, the number of employees and their earnings, that they would have saved over $30,000.00 in various taxes had they been a different type of entity. The color drained from their faces as they told me they had made even more money the previous year. I asked them if the lawyer that had done their incorporation work had bothered to ask them what they intended to do with the business before doing the paperwork. They told me that he did not. Now, you have to understand that this firm was one of the largest and most respected law firms in our area. Because the lawyer did not bother to ask, and because they did not bother to ask the lawyer before engaging him, they paid dearly. You will not make that mistake.
There are three primary considerations when deciding what form of business to choose:
1) The liability shield. Does the choice of business structure offer a liability shield and, if so, how does it work and how much protection does it provide to business owners;
2) Tax efficiency/tax considerations. What is the tax treatment of the business choice? What are the various pros and cons to the tax treatment of the business choice and how can we maximize the tax savings for the business owner(s) while minimizing the tax burdens;
3) Operating efficiency. Operating efficiency refers to: a) the stability of the business; b) the flexibility of the business; and c) the administrative costs of the business. When describing the stability of a business entity, professionals are asking whether the business dies with the departure of an owner (some do) or does the business continue. Flexibility refers to the flexibility the business owner has in the structure and day-to-day operations of the business. Administrative costs refers to the legal fees, accounting fees, filing fees and other associated expenses that the business owner incurs to set up the business and to meet ongoing compliance costs. As we move forward, each of the various business choices will be examined against these criteria.