Having a legal business formation does two main things for you.
- Provides protection for your personal stuff if the business gets sued (aka: Limited Liability)
- Enables alternate tax structures which may save you money on taxes
I am not a Lawyer, so this is just a summary and is not considered legal advice. Make sure you do additional research as you go down this road. This article is just a quick look into what you need to consider.
Definitions: Limited Liability
Limited Liability is lawyer speak. It means that a persons financial liability is limited to the value of a person’s investment in a company or partnership. If a company is sued, then the company is financially liable, not it’s owners or investors. (more from Wikipedia)
Avoid Losing Your House – Form a Legal Business Entity
One of the main risks of being a business owner is the liability you may have for accidents that occur while doing business, or for debts that the business takes on (as long as they are not personally guaranteed). If you have an employee who screws up and burns down a million dollar house, your business is liable for rebuilding the house. If you only have half a million in liability insurance then the remaining half million has to come from somewhere. In this case, if the business does not have $500k sitting around, you will likely have to give up all the assets of the business and close down. BUT, if you don’t have a legal company who is doing the business, you as the owner will be personally liable for paying back the remaining cost of rebuilding by selling your house or your retirement savings.
Piercing the Corporate Veil
Even if you have a legal entity, there are a few situations where business owners can still be liable for business mistakes. A few examples of things which could cost you are mixing of personal and business finances, fraud, failure to keep documentation current with the state, failure to pay taxes, or signing personal guarantees for business loans. Each state has a different set of precedence for when this may occur, so be sure to discuss with your Lawyer and Accountant what your specific risks are in the state you decide to incorporate in.
Choose a Legal Entity Type
Each legal Entity Type has slightly different ways to be treated for liability and taxation. Some states have variations on these general themes. You register for a legal entity with the State you choose. You are able to change the type of legal entity that you have if you must, but each state has different procedures for how to do this. For this reason, often times it is easiest to start with an LLC and then change to S-Corp elections or a Corporation when appropriate.
No Liability Protection, Taxes paid on personal tax returns. This is the default legal entity if you conduct business without filing any paperwork. There is zero protection from personal liability. This is bad.
No Liability Protection, Taxes paid on personal tax returns. This is the default legal entity if you conduct business with a business partner without filing any paperwork. Your business partner can sign on your behalf without recourse, you could be held responsible for your business partners personal financial issues. This is the absolute worst. Don’t do this.
Limited Liability Company
Liability protection in place, taxes are considered “pass-through” to your personal tax returns. Can be Single Member LLC or Multiple Member LLC. Profits are disbursed however the owners choose. You can elect to be taxed as an “S-corporation” which means you will be taxed as a corporation. Bylaws are the guiding framework for how the business is organized. This is the most flexible and easy to use.
Limited Liability Partnership
Liability protection in place for the limited partners, but not the managing partner, Taxes are considered “pass-through” to your personal returns. This is not very common and is used in specific investing situations. Your Lawyer would be the best person to advise you on when this is appropriate and how to ensure protection stays in place.
Liability protection in place, taxes based on corporate tax rates to be paid before disbursement of profits to shareholders. This is the most formalized and standardized structure. Profits are disbursed based on ownership and type of shares as a dividend. On your personal tax returns, any dividends are taxed as passive income, which varies by state. Advantages of a corporation structure is that you can disburse and sell shares of stock of your company to raise capital.
Social Justice Corporation
Taxation and limited liability just like a Corporation. The primary difference is that the purpose of the company is not profit, it’s a Social Justice cause that is stated at formation. This structure was created so that the board of directors has liability protection from shareholders for negating profits in order to serve a stated social justice cause. This is a fairly new entity type and there are not many examples of this at this time.
Liability protection for the board of directors, no owners, no taxes. The not-for-profit organization does not have any owners, and no profits are disbursed. For this reason there are no taxes paid because all of the money that goes into this corporation is to be used for it’s stated purpose.
Registering with the Federal Government
After you register your business entity with the state, you will need to get a federal Employer Identification Number (EIN). This will be used to file your federal taxes and several other business activities. It is free to do for yourself here.