The Importance of an Entity for Your Business

This is the first of a three-part series discussing legal steps an entrepreneur, business owner or professional should take when starting and growing a business.

Many people believe that entrepreneurs are turning this economy around. We work with entrepreneurs, business owners and professionals on a daily basis. Many of them are glass-half-full kind of people. That being said, too many bright, enterprising individuals do not fully recognize the impact a lawsuit can have on their business and their family. It is vital for people starting and growing their business to do everything they can to protect themselves and their family in the event they are sued on a claim relating to their business.

So, it all starts with an idea. You wake up in the middle of the night and run to your computer. You type the name into a box on the computer, and find the domain is available! After you have put together a business plan, the next step is to form a business entity. Now, some people, including many accountants, will tell you to wait to “see how things go.” Or, they may say you are “too small” to need a corporation or LLC. Having seen what can happen in a courtroom, we believe the entity should be formed from the start, or as soon thereafter as possible.

If you don’t form a business entity, you are a sole proprietor. A sole proprietor has unlimited personal liability for the debts and obligations of the business. Similarly, if you and a partner go into business, and you do not form an entity, you are deemed to be a general partnership. Each partner has unlimited personal liability for the debts and obligation of the business. In other words, nothing stands between you and the person suing you in the event of lawsuit.

A business entity, such as a corporation or LLC, provides personal liability protection because it has its own legal identity separate and apart from its officers, directors, shareholders, managers or members – even if the entity consists of only one person. If you are sued based upon an occurrence arising during your business operations, a properly formed and maintained business entity can limit exposure to a judgment solely to the assets of the business, and not your family.
If at all possible, it is best to form the business entity from the start – before you sign a lease, contract, franchise agreement or otherwise start to do business. Once the entity is properly formed, every agreement must be signed in the name of your business entity and you should never write a check, or make a charge on the corporate credit card, that you cannot justify as a business expense with your tax advisor. Forming a business entity before you start conducting business can not only provide personal liability protection from the start, but can also allow your entity to develop corporate credit, which can allow for more financing options as the business grows. Many people do business under a fictitious business name known as a “DBA,” which stands for “Doing Business As.” A DBA is not a business entity, and provides absolutely no personal liability protection.
For virtually all of our small business clients, the choice of business entity is usually either an “S” corporation or an LLC. Both the “C” and the “S” corporations require corporate formalities, such as annual meetings and the keeping of minutes, to be maintained. S-Corporations have many limitations in structure, such as limits on the number of shareholders. We often recommend forming an LLC because the corporate formalities are significantly reduced.

One of the key differences between a corporation and an LLC are the formalities involved with forming and maintaining each entity. In a lawsuit, a failure on the part of the owners to respect the separateness of the corporate entity from themselves can result in the entity being disregarded, and the personal assets of the individual owner(s) exposed to satisfy claims against the business. We have often found that corporations formed using off-the-shelf or online “self-service” document companies are wholly insufficient to provide the intended protection in a courtroom, either because they were not formed correctly or because they have not been maintained by the principals.

If properly formed, an LLC does not need to maintain corporate formalities, such as holding meetings and keeping minutes, and provides more flexibility in many other respects, including capital contributions based upon services or “sweat equity,” rather than cash. Moreover, an LLC can provide greater personal liability protection where there are two or more business owners.

It is important to note that in California an LLC may not render professional services. Some professions are required to be professional corporations in which limitations are placed on who can be an officer, director, or shareholder, and certain requirements of the governing agencies must also be met. That being said, professionals are business owners, and like any business owner, should not rely on insurance as their only defense against lawsuits arising from their business.

It is advisable to consult with a business lawyer and your tax advisor before forming the business entity. Too often we hear that the formation of a business entity is a “simple” matter. While the actual filing of Articles may be simple, legal advice pertaining to your particular business and its legal needs is not so simple. Spending the time and money to set up and understand your business from the beginning, can save you significant money down the road.

This is the first part of a three-part series discussing legal steps an entrepreneur, business owner or professional should take when starting and growing a business. Next we will discuss trademarks and copyrights to protect your investments.