Anytime you form a separate legal entity for a business or to protect safe assets, it is very important to complete the entity structuring fundamentals.
When an entity is formed you should be very clear on the structure that is best to support your goals, both short- and long-term. For example, a C corporation may have lower tax brackets than you or I do personally AND you may pay fewer taxes in year one, but it may be the WRONG structure for your results in year 2, 3, 4 and so forth. If you are not looking to retain earnings in the company and grow and expand with infrastructure and overhead, it may likely be the wrong entity for your business.
If you are forming an LLC, you should know how the LLC is taxed and if it is managed by managers or by members. There is a big difference, especially with how the LLC is taxed. In order to select the best entity, keep in mind that you must approach it from two main points of view: what is the best entity from a tax point of view and what is the best one from a legal point of view.
After you are clear on your goals both short- and long-term, it is time to form the entity. You want to be clear on who is the initial director if a corporation or manager/member, if an LLC. After formation of the articles of organization or articles of incorporation (for a corporation), your next step is to open a bank account and capitalize the new entity. This seems simple, but there are so many people that open an LLC bank account with a check with revenue and never properly have the owners capitalize, put money into the account, in exchange of ownership in the company. If you are the owner of the entity, you should be the one putting money (or service or equipment) into the company in exchange for ownership interest. If you have another entity that is the owner, that entity would put money into the operating company in exchange for an ownership interest. If you have a partner and you are not each going to put in capital to match your ownership percentage and one is going to contribute services, that may be a taxable event (check with your CPA). In other words, if you get a 50% ownership in a business with no money in exchange for your labor (sweat equity) and your partner puts in $50K for their 50% ownership, the IRS looks at this as if you obtained $50K in value and would owe taxes on the $50K. In that situation, are you able to say of the $50K, $45K was a loan and therefore if your partner put in $5K also, then there is no tax issue. That is correct, but now you have a totally new situation where the business will need to pay back the $45K loan out of profits before either partner is paid any profits.
Next you have to make sure that if you were operating as a sole proprietorship before or a general partnership now, that when you form the entity you actually make a complete transition to that new entity. Over the years I have seen too many people that are still operating as a sole proprietorship, even though they have formed an LLC. How is this possible? Several mistakes are when you don’t open a new bank account in the name of the LLC or corporation and keep operating under the bank account in your name as a sole proprietorship. The other big issue is if you have a DBA or fictitious firm name linked to you personally and you form the separate legal entity and forget to reconnect the DBA name to the NEW entity – that is a big mistake.
Corporate and LLC formalities are a must. A corporation and an LLC are separate legal entities from you and I personally. They can do everything you can do except act and think. They do that through minutes, meetings and resolutions. This is the documentation for major decisions made by an entity such as adding a shareholder, changing the officers or managers, leasing real estate…Some falsely believe that LLCs are “easier” because they do NOT require the same formalities as corporations. When we did our research years ago with looking at what judges actually do, we found they expect to see the same corporate formalities that apply to corporations. That means an LLC will need an operating agreement, minutes, meetings and resolutions for major decisions, membership certificates and a membership ledger to track the owners. This is all part of protecting both the LLC and corporate veil. If someone is going to sue your entity and you do not operate it as such a legal entity, then you MAY be personally liable.
The final big step to make sure your entity is structured properly is to make sure your taxes are being paid properly. That starts with knowing how your entity is taxed and the responsibilities with that. If the entity is an LLC taxed as an S corporation, at some point in the year you will probably have some type of payroll required, even if just to pay yourself. If you have an LLC taxed as a partnership you will realize if you are one of the members of the LLC, you will not be paid a salary. You may be paid what is called a “guaranteed payment,” which is similar to, but not a W-2. It is very important to make sure that you work with a good tax team to keep you on track with your business entity.