Learning how to transition from one company to two effectively is key to help protecting your net worth.
When starting a business you formed a separate legal entity to separate your personal and business assets, lower your audit of risk, improve your chances for more business credit and convey a more important marketing message. As time goes on and your business succeeds you will want to examine when the time is right to form a separate legal entity to now reduce the liability exposure to your current business.
How to Transition from One to Two Entities and Stay on Track
You may have a successful online internet business and now you are going to introduce a new product to your list that may have more liability associated to it. An obvious one would be if you were looking to invest in real estate. That would definitely be in a separate legal entity from your operating business. Many times I talk to business owners who have been in business for 10, 15 or 20 years and still operating EVERYTHING through one legal entity! That can be very dangerous. That means one lawsuit where the insurance company comes up with an excuse (also known as loophole) where they do NOT have to provide coverage. That means potentially, 10, 15 or 20 years of hard work down the tubes!
Let’s assume you are going to add a second legal entity for part of your business to separate out liability (or maybe you have a different partner on that one). Let’s cover the steps to make this a smooth transition! The easiest way to look at this as if you are starting over with the same steps you used to form your first company. The mistakes come in when you are tempted to take short cuts to save money (like not getting separate business cards, a separate business license)
Here are the steps to transition from one company to two for each company:
Trademark your business name
Form a separate legal entity
Obtain a separate LLC/Corp record book.
Obtain a separate EIN number.
Open a new bank account for the new entity
Proper capitalization from the correct owners (you, another entity, trust…)
Apply for a business credit card in the name of the new LLC/Corp.
Separate the expenses related to this new entity.
Apply for a business license http://www.businesslicenses.com/
Check with a local professional for other requirements which may include, other state filing requirements with the department of taxation or franchise tax board.
Establish a DBA name to this separate legal entity is required.
Establish a separate set up books. If you are using QuickBooks® or Xero create a new company file for the new company.
Obtain separate insurance if required by the company
Establish a separate payroll account if payroll is required.
If the Entity is in Nevada, and you are operating in another state, take the steps to foreign register in that state you are doing business.
Establish a 5-year business plan (so the entity is not considered a hobby plus a good idea to keep you on track anyway).
Establish new accounts with vendors for the new business. Even if your first company does similar services, it should be separated.
Establish a separate merchant account and the new entity.
Follow LLC or corporate formalities.
Avoid commingling of funds.
The key is to be organized when you transition from one company to two. I know it would be easier to just keep things simple, but simple and asset protection are inversely related. Successful business people do not have all their business holdings in one LLC or corporation. The key is to separate your assets and diversify your risk, just like you would diversify your investments for success.
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.
Making sure your entity is in compliance is a very important step in the process to build and protect your wealth! Take the time to create an action step or two so you keep moving forward in your business and towards success!