Is there a right time to convert a sole proprietorship into an entity such as corporation or a Limited Liability Company (LLC)? What is the difference between a partnership and a corporation/LLC? How do I decide ownership interests in a corporation or LLC? The answers to these questions are important and require careful thought.
At any stage of your business, a business entity affords greater protection from personal liability than does a sole proprietorship. Anytime you operate as a sole prop (regardless of revenue or type of business), your personal assets are exposed to the liability of the business. Should you have a judgment against your business, your personal assets are subject to that judgment. Additionally, as a sole prop you would be named individually in a lawsuit. This could affect your ability to obtain a line of credit or refinance your home even if the lawsuit has no merit. By contrast, in most cases as an owner of a corporation or LLC you would not be personally named as a defendant; the corporation is usually the main or sole defendant.Of course, some businesses may not have very high risk factors that require the heightened protection offered by the entity. Other businesses may not earn enough money to truly merit the extra costs of forming the entity (the minimum annual franchise tax for a corporation or LLC is $800). Even with these factors in mind, the basic premise holds true: you are far better protected with a corporation or an LLC than with a sole proprietorship.
Keep in mind, too, that there are often tax benefits to forming the right type of entity. One additional thought to bear in mind is to always consider the benefits of insurance for your business, whether as a sole proprietorship or legal entity.
From a legal standpoint (tax issues aside), a general partnership is similar to a sole proprietorship; there is no legal distinction between you as a general partner and you as an individual. As discussed above, you as the individual share the same legal burden as the business. In contrast, the corporation or LLC is a separate legal entity and, when maintained properly, shield its owners from the liability that the entity incurs. In most cases, as a corporate shareholder (or LLC member), you can only be held liable for the amount that you have invested, while as a partner you may be held liable for any and all of the partnership's obligations.
One issue faced by businesses with multiple owners is how to divide that ownership, and who will have management control of the business. A quick look at the pyramid control of a corporation is as follows: the shareholders, who own the business, appoint the directors of the corporation. The directors then appoint the officers, who are generally tasked with the day to day management of the business. A shareholder may be (and often is) a director and an officer. An individual may earn his or her shares either through monetary capital infusion into the entity, or by offering his or her expertise to launch or operate the business.
It is generally up to the incorporating parties to determine who will get what, but a few general principals to keep in mind are: (1) will there be a majority shareholder, or will there be a possibility of a stalemate in decision-making in the entity; (2) similarly, will you have an odd number of directors to avoid ties in decision-making, and (3) in an S corporation or LLC, the percentage of ownership will have a direct impact on each owner’s tax return.
There are on-line services available for the experienced business person. However, there are many issues involved in forming a company and it is best to seek both legal and financial advice from a professional who can ask the right questions to help you get started.
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About the author
After earning his law degree and passing the California State Bar in 1994, Mr. Stavropoulos began practicing law in a small law firm in Pasadena, California where he was involved in business litigation and real property matters. In February 2000, he started his own law practice. He continues to emphasize his practice in the representation of individuals and small and medium businesses, counseling clients in business transactional matters ranging from entity formation, employer/employee relations, contract draft and review, as well as litigation stemming from such issues. Contact him at www.petestavlaw.com. Read his blog at www.rosecitybusiness.com
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