By: Gina Bongiovi, special to bizNEVADA
To Incorporate or Not to Incorporate?
Let’s begin with discussing whether it makes sense to form an entity at all. If you print business cards and attend networking events, you are automatically acting as a sole proprietor. (You still need proper business licensing, but that’s a topic for another article.) Operating a sole proprietorship means there is no distinction between you and your business and that you would be personally on the hook for any liability arising out of your actions as a business owner. Translated: you sign a contract for services and fail to pay; the party expecting the money can come after you personally.
Similarly, if you and another person come up with a business name, print business cards, and begin doing business, you have automatically formed a general partnership. This is an even riskier proposition because not only can each of you be held personally liable for any issues that arise with the business, but any partner can bind the “company” (the other partners) without first getting permission.
Forming an entity separates your personal assets from your business assets so that a lawsuit against the business doesn’t put the business owner’s personal assets at risk. The concept of the “corporate veil” describes this separation – it’s as if a veil shrouds the personal assets from liability stemming from business activities. The strength of the corporate veil depends on whether and how the business owner has managed the business. More on that later.
Historically, to avoid personal liability, one would have to form either a corporation or a limited partnership. A corporation would provide limited liability for the individual shareholders, but could not be taxed as a partnership, which was desirable for many companies. A limited partnership, with that partnership tax treatment, offered limited liability to those named as limited partners, but not to the required general partner who had unlimited liability. The limited liability company was created to offer the best of both worlds – limited liability for all owners found in a corporation, but with partnership tax treatment previously found only in a limited partnership. By 1996, all 50 states recognized the LLC structure, and it remains a popular option today.
Which is Better – LLC or Corporation?
Contrary to popular belief, a corporation and an LLC provide the same level of limited liability protection for the business owners. The statutes, NRS 78 and 86, explicitly state that the individual officers of a corporation or members of an LLC are not personally liable for the debts or obligations of the business, providing the entities are managed properly.
Whether you should form an LLC or a corporation depends largely on the type of business involved, how it will be funded, the growth strategy, how it will be managed, and the ultimate exit strategy. As you may be thinking, these questions indeed should be answered at a stage of the business during which you have the least amount of information. That’s why it’s so important to put a business plan together prior to making any of these decisions. Incidentally, the value of a business plan is not in the resulting document; it’s in the journey of researching and learning about the market and your business model’s probability of success.
Keep in mind your company exists in two different worlds – the legal world and the tax world. Legally, you can operate as a sole proprietor, a partnership, a corporation, or an LLC. There are other types of entities like LLPs and LLLPs, but we’ll focus on the most popular options – corporations and LLCs – for now. As discussed, a corporation and an LLC both provide limited liability protection, but the final decision may be based on tax considerations. While a corporation can only be treated as an S-corporation or a C-corporation, an LLC has those choices, plus that of a disregarded entity if it has one owner or if the only two owners are married, or as a partnership, which achieves the goal that originally brought LLCs into existence – partnership tax treatment plus limited liability for the owners.
We find ourselves defaulting to the LLC structure unless a corporation makes more strategic sense or is required based on ownership or other factors. A corporation may be more appropriate for high-growth companies planning to seek sophisticated funding (such as tech startups), those interested in attracting international investors whose countries of domicile may not provide benefits to LLC ownership (looking at you, Canada), or those who want to offer preferred and common stock.
LLCs may be preferable for any of the following reasons:
* LLCs tend to be lower maintenance, as they don’t typically require bylaws, a board of directors, or advance written notice of company meetings (though we do encourage LLC members to hold at least annual meetings);
* Corporations cost more to maintain in Nevada since the associated state business license fee increased by $300;
* LLCs have more tax flexibility;
* LLCs can be taxed as disregarded entities.
Clearing Up Confusion – S Corp or LLC?
When someone wants to “form an S corp,” we must clarify the type of entity because, as discussed above, either an LLC or a corporation can be treated as an S corp for tax purposes. Similarly, we often encounter advisors who will talk about “an LLC or an S corp” as if they are two distinct choices, which can be confusing for the same reason – an LLC can be taxed as an S corp. Often, when an advisor discusses an LLC and an S corp as if they are completely separate, the “LLC” refers to the default tax treatment – a disregarded entity if a sole owner or married couple, or a partnership if two or more unmarried people are involved. If you encounter this confusion, don’t be afraid to ask for clarification.
S Corp or C Corp?
The S corp tax treatment is a “flow-through” or “pass-through” structure, which means that the business profits and losses will “flow” or “pass” through the corporate tax return and show up on the individual owners’ personal tax returns. This means the entity itself is not taxed on the profits and losses; the individual owners will pay taxes on those amounts through their personal tax returns.
The C corp tax treatment is usually disfavored because, unlike the S corp, the profits of the corporation are taxed twice – once at the corporate level and again at the individual shareholder level when those same profits become dividends.
The new tax laws have created rumblings that the C corp structure is now more favorable than the popular LLC-taxed-as-S-corp approach. We haven’t found that to be the case, but it’s always best to enlist the help of both a lawyer and a CPA to discuss the pros and cons of each in light of your business plan.
Maintaining Your Corporate Veil
I mentioned earlier that corporations have more stringent requirements than LLCs when it comes to maintaining corporate records. That doesn’t mean LLCs don’t have any requirements. Regardless of the type of entity you form, it’s crucial to keep that corporate veil in place by not allowing anything to pierce it. A common approach to piercing the corporate veil is to argue that the entity is just an “alter ego” of the individual business owners who are using the entity to shelter assets, avoid taxes, or otherwise abuse the protections of the corporate veil. Evidence of this can include personal expenses being paid from the business account, under-capitalization, personal use of business assets, and failure to observe corporate formalities.
Anytime you take an action that might blur the line between your business and personal assets, be sure to ratify that action with a corporate resolution. Your CPA might ask for this too. For example, if you are going to pay an otherwise personal expense, like a cell phone bill, out of the business account, make sure that the owner(s) have signed a resolution approving this expense so that it becomes a legitimate business expense. Don’t get carried away with this, however. While a cell phone’s function in business can easily be justified, a vacation to Tahiti might not. Date, sign and file these resolutions in your corporate book. You know, that three-ring binder you probably received when you formed your entity? The one collecting dust on the shelf that likely contains only the tabs? Yeah, that one.
Similarly, be aware that any personal guaranty will act like Edward Scissorhands to your corporate veil. It is a contractual provision, or maybe a completely separate contract, that sets aside the corporate protection as to the obligation it refers to, and holds the individual guarantors (often the business owners) personally liable. You almost can’t rent commercial space, borrow money from a bank, or get a credit card without signing a personal guaranty. While they eliminate the veil as to that obligation only, it’s worth mentioning because we meet with too many people who signed them without understanding the consequences.
We haven’t even explored the importance of business licensing, owners’ agreements, or managing the business to achieve your ultimate exit strategy. From the moment a business idea pops into your head to the day you sell, you’ll make thousands of decisions, large and small. Surround yourself with a team so you can leave the technical legal, tax, financial, insurance, and banking matters to those who deal with them every day and focus your energy and expertise on running the company.
Gina Bongiovi is the managing partner of Bongiovi Law Firm and dedicates her practice to serving small businesses. A Las Vegas native Bongiovi graduated magna cum laude from the UNLV Honors College with a B.S.B.A. in marketing and minor in business law in 2001. In 2007, she was one of the first students to earn a dual law degree/MBA from the William S. Boyd School of Law and College of Business at UNLV. https://bongiovilaw.com/