Entrepreneurs create formal business entities (most often limited liability companies and corporations) for many reasons. Founders commonly cite the limited liability protection and the professional impression it can have on vendors, customers and would-be investors. While these are two major benefits of forming an LLC or corporation, this only touches on the predominant purpose that forming an entity can serve - building and protecting value.
Centralized Management. An individual who begins a business is, by default, operating under a sole proprietorship structure. When more than one individuals form a business, the default is a general partnership. The former often becomes the latter as the business gains momentum and brings in additional partners. These are legal designations with real consequences.
For example, any partner in a general partnership can legally bind the partnership to a contract. As there is no limited liability protection in a general partnership, all other partners are personally liable for performance under an agreement signed by any partner. It only takes a single bad contract to doom a budding business.
Forming a manager managed LLC or a corporation allows for particular individuals to be designated as the only persons able to generally bind the company. Further, designating officers can allow for delegation of specific company powers. This is an incredibly important implication—a properly formed business entity may protect the business from secondary participants overreaching their intended authority.
Transferable Ownership. A sole proprietorship leaves no room for additional ownership in the business and, of course, if a sole proprietor leaves the business, it ceases to exist. Ownership in a general partnership is not easily transferable; although, a profit interest in the partnership can generally be assigned. Only if all existing partners allow a new partner into the partnership can the new partner participate as an owner; even then, the exiting owner may face continuing personal liability on the existing obligations of partnership.
Ownership is much more easily transferable in LLCs and corporations. This is referred to as equity interests, and it is key when the funding for the business is going to come from outside investors. Equity also allows for more complex structuring in the ownership and for using business combinations where it provides a benefit. Another major advantage of having equity interests is that it allows the business to be sold as a whole business, rather than piecing out the assets. Businesses often develop good-will value over time that is most easily captured when the business as a whole can be transferred. Finally, easily transferable ownership in combination with succession planning can allow the business to be transferred to children.
Continuity. Unlike sole proprietorships and general partnerships, LLCs and corporations are generally set up to have perpetual existence. This means that the exiting or death of an owner does not end the business; it is a distinct and separate legal entity. This trait of formal business entities eliminates the very real risk of an abrupt and unexpected ending that sole proprietorships and general partnerships may face. This is a risk that can be a concern to investors and business affiliates alike, hindering a business’s ability to grow.
Taxes. Various methods and strategies exist that may save an LLC or corporation owner money on taxes, ranging from tax deductions and making “83(b) elections” on early issued equity, to implementing the best mix of salary and dividends in a “C” corporation.
Of course, once the business entity is formed it has to be maintained. States impose different filing requirements on businesses, which overlooking or disregarding could result in administrative dissolution. On a more nuanced level, failure to treat the business entity as a separate legal operation can lead to “piercing the corporate veil,” where a court will disregard the limited liability protections normally afforded and a business owner’s personal assets may be put at risk.
Gutwein Law can help you choose the type of entity that best fits your business and goals, form that entity, and take the necessary post-formation steps to insure you are realizing the full potential of your business.
About the Author - Brian Casserly
Brian Casserly is an attorney at Gutwein Law. He received his MBA from Ball State University and graduated from IU McKinney School of Law in 2013. He focuses primarily on business law, non-profit organizations and real estate transactions.