Business Life Forms
In nature, all life can be reduced to two forms -- plant and animal. In the marketplace, all business owners can be reduced to two forms -- human and non-human.
Human owners include proprietorships, whether solely owned or a simple general partnership between two or more humans. Non-human owners are the legally structured ones, like corporations or limited liability companies (LLC). The distinction is important for two primary reasons: Legal issues, like contracts and lawsuits, and paying taxes.
Business Morphing
In nature, a plant can't change its DNA and turn into an animal. But in the marketplace, a sole proprietorship can morph into a corporation, separate from its human shareholders.
It's quite common for a business to begin life with human ownership, because it's a relatively simple and inexpensive process. But since the legal responsibility buck stops with the business owner, in proprietorships, the estates of the human owners can be at risk. Consequently, when a business should morph into a non-human form -- like a corporation -- is a critical question that should be asked and answered on a regular basis, as long as a business remains owned by humans.
Here are two basic advantages of morphing your sole proprietorship or partnership into a corporation or LLC:
1. You create a legal, tax paying, non-human entity, which can do business, enter into contracts, and be sold or passed on to the next generations.
2. This entity comes with what is called a "corporate veil."
This corporate veil thing is pretty handy. For example, if an employee of a business injures someone or damages something while on the job, any associated claim would typically be filed against the negligent employee and the business' legal ownership entity. If the business is incorporated, the corporation's assets may be at risk. If not, the personal assets of the human entity, the sole proprietors or partners, are at risk.
To Incorporate Or Not To Incorporate
Should you incorporate in the very beginning? Frankly, until you have contracts, employees, vehicles, equipment, etc., you might be able to spend that $500 to $1,000 incorporation expense on something more immediately critical, like a computer, software, or marketing.
However, one of the dangers in waiting is that you actually might forget to incorporate until it's too late. So how do you solve this problem? With incorporating triggers. Here are a few to consider, each followed by a threat example.
You should incorporate when:
1. You hire your first employee, especially if they work off your premises, like a delivery or an installation. Threat example: If your delivery person causes an accident in one of your vehicles, any claim for damages would be against that individual and his employer, which hopefully would be the corporation.
2. You enter into contracts on behalf of the business. Threat example: A customer feels that your company's performance has not met contract provisions and decides to take legal action. If your business is incorporated, any claim would typically be against that legal entity. This is one reason to always sign contracts entered into by your corporation with your corporate title following your signature.
3. You make purchases from vendors on an open account basis, which is to say they extend credit to your business. Threat example: If your company has difficulty paying vendors, as long as you have not endorsed a personal guaranty to a vendor, any action they might take to collect will be against your corporation, and not you personally.
Incorporation Dangers
There is some danger in being incorporated, and it has to do with how you do business and manage your corporation. Here are a few of the mistakes you can make after you incorporate:
- You don't tell anyone, like the people you do business with, that you are incorporated.
- You don't put "Corp", "Corporation", or "Inc.", WHEREVER your company name is shown.
- You don't have a checking account in the corporation's name.
- You don't maintain proper corporate documentation, like annual corporate minutes, documentation of shareholders and directors meetings, issuing shares of stock.
If you fail to maintain a corporate image, documentation, and financial records, you are at risk of having something happen called "piercing the corporate veil." This is when someone brings a claim against your company and they try to get to your personal assets.
Their attorneys will actually look into how you conduct your business. If they can demonstrate to the court that you're not operating as a real corporation, and therefore, not entitled to the liability protection afforded by the corporate veil, they may be able to have your corporation declared a sham, and get to you and your personal assets. This is not an easy thing to do, but it can be done if you help them.
Think of your corporate veil as you do your roof -- maintaining both will protect you from dangerous things that fall from the sky, like hail and attorneys.
The Big Three Non-Human Owners
When you decide to change from a human owner to a non-human owner, what form should you choose? There are three primary choices:
1. C Corporation. This is the basic corporate structure used by big companies and small.
2. S Corporation. This form begins as a C corp, and then morphs into an S corp. It provides the same liability protection of a C corp, but any profits are passed through to the shareholders as unearned income, to be taxed at the personal tax rate.
3. Limited Liability Company. This is a relatively new form of non-human business entity that fits some ownership scenarios. An LLC is not a corporation, but benefits from similar liability protection for the members, which are like corporation shareholders. Since LLCs can be treated differently in each state, check with advisors to see if this option might work for you.
Regardless of which form of ownership you choose, human or non-human, be sure to talk with your attorney and CPA about what's right for you.
Write this on a rock... If you aren't incorporated, make sure it's because you have intentionally chosen this ownership form for a specific reason. Be sure not to wait to incorporate until it's too late. And when you incorporate, run your business accordingly.
Jim Blasingame
Small Business Expert and host of The Small Business Advocate Show
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