Think Twice Before Starting an LLC: 3 Considerations Before Finalizing An Entity
Forming a business entity can safeguard your assets and get you started on the path to entrepreneurship. With that said, it is not as easy as 1, 2, 3, LLC! Given the ease of creation, business owners tend to default to selecting an LLC for their business.
But there are several different business entity structures to consider. Depending on the size of your company, revenue goals, tax considerations, legal protections, and more, you may be surprised by the structure that best suits your needs—and it might not be an LLC.
Know All Your Options
So, what options do you have for building a business entity? Let’s take a look at some of the most common options:
- LLC (Limited Liability Company)
- The Basics: A business entity that is separate from its owners. LLCs are governed by state law and are designed to give business owners additional liability protections that are not otherwise available.
- Pros: Simple formation, flexible ownership, additional tax options, and limited personal liability from business transactions.
- Cons: Potentially higher annual fees, rules fluctuate between states, some sophistication is necessary- think operating agreements.
- Sole Proprietorship
- The Basics: A single-member business that is never incorporated with a state filing.
- Pros: Extremely simple formation, easy record keeping, low cost, and no corporate business taxes.
- Cons: Unlimited personal liability, limited outside investment opportunities, and generally higher individual taxes.
- The Basics: A formal arrangement between two or more parties to manage and operate a business.
- Pros: Simple formation, extra knowledge and experience via other partners, and shared costs.
- Cons: Unlimited personal liability, tax complexity, potential legal disputes among partners, and potential misalignment of work/effort between partners.
- The Basics: A business entity created and incorporated by individuals (known as shareholders) that are separate from its owners.
- Pros: Limited personal liability, access to outside investors, and business security/longevity.
- Cons: Difficult formation, rigid requirements, double taxation, and expensive.
Consider Each Business Entity’s Tax Implications
As you can see, business taxes take on different flavors. Sole proprietorships, partnerships, and most LLCs are taxed differently than corporations. Creating a strong tax plan from the beginning can get you started on the right foot.
While tax implications shouldn’t be the only factor you use when selecting an entity, it’s good to compare and contrast these tax requirements as part of your overall decision. Think through these common scenarios:
- Is your intent to work alone and have simple operations ~ Sole Proprietorship
- Do you desire long-term tax/entity flexibility and simple operations ~ LLC.
- If there are multiple owners and you want long-term tax and ownership flexibility ~ Partnership.
- If you dream of creating a large company, are comfortable with complexity and see a need for large cash infusions in the future ~ Corporation.
There are countless considerations when it comes to the taxation of legal entities. Ultimately, it comes down to taking a deep dive into your unique business and deciding which structure is best to get started in the short term and flexible enough to grow with you in the long term.
What Legal Protections Do You (And Your Business) Need And Want?
As we reviewed earlier, business entities provide certain levels of legal protection. The amount of legal protection you need and/or desire will help you decide on your entity choice.
Regardless of the entity’s choice, it’s essential to keep your operations organized if you want to achieve legal protection. That means titling assets correctly, separating business from personal expenses, and keeping up with the compliance activities that your chosen entity requires. In other words, run your business like a business.
A few considerations regarding legal protection:
- When set up properly, LLCs shield the personal assets of members from business creditors. They can offer more protections than a partnership if run correctly.
- Corporations offer the most protection, but they are also the most complex and cumbersome to manage.
- If you think you will keep your business small, you may not need a ton of protection and could benefit from the simplicity that a Sole Proprietorship offers.
- In addition to limiting your liability via your business entity selection, a solid business insurance policy can help protect your assets.
The Boat Slip Inside of an LLC — A Case Study
Discussing business entity pros and cons, tax implications, and legal protections can be extremely confusing. To bring things to life a bit, I wanted to share a personal story to illustrate the impact of business entity selection.
Three like-minded neighbors and I got together and formed an LLC to purchase a pier with some boat slips in Grand Isle. Logistically, we needed to buy a lot first, then fund the LLC for future maintenance and updates to the pier. These costs were manageable with four investors.
As time went on, complexity arose when members of the LLC began moving and trying to sell their piece of the property. Instead of selling ¼ of the pier, you have to sell ¼ of the LLC interest. What a headache! The paperwork became a complete nightmare.
When we finally found someone willing to buy the pier, the bank refused the loan, given the buyer was purchasing an LLC interest and not the property itself. To top it off, we couldn’t find our newest operating agreement. That started our search for a previous owner to sign off on the new operating agreement. Long story short, I am still a member of an LLC with ownership in a pier across the street from the summer home I sold in 2019.
In hindsight, forming an LLC with four people to buy a pier added complexity and resulted in a lot of confusion and wasted time and money. We chose the LLC option based on how easy it was to set up, but private ownership combined with insurance protection may have been a smarter way to go.
An LLC Isn’t For Everyone
As you can see, forming an LLC is not always the best decision. While many business owners default into LLC formation, it can have long-term consequences.
When choosing a business entity structure, be sure to thoroughly explore and understand all of your options, build a strong tax plan from the start, and arm yourself with the proper legal protections. You want your business to run smoothly and efficiently for years to come. The right business entity can help you make progress toward that goal.
Given the long-term impact of business entity selection, it’s best to consult with a professional. Our team at Bienvenue Wealth will help you consider all your options to make an informed decision about your choice. Schedule an intro call today!