/ Forming an Entity: A Cautionary Tale /

Forming an Entity: A Cautionary Tale

08.18.2015


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Scenario: Frank makes and sells his own BBQ sauce and operates as a sole proprietorship. Despite the nagging of his lawyer, he never filed an entity for his company. While driving his delivery truck, he hits a biker on the street and is sued. Nobody is perfect (and Frank DEFINITELY isn’t). To what extent are Frank’s assets at risk to satisfy the claim?

Because Frank currently operates as a sole proprietorship, all of his assets are at risk – whether business or personal. What’s worse, he may have otherwise had more money to cover the suit, but when he went to the bank a few months ago, he wasn’t able to acquire a loan for the business because he was operating as a sole proprietorship. Not having an entity also made fundraising difficult. Even if Frank had been driving his company’s truck in our scenario, as a sole proprietor, a claimant would be able to look to even his sweet ‘92 Impala at home (which he kept from high school to keep him humble when he became a BBQ mogul) to satisfy any damages. How might this situation be different for Frank if he’d listened to his attorney and filed an entity for the business?

Let’s say that Frank filed an LLC for the business. Frank’s personal assets would be protected, which means that in a suit against the company, that sweet Impala stays put. Also, in operating as an LLC, Frank was able to elect to be taxed as a sole proprietor with pass-through taxation. This means that the company’s profits avoid double taxation, which occurs when profits are taxed on the company and personal level. Instead, the profits “pass through” the company and are not taxed at the company level, but rather at the personal level on an individual’s tax filings. Pass-through taxation is a real benefit, especially considering that the cost of setting up an LLC is comparable to other entities.

If Frank operated as a corporation, then his personal assets would be protected, too. In the case of a C-corp, while personal assets are protected, profits are double-taxed – both at the company level and at the personal level. In contrast, an S-corp benefits from both limited liability as well as flow-through taxation. They are similar to LLCs in this respect, but in general, the formation of a corporation is somewhat more involved than operating as an LLC, and depending on whether Frank formed an S-corp or a C-corp, there are certain more cumbersome governance rules and regulations regarding shareholders.

The bottom line, though, is that Frank screwed up by not listening to his attorney. Frank should have filed an entity for his business. Now he is paying the price. Don’t be a Frank. We would love the chance to discuss how we could help you figure out what entity option would best work for you.