Do I need a separate business entity? If so, what kind?

By Michael Taylor

A few weeks ago I got together with a friend I grew up with because he was looking for advice on creating a business entity. He wanted to know if he should create a corporation, a partnership, an LLC (limited liability company), or remain a DBA, “Doing Business As.”

Since I’ll use his business as an example for the discussion, and I like his product, and he’s a friend, I’ll give him a free plug: He sells V-Neck sweat-wicking t-shirts over the internet. The product is called Vdri, and the shirts are meant for wearing under a collared shirt, or while exercising or sleeping. I’ve been wearing my Vdri shirt happily for the last few weeks. Anyway, back to the business discussion.

In exchange for my t shirt I gave him what I think is thousands of dollars worth of legal and accounting advice in 30 minutes, and I’ll pass it along to BizBox audience as well. (Feel free to send me free samples of your business wares too!)

The decision to move from a DBA to forming a business entity comes down to
1. Do you need business and financial liability protection?
2. Is your business complicated enough to need its own bank account and credit card?
3. How do you want to be taxed?
4. What kind of employee and ownership structure do you have?

Let’s take it one at a time.....

Business and Financial Liability
What if the sweat-wicking shirt catches fire at your alumni bonfire and somebody decides to sue you and your company? I know its crazy, but it’s a litigious world out there. You definitely do not want a former customer and his lawyer to seize all of your personal assets as they seek redress over accidentally singed fibers. A separate business entity provides a layer of protection against that.

In addition, a business entity may provide financial liability protection, limiting your losses to the business rather than your personal assets.

Bank Account and Credit Card
In my experience, banks will not open business checking accounts in your company’s name without a proof of entity formation from your Secretary of State and a separate federal tax identification number, or EIN (employee identification number).

Credit card companies can be more lenient and may allow you to get a credit card as a DBA. Vdri in fact already had a credit card, but my friend has been selling enough shirts that it’s become time to open up a bank account solely for the business

Keeping business and personal financial records pretty much requires separate bank and credit cards accounts, so you’re going to need to form some kind of entity once you move beyond the simplest start-up.

How would you like to be taxed?
You’re not allowed to say “No Thanks!” to that question, even if you want to.

Here’s the basic choice: An LLC or limited partnership is not taxed on its own, but rather, passes through any tax liability to its partners or, in the case of an LLC, its members. So if Vdri becomes an LLC and racks up profitable tshirt sales, my friend will end up owing additional taxes on his personal tax return.

A corporation, in contrast, must pay taxes on profits generated by the company in any year, at the corporate tax rate. My friend would personally owe taxes only on dividends he received from the corporation, or on any salary he takes from Vdri. Profits on tshirt sales would be taxed once at the corporate level, and then again at the personal level in the form of dividends, a phenomenon known as ‘double taxation.’

Generally speaking, corporations are considered “tax-appropriate” if the business is capital intensive and needs to reinvest profits in any given year in order to grow. An LLC or partnership probably works best if profits do not need to be reinvested.

Since Vdri does not run a manufacturing plant (it subcontracts that kind of work) I think the pass-through taxation of an LLC or partnership is preferred.

(Incidentally I’m only speaking of C-corporations, not S-corporations, which may have ‘pass-through’ taxation similar to an LLC.)

Employee and Ownership Structure
Here’s where LLCs have great advantages over corporations for small businesses and entrepreneurs, and why I recommended an LLC to my friend for Vdri.

Corporations typically must officially maintain a great number of corporate positions such as president, secretary, and treasurer. Corporations must maintain records of meetings held. Perhaps most onerously, corporations must distribute profits strictly according to proportionate ownership. While this may make sense at first glance, in fact many companies have good reasons for making distributions of profit disproportionate to ownership.

LLCs by contrast may make distributions according to any plan lawfully decided upon by its voting members. I mentioned to my friend that Vdri, if it were an LLC, could decide that whoever wears the funniest hat at the annual Holiday party would reap all of the years’ profits.

Rewarding employees and negotiating with outside investors – key challenges for many small business owners – is helped greatly by the LLC structure. A corporation simply does not have that flexibility, but must distribute to owners according to strict ownership percentages.

I’m pretty sure Vdri will go the LLC route, as do many entrepreneurs these days, given its flexibility as a business structure.

Comments (0)

April 29, 2008 10:02 AM