A business entity is a separate legal structure under which a business operates which is distinct from the individual or individuals who own the business.
In the eyes of the law, a business entity exists in isolation from its owners. This offers its owners the ability to separate and protect their individual, personal assets and income from certain existing and potential liabilities associated with the business operation.
To more fully understand the nuances associated with each type of business entity, this post offers you additional information so you may carefully consider:
- personal liability protections offered by the formation of a business entity
- various types of business entities you have to choose from
- business owners’ titles and roles for each business entity
- types of liabilities which do not escape your personal responsibility when you own a business entity
- how to maintain a business entity in good standing in the eyes of the law.
Personal Liability Protection Definition
It is important to build strong fences around your personal assets and income which includes things such as your home, checking account and savings accounts, automobile, investment accounts, rental real estate and the income derived from assets, other investments and other businesses.
We will discuss six business entity types and describe the business owner’s personal protection from liability which ranges from none (in the case of the sole proprietorship and general partnerships) to the maximum liability protection possible (in the case of the corporation and LLC).
Business Entity Types Charts
We’ll discuss these business entities in such a way so that you may compare C Corps and S Corps to LLCs, Partnerships, both general and limited, and the sole proprietorship.
Download the Business Entities Overview Chart here to help you learn about the differences between the various types.
C Corporations Vs. S Corporations
Let’s start with C corporations and S corporations. It’s important to understand that in order to be recognized as an S corporation, you must first form a C corporation. You must elect special “S” shareholder tax treatment and in most cases when a federal S tax election is made, the state in which you operate will regard the corporation likewise as an S corporation for state tax purposes. This varies widely by states so you will need you look into that on a case-by-case basis. We’ll talk more about that in a later post.
Many people have asked me over the years what the significance is with regard to the letter C or S when discussing this topic. These two letters simply refer to this sub chapter within the Internal Revenue Code. Nothing too fancy or earth shattering! There are major differences between a C Corporation and an S corporation beyond tax treatment. Most notably there are other restrictions for S corporations which include the necessity for shareholders in an S corporation to be a US resident.
Additionally, an S corporation may not have more than 100 shareholders. For most of us, that restriction is not a major problem. However if your intention is to build a business to ultimately go public or be sold to shareholders on one of the stock exchanges, an S corporation would not be a viable option for you. We will be discussing in greater detail the federal tax differences between a C corporation and an S corporation in another post.
For now, we are simply focusing on the basic requirements you should consider about the type of shareholders eligible for these two types of corporations. Being able to protect your personal assets and income is available if you choose to form either a C corporation or an S corporation. In this regard, there is no difference.
Limited Liability Companies
A limited liability company (also known as an LLC) has become very popular over the past decade.
In part, its popularity has increased because it shares similar protection from personal liability for business debts and other liabilities as it compares to the S corporation and C corporation.
Likewise, the LLC has great flexibility when it comes to the type of owners who are eligible to form a limited liability company. U.S. Residents and Non-Residents alike, Corporations, LLCs, Trusts and Estates may own a Limited Liability Company.
You may form either a Member Managed LLC or a Manager Managed LLC. The former is when the members collectively manage the LLC. And the latter is when one of the members is designated as the manager of the LLC.
Another attractive feature of the LLC is its simplicity in formation and ongoing maintenance. We’ll talk more about that in a later post.
Partnerships can either be a “Limited Liability Partnership” or a “General Liability Partnership”. The difference and distinction is very important because a limited liability partnership, if properly set up, can offer investors’ personal protection from business debts and other liabilities to the extent of their investment in the partnership. Whereas a general partnership offers no personal protection for the business owner or partners from the business debts and other liabilities.
It’s also important to understand that if two or more persons begin to do business together, a general partnership has been formed in the eyes of the state and federal government. To many, this is a surprise and especially so if you fully understand the depth of a partner’s exposure to personal liability in a general partnership!
Again remember, a general partner has full liability on a personal basis for anything that occurs in a general partnership, its debts and obligations and any other unknown liabilities. And to make matters worse, anyone who is considered to be a general partner may bind the entire partnership (and all of its partners) in a contract.
Similarly, as a sole proprietor there are no personal protections offered to shield the owner or proprietor from the debts and obligations and other liabilities associated with the business enterprise. In plain speak, this means if something goes wrong in either a sole proprietorship or general partnership its owner or owners are fully exposed to the debts, obligations, liabilities and judgments. In these two cases, there is no fence surrounding the business owner to protect him or her in any way!
If you are launching a business with the intent of protecting your personal assets and income from potential liabilities, known and unknown, as a result of owning and running your new business, I think it’s safe to assume that creating a sole proprietorship or general partnership is off the table. Accordingly, we will not spend much time on these two forms of business entities as they simply will not provide the basic protections most business owners seek.
Business Owner Titles & Roles
The titles and roles for business owners in the each of the various business entities is an important concept to understand once you’ve begun to operate your business and should be given consideration before you choose a business entity.
Knowing what role an owner plays in a business and how to properly title and execute documents will be very important. This is because your role as an owner and knowing how to properly execute contracts will impact how strong your fence remains around your personal assets and income.
C Corp Vs. S Corp Titles and Roles
In the cases of a C corporation and S corporation, the title and roles are the same. A board of director serves to oversee the managers and executive officers. The executive officers, including a president, vice-president, treasurer, and secretary must be established by both C and S corps.
In many states, it is possible to have one shareholder who serves in multiple roles and holds several executive officer titles. Executive officers are responsible for overseeing the day-to-day business operation and for supervising the corporation’s managers and/or employees. The owners of an LLC are called “members”. They do not have executive officer positions such as President and Vice-President which is a requirement for a corporation. This may be confusing to many. In fact, I have observed many business cards where the owner is identified as President in his own LLC. This is incorrect and may be misleading.
In a subsequent post, we will cover the topic of titling and signature requirements in more details for each of the business entities we’re are discussing. For now, it’s simply important to recognize the owners of an LLC are referred to as a member and not a shareholder.
Generally speaking, all members in a given Limited liability company manages the day-to-day business operations in the LLC. If there are many members who form an LLC, having all of them running around running a business can become problematic. And in such a case, it’s common practice for a single member be designated to manage the LLC on behalf of all of the members. This type of Limited Liability Company is called a “Manager-Management LLC.
In every partnership, a general partner always exists regardless of whether the partnership is a general partnership or a limited partnership. That may not be intuitive. The owners in a limited partnership, will serve either in the role as a general partner or as a limited partner. If a partner is designated as the general partner, they are responsible for managing the day-to-day operations of the partnership. The general partner is also responsible for all liabilities related to the partnership. This fact is significant and should be considered carefully. Whereas, the limited partner is typically an investor in the limited partnership and does not manage the business affairs in the limited partnership.
All of the business owners in a general partnership are all referred to as a “general partner”. And you can probably guess by now that means each general partner is responsible for managing day-to-day operations as well as for the liabilities, known and unknown, of the partnership. It’s been many years since I’ve found a new general partnership being formed because of the large potential liability exposure for its owners. That said, it’s not unusual to run across a general partnership which was formed several decades ago and is still operating under the same formation.
When we cover multiple business entities in a subsequent post, we will discuss various ways to reduce the liability exposure for the general partner in a limited partnership. Until then, suffice it to say most new business owners do not embrace the idea of forming a general or limited partnership.
Liabilities Not Protected by the Formation of A Business Entity!
Warning! Just so you don’t get ahead of yourself, I feel it’s important to caution you about the various types of debts, obligations and other liabilities the formation of a business entity will not be protected for personal liability purposes for a shareholder, member or partner. Understanding this concept, about these differences in personal liability protection, is very important!
DEFINING BUSINESS DEBTS AND OTHER LIABILITIES WHICH A BUSINESS ENTITY WILL AND WILL NOT SHELTER.
In general terms, when you form a C corporation, S corporation, Limited Liability Company, or are designated as a limited partner in a Limited Partnership, you are not personally or individually held responsible for the debts, obligations, liabilities and court judgments of the business. Despite the fences the formation of a C or S Corp, LLC or Limited Partnership provides a business owner, there are many debts, liabilities and obligations associated with every business which fall outside of this rule! Let that sink in… because it is a very important point and one which many new and existing business owners overlook.
Regardless of the business entity formed, the following debts, obligations and liabilities will NEVER be protected or remain outside the fence that surrounds your personal assets and income! Those unprotected debts, obligations and liabilities include:
- Unpaid payroll withholding taxes and the penalties associated with late or nonpayment.
- Unpaid personal federal, state and local income taxes and penalties as a result of income you’ve earned from your business.
- Personal guarantees associated with business bank loans, leases, vendor agreements, and/or any other liability.
- Shareholder, Officer and/or Board of Director negligence.
- Professional services by certain professional are not protected from malpractice liability.
- Misrepresentation of the business’ financial condition to lenders and creditors.
Let’s take some time to go over these unprotected debts, obligations and other liabilities.
Unpaid Payroll Withholding Taxes
When you have employees and you pay them a salary or wages, there are certain payroll taxes which are withheld from the employee’s paycheck every payday. These payroll taxes include Federal Income Taxes, FICA and Medicare Taxes. As the employer, you are always held personally responsible for remitting those payroll taxes in a timely basis to the federal government. If you do not do so, the IRS will hold you personally financially responsible for them. They will also penalize you and this penalty does not escape your personal financial responsibility either.
Unpaid Personal Taxes
Similarly, most States will hold you personally responsible for remitting the State Income Taxes withheld from your employee if you don’t remit them timely. If your business earns income and such income results in owing personal federal, state and/or local income tax, payment of these individual income taxes is held outside of the business entity and is the business owner’s personal financial responsibility.
If a shareholder pledges his or her personal assets, income or real estate and the business defaults on its terms with a lender, vendor, or other party, those personal assets and income will be subject to collection.
If your business is used as a means to defraud people or you intentionally make reckless decisions or have blatant disregard for others and such actions or inactions results in harm to others, or their property, you may be held individually liable for such losses. Attorneys refer to this as “piercing the corporate veil” and it is applicable to all business owners seeking shelter from personal liability.
If you’re a licensed professional service provider, such as a doctor, attorney, accountant, nurse, etc., your errors, omissions and/or negligence are not protected by the formation of a business entity.
And last but not least, if as an officer, Board of Director, shareholder or member you represent to a lender or other creditor that your business is in good financial condition when it is not, such actions will be considered a fraudulent act and will be the basis for an Attorney seeking to pierce the corporate veil.
As the old saying goes, there’s no such thing as a free lunch! This is the case with regard to protecting your personal assets and income. Implementing the strategy of forming a separate entity is wise, however it is not a free hall pass for the business owner to purposely not meet its financial obligations.
Maintaining Your Business Entity
Once you’ve decided which business entity you would like to form and have taken the initial steps to set up your business entity with your state filing office, certain care should be attend to given to the maintenance of your separate business entity throughout the years of operation. Although, you need to consider other matters before you choose your business entity, this is a good time to review the various requirements to keep the various business entities in good standing.
Depending on the business entity you ultimately choose will determine which steps need to be taken and to what extent or efforts it will take to maintain your business properly. The steps vary and are more difficult for corporations, a bit less difficult for LLCs and non-existent for partnerships and sole-proprietorships.
Officers of the corporation, whether it be a C or S Corp, must keep an eye on the day-to-day operations of the business and they may not be negligent in their duties. They are also responsible for holding regular board of directors and shareholder meetings and keeping minutes of those meetings. It’s important to understand that each state has its own corporate code which defines the minimum standards each corporation must maintain to remain in good standing.
The last point of discussion related to maintaining your business entity is about a very common error many small business owners make. This common mistake is the practice of co-mingling personal financial affairs with the business income and expenses. It’s not unusual to find a business owner who pays for his groceries from his corporate checking account and this is exactly what a prosecuting Attorney will be looking for to pierce the corporate veil!
One of the best ways to build a strong fence around your personal assets and income is to be certain that all personal expenses are paid for with a personal checking account and only business income and expenses run through your business checking accounts.
Truly, that’s not very difficult to do and it will go a long way to preserve your rights as a business owner.
In the next post in our Business Entity Series, we cover in depth how to protect your business name and most importantly, why you should do so.
Holly also founded ExitPromise.com and to date has answered more than 2,000 questions asked by business owners about starting, growing and selling a business.
Latest posts by Holly Magister, CPA, CFP
- How to Pay Yourself as a Business Owner - November 6, 2019
- How to Overcome Customer Concentration Objection When Selling a Business - May 22, 2019
- Understanding the Business Buyer Types When Selling Your Business - April 12, 2019