If you are considering starting a business or organization, or already operate one, it is probably a good idea to set up some sort of legal entity. The article below describes the various benefits in setting up a legal entity, the different types of legal entities, the process through which one can set up a legal entity and the personal liability that may attach to individuals who decide to forgo setting up a legal entity.
What is the Purpose of Incorporating a Business or Setting up a LLC?
A. To Protect the Business Owner(s) from Personal Liability
Probably the most important reason to incorporate your business or to set up a Limited Liability Company (an "LLC") is to protect your personal assets from being seized in a lawsuit arising from the operation of your business. Failing to incorporate or set up an LLC while operating your business is a serious mistake. By failing to set up the appropriate entity for your business you are assuming personal responsibility for the debts, obligations and casualties that may result throughout the course of your business. You can avoid this scenario and protect your personal assets by incorporating or setting up an LLC. When you properly set up a corporation or limited liability company, by operation of law, it becomes a legal entity that is separate and distinct from its owner(s).
This separate legal entity has the ability to enter into contracts, own assets and undertake obligations. All of the aforementioned are just some of the activities that your business will be able to undertake. In most circumstances, when engaged in the aforementioned activities, should a lawsuit arise, the third party involved with the corporation or LLC will only be able to look towards the business and its assets for liability-- not the owner(s) personal assets and property.
The legal theory and policy at work in these circumstances states that the third party bringing the lawsuit entered into the transaction that formed the basis of the lawsuit with the business as a separate legal entity, not with the owner(s). The third party relied upon their own judgment as to the prudence of entering into a transaction with that business-- taking into account the business assets and viability and not that of the owner(s) of the business. Similarly, it could be said that the owner(s) of the business, when entering into the transaction that gave rise to the lawsuit, did so on the express condition that it was the business (in existence as a legal entity) that was entering into the transaction and not the owner(s) personally.
B. To Express the Contractual Expectations of the Business Entity's Owner(s) and Determine How the Business Will be Run
Whether you have set your business up as a corporation or as an LLC, you should always have some type of document or agreement specifying the rights, liabilities, powers and duties necessary for the operation and management of the corporation or LLC. When setting the business up as a corporation this document is called a charter and when the business is set up as an LLC it is called an operating agreement. Both the company charter and the LLC operating agreement serve the important, prevailing function of providing a framework of rules, rights and regulations that the company/ LLC's officers/members use to operate and manage the company/LLC.
Failing to have a properly drafted charter or operating agreement may result in costly litigation in the future due to: 1) Members selling their interests in the LLC, wanting to quit or filing a lawsuit against the company, 2) third parties filing a lawsuit against the LLC or company, 3) derivative suits by shareholders or most importantly may 4) result in personal liability, in spite of the existence of the legal entity, due to the owner(s) failure to follow the legal formalities (such as holding meetings, keeping minutes and having an operating agreement or charter) necessary to maintain the business as a separate and distinct entity (for liability purposes). The four main reasons for a charter or operating agreement are summarized and set forth below:
- properly describe ownership interests;
- lay out the financial interests of the owner(s)/members;
- describe how the business will operate and the duties and responsibilities of the owner(s)/members; and
- most importantly, to protect the owner(s) from personal liability by following one of the legal formalities expected of a corporation or LLC under law
1. Choosing the Proper Entity
The law recognizes numerous entities. The three most popular are the: Limited Liability Company ("LLC"), the S Corporation and the C Corporation. Selecting the appropriate entity largely depends on the particular circumstances of your business. Things such as the number of shareholders and the number of owners (and how ownership can be transferred) will affect the appropriate entity choice. Furthermore, choosing a C Corporation instead of an S Corporation can result in double-taxation of the entity's profits (taxation at both the corporate and personal level); yet there are circumstances where incorporating as a C Corporation is necessary.
2. Filing the Proper Paperwork With the Secretary of State
After the appropriate entity form has been chosen based on the particular needs of the business, the necessary fees and the appropriate paperwork must be paid and filed with the Secretary of State's office (there may be other factors to consider when choosing in which state to incorporate). This is a relatively straight-forward process where the business files what is known as its "articles of incorporation" with the state.
3. Drafting an Operating Agreement
As described in Section B. Having a professionally drafted operating agreement is a necessity.
Now What? Things to Consider When Conducting Business as an Agent of Your New Entity
Setting up your entity is only part of the battle. There are numerous other responsibilities and considerations that need to be undertaken before and while you conduct business; responsibilities such as:
- registering your entity with the appropriate agencies,
- making sure your business is in compliance with the applicable laws and regulations (i.e. zoning, OSHA, FMLA, EEOC, ADA, Worker's Compensation), and
- applying for the proper permits and licenses.
Feel free to use the contact form or call should you have any business related questions. From setting up your business, handling a business transaction or making sure that your business is in complaince with local, state and federal laws-- the McClain Law Office is here to answer your questions and serve your business.