A business entity is the separate legal business 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 and choose the best one for your circumstances:
- 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 — Business Entity Definition
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 — Business Entity Definition
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 — Business Entity Definition
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.
Sole Proprietor — It’s Not a Business Entity
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.
LLC Titles and Roles
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.
Partnerships Titles and Roles
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.
For these reasons, unless your business employs an accountant or CPA, it’s wise to outsource this responsibility to a reliable payroll processor to handle everything for you.
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 inaction resulting 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.
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Iâ€™m trying to get a better understanding of reasonable compensation and distributions for husband and wife ownership of three S Corporations. All three S Corporations are retail brick and mortars. Husband takes a salary from one S Corporation and the wife takes a salary from another S Corporation. The third S Corporation was recently formed and salaries will not be taken until next year. Based on some research done I believe the salaries are reasonable based on similar job duties in the area and net profit. I have a few questions below to make sure IRS guidelines are being followed for reasonable compensation and distributions.
Is there any risk if the reasonable compensation was divided between the three S Corporations and the owners received W-2â€™s from each S Corporation for the prorated amount? My theory behind this is the owners can only be working for or at one location at a time.
Any guidance or comments would be greatly appreciated.
I applaud you for your concern regarding reasonable compensation paid to you and your wife as an S Corp Shareholder. Most business owners do not understand this risk.
If you’ve done the research, I recommend that you document, document, document. Keep everything you’ve found to support the amount you are paying you and your wife in your tax records.
If audited, you won’t have to reconstruct your findings.
The IRS will consider how many hours you (and your wife) are dedicating to each operation and that’s something you should document as well.
You are on the right track!
All the best…
My siblings and I formed an LLC to manage the family’s home property in WV that was deeded to us equally. Recently, we received a substantial sum from a conservation easement sale. Two of the members want to continue to operate a small beef cattle farm on that property. What would be the simplest but most protective way for the LLC to relate to this small operation? Should we 1) lease the property (including land and barns) to these members? or 2) Should they establish a DBA? or 3) Should we ask them to form their own LLC?
Having a lease between the LLC and the business operation makes good sense and should be arms length with regard to its terms. Meaning what you’d expect a third party to pay and agree to should be what you include in your lease agreement.
Whether the two family members choose to file for a DBA or LLC is really up to them. That said, it would be wise for your LLC to require in the lease that the property be properly insured with the LLC being named as an additional insured should something go wrong.
A business attorney should be consulted as you and your family members draft these agreements to protect all interests.
All the best…
After 65 years in family owned and operated business, we are thinking of selling-
We are the 3rd generation owners, and we still operate with a profit, tho is getting smaller every year. We are wondering the best way to sell a older hotel that we did purchase at a great price from our parents- and now worried about all the tax money we are going to have to pay after the sale. Any advise ?
Thanks for your question. I’ll help answer about reducing your tax bill, but you may still want to hear other opinions about other ways to handle the sale.
One of the issues with a hotel is whether it is “real estate” or “a business”. It is a bit of both, really. If you were lucky, you have two or more entities with the building being a separate entity. Most likely, this isn’t the case, so you have to be careful on using the biggest tax savings tool at your disposal…a 1031 exchange.
A 1031 exchange will let you defer the profits on real estate (and only real estate as of 2018). That means if you sell the hotel, there likely will be gain on the other assets that you sell, such as furniture and fixtures, goodwill, and anything that is NOT the building. You can exchange the building for any other type of income-producing real estate, not limited to hotels or motels, as long as the replacement property is greater than or equal to the value of the property being sold. Again, this may be tricky because if you sell the hotel as a single entity, you may need to get an appraisal to determine how much of the price is to be allocated to the building and you may need to sell the building separately from the rest of the business.
If you have no interest in purchasing other income-earning real estate, then forget the whole 1031 idea.
In that case, you will need to be careful because you will have two types of “income” in concern to the tax bill. One part will be the recapture of the building depreciation, which is subject to a flat tax rate of 25%. The rest will likely be long-term capital gain, which is capped at 20% rate. Of course, if you are in a state with income tax, most states only have one rate for all income, so be aware of that, too.
The other option is that you DON’T sell the building, but if the hotel and all its assets are held by a corporation, then you could sell the STOCK of the corporation instead of selling the assets separately. Selling the stock of the corporation transfers the existing entity to someone else and you, the selling stockholder, get to treat the sale as a long-term capital gain.
There are a lot of variables here, but mostly your options may be dictated by the way the ownership of this hotel was originally set up or the way it was set up when you purchased it. For this reason, always consult your tax advisor prior to the sale for the best and most accurate advice as it relates to your situation.
I am a Business Broker adviser for EXIT Promise and have had limited experience in the hotel industry. If profits are going down, this will impact sale price and probably make finding a buyer more difficult. However, with the help of the right broker, you may find the right buyer. In my area, state of GA, I often partner with the brokers who specialize in both the sale of a hotel business and the real estate. They know the market and potential buyers in the market. You may want to look at hotels listed for sale on business listing sites such as bizbuysell.com and see what brokers are representing these hotels. They may be some of the industry experts in your area. Also, reach out to your network of other contacts in the hotel industry and leading business brokerage firms to find a broker that might help you successfully sell your business and property. I hope this helps.
Thank you for such a great article and all the wonderful information! And thank you for taking the time to answer my question! 🙂
It’s my pleasure Thomas!
I have 2 related businesses under a DBA and would like to convert to an s-corp (to relieve me of the self employment taxes) Iâ€™m considering naming the s-corp something different than what I actually do, then convert, or obtain a new dba for the 2 businesses. I.E. ABC corp. doing business as business1 and business2. OR should I simply name the s-corp my main business name and get the one dba for the second business. I.E. Business1 Corp doing business as business 2.
Either of your two choices would work if you are simply trying to form an S Corporation from your two existing businesses you’ve been operating as sole proprietorships.
If you plan on adding any other lines of business in the future, the first option may make more sense.
All the best…
Great article, thanks!!
I am starting a personal training and coaching company. The reputable company that I obtained my personal training certificate from informed me that I could (in Arizona) file for a DBA and then obtain liability insurance to protect myself if a client were to get injured or hurt themselves.
I have also been looking into creating an LLC. However, creating a DBA seems a lot simpler and potentially cheaper.
Which would you suggest?
Also, if I create an LLC, would I still need to purchase liability insurance? Or am I already covered incase a client gets injured?
The first line of ‘defense’ should be obtaining liability insurance, regardless of your decision to form a business entity or to operate your business as a sole proprietor (with or without a fictitious name)!
If you choose to form a business entity, you will have certain additional liability protections that a sole proprietor would not enjoy.
If one of your clients is injured and sues you, having the liability insurance will be valuable to you and if your business is formed and operated as a truly separate business entity, you will have more personal asset protection. As a sole proprietor, the client would be able to sue you individually and pursue any personal assets and income you have.
You are correct in your assessment that it is easier and typically less costly to startup as a sole proprietor and file for a DBA / fictitious name. That doesn’t mean in the long run it’s the best option or even the least costly.
Hope this helps you a bit Thomas. All the best…
I’m a golf instructor who wants to go into business for myself. Plan to offer lessons to individuals who pay by the hour. There shouldn’t be too many business expenses—-other than necessary supplies needed for the golf range. I also intend to purchase some sort of liability insurance. Am I correct that setting up a DBA would be most appropriate?
If you file individually a fictitious name (Kevin Baker DBA XXXX), you will be operating your business as a sole proprietor. This means you’d have no liability protection whatsoever if one of your clients or a golf club where you offered lessons sued you. It’s important to understand and assess this risk.
Also, sourcing liability insurance for this type of business (as a sole proprietor) may be difficult to do. You should ask a commercial property & casualty insurance broker about this type of liability insurance.
What’s most appropriate for your circumstances depends on many factors so I am not able to make a recommendation. Consulting with an attorney who is well-versed in business formation would be worthwhile.
All the best to you as you startup your business Kevin…