How to protect your home and family: Business Entity Formation 101

Article Scope and Purpose: This is Part 1 in a series of articles that provide foundational information on limiting business owners’ personal liability through proper entity formation and operation.

Everyone wants to start their business off right, but what is right, and what happens if they do it wrong? This article is intended to give Utah business owners and entrepreneurs a basic knowledge of entity types, why they exist, and the pros and cons of each. If you need more extensive answers to the questions below, please contact our Salt Lake City, Utah, based law firm and speak to a lawyer directly.

Why Proper Entity Formation is Essential to Asset Protection

People are often afraid of becoming the entrepreneur they dream of and executing on good ideas because of the inherent risks of business ownership and going at it alone. Legal liabilities come in many different forms a breach of contract (i.e., breaking a promise), tortious acts (i.e., negligent or intentional harm to others), tax liabilities or other governmental fines, employee claims, etc. Many know or have heard that if the business fails, they could lose their home, car, bank accounts, or other assets — leaving their family destitute due to these liabilities. Though true, this isn’t the case if you take the correct steps to protect those assets.

There are many types of entities and business structures, but only some protect assets while others expose business owners to liabilities. Both individuals and entities have to pay taxes and are liable for contracts entered into or broken and harm caused to others. The method each pays taxes and the different limitations of liability are the primary reasons to select one over another.

Sole-proprietorships and most partnerships expose business owners to lawsuits and offer no protection. However, the correct formation and operation of entities like LLCs and Corporations, in addition to other legal structures, can eliminate or substantially reduce the risks of loss and financial ruin to individual owners and their families.

If you (1) want to start a business but don’t know where to start, (2) have already started one but want to make sure you have done it correctly, or (3) are facing a possible business failure then continue reading to find out how to protect your home and family from the risks of business ownership.

How Business Fail

Generally, business failure occurs when the business’s financial obligations exceed the business’s assets, or when the business becomes unable to fulfill an overwhelming portion of its contractual or financial obligations. At that point, it becomes impossible or impractical for owners or managers to continue the venture.

According to Investopedia and the U.S. Bureau of Labor Statistics (BLS), “approximately 20% of new businesses fail during the first two years of being open, 45% during the first five years, and 65% during the first 10 years. Only 25% of new businesses make it to 15 years or more.” That is bad news for the majority of spouses and children of entrepreneurs who can be liable for the debts and obligations of the business when it fails.

Initially, an eager entrepreneur starts out with ideas and passion. They invest substantial time, money, and assets into the endeavor. Often, both the business and the individual owners contribute money and assets to the business. They may even take on debt to get started or expand. Ideally, they find customers and contract to serve them or sell them something. To fulfill obligations, the business buys assets and equipment computers, office supplies, cars, and even buildings. From the very beginning, the business becomes obligated to pay debts and fulfill contracts.

Sometimes, for no fault of the business, customers dry up or the economy suffers a downturn. Occasionally, businesses suffer from failed management or a catastrophic event not covered by insurance. These can cause the business to fail or become insolvent (unable to pay its debts). It’s even possible the business is thriving but the owners lose interest and are unable to find a buyer for the business. So they may just walk away. But then what?

After a Business Fails

If the business is incorrectly formed, operated, or incorrectly closed or wound down, then the consequences of business failure are likely unpleasant or even destructive to the owners and their families. Creditors, contractors, customers, and others will likely come calling. They will want to be reimbursed for the money they spent or lent and time and resources lost. It might even end in bankruptcy for the business or the owners themselves. Sole-proprietors are responsible for all personal and business obligations, whereas owners of LLCs and Corporations have little or no responsibility for business obligations.

However, if the business was formed and operated correctly, then the owners and their families will likely be protected in full or part by the “corporate shield” (also frequently called or referenced as “the corporate veil,” or “liability shielding” or even “limited liability”). This is legal jargon that simply means to separate the business assets and liabilities (leases, loans, cars, contracts, accounts, etc.) from a business owner’s personal assets and liabilities (i.e., their home, car, bank accounts, etc.) The corporate veil only exists if the business was correctly formed as a separate legal entity and the owners operated the business according to the legal requirements.

How to Correctly Form and Operate a Business Entity to Protect Your Home and Family

Why start a business and work hard if you can lose it all at the drop of a hat? You shouldn’t, but you should take advantage of the corporate veil to obtain asset protection as a business owner. In order to answer questions on entities and asset protection in more depth, we have added a list of common questions with answers below.

The Q&A section below provides information and answers to questions surrounding entity formation, including entity types, taxes, and ownership and management structures, each of which is essential in answering, “How can I protect my home and family?” You will find answers to questions like, “What kind of entity should I form, an LLC or a Corporation?” and definitions to unfamiliar words or legal phrases.

Even if you find answers to your questions, you should seek capable counsel with experience in litigating commercial liability, and financial reorganizations or bankruptcies to give you specific counsel and to draft the necessary documents when forming your entity. Our attorneys have that experience and can counsel you on how to protect your assets or what to do if you are currently exposed to liabilities.

Let us help you accomplish your goals. If you wish to limit your liability and protect your assets, or if you are facing a potential loss of your assets, speak with one of our qualified attorneys.

COMMON QUESTIONS & ANSWERS (BUSINESS FORMATION AND ASSET PROTECTION)

Which type of entity is best for my business?

To answer this question, you must know:

• How many owers there are or will be (1 to 1000+);
• The role of each owner or member (one or more active partners/CEO/CFO/etc., many passive investors etc.);
• Purpose of the business (perform a service or provide a product, tax sheltering, asset holding);
• The business goals (produce a profit or be a non-profit 501(c)(3));
• Who will manage the daily operations of the business;
• Who will have the final say over key decisions within the business or about assets of the business; and
• The total assets that will be contributed to the business (a business must have assets, whether that is money or property).

Though other facts may impact your decision, these are the primary ones. The answer to each of these will impact the owner’s decision. The entity election will have short term and long term consequences on many things, like taxes, distributions, control, investment opportunities, future purchase, the potential future sale of the business or assets and more. Speak with a qualified attorney to find out which entity type is best for you.

What is a business and how do I start one?

In Utah, and around the world, “business” is simply the engagement in commerce for profit or by an individual (sole-proprietor), group of individuals (a partnership), or a legal entity (LLC, Corporation, etc.) Both individuals and legal entities conduct business.

In Utah, anyone can start a business in their garage, basement, or home office; indeed, many entrepreneurs do this in the beginning (look at Steve Jobs). But as the business and revenues grow, so does your risk exposure. By forming a legal entity you can avoid losing your house, car, money, and other assets if the business fails. You also may need financing or some form of investment. You may wish to take on a partner or employee. All of these opportunities come with risks. Forming an entity helps limit your personal risks by creating a legal shield between the business and you. The legal shield is referred to as the “corporate veil.” Don’t wait too long to obtain the legal protection an entity can offer you.

What is a “sole prop,” “sole-proprietor,” or “sole-proprietorship”?

They are all the same thing. Sole-proprietorships are businesses formed by individuals and require no formal documents other than a business license — all they need to do is start selling goods or services. In a sole-proprietorship, the individual and the business are the same legal party. Each is obligated by the actions of the other. Both are liable for each other’s acts and obligations because they are one and the same. Sole proprietors are not entities.

What is a business “entity”?

A business “Entity” or “Entities” (LLCs, Corporations, both S-Corps and C-Corp, etc.) are “legal creations” authorized by the government to have many of the same rights and obligations of individual citizens, but they also limit the legal liability of the individual the owners. The legal liability of the owners is limited through the legal doctrine known as the “corporate veil.” The corporate veil prevents the owners from losing personal assets if the business fails or suffers a catastrophic event. Entities are not sole proprietors

In legal speak: entities are legal non-persons structures established by the agreement of members or shareholders (or other statutory formalities) to accomplish a designated business goal. As entities pursue their business goals through the actions of their members, managers, or other officers, they gather value (in the form of assets and money) and liability (from contracts or tortious actions). That value can be retained or sold.

How do I create a business entity?

Entities are created through the filing of formal legal documents (Articles of Incorporation or Organization) with the Utah Secretary of State and the IRS.

Can I (as a non-attorney) set up an entity myself?

Yes, non-attorneys can set up entities (by filing Articles of Organization/Incorporation and other documentation with the secretary of state and the IRS). However, an attorney can counsel you on which entity is best for your circumstances and provide asset protection plans, operating agreements, and counsel on the formal acts required to obtain and maintain the liability protection that such an entity offers. To set up a legal entity yourself in Utah, visit the Utah Secretary of State’s website.

Why should I form an LLC or Corporation instead of a Sole-prop or partnership?

A new business owner(s) should set up an LLC, Corporation, or another specific entity type, because those entity structures provide owners with substantial liability protection that sole-proprietorships or partnerships do not (known as the “corporate veil”). However, the protections offered by such entities are not automatic, and a business owner must follow certain rules (often referred to as “corporate formalities”) to obtain and maintain legal liability shielding of the corporate veil.

Why do LLCs and Corporations exist?

Governments created entities because they desired to promote new businesses local economic growth. By separating the liability of business from the owners, entities allow people to take the risk of starting a new business. Those risks generally include lawsuits for breach of contract (breaking a promise) or tortious acts (harm to others), among other risks (tax liabilities or other governmental fines, employee claims, or personal injury claims etc.) Sole-proprietorships and partnerships have essentially always existed but provided little to no protection against such lawsuits.

Once people have gained assets through hard work, they often wouldn’t want to risk losing those assets by starting a business and taking on debt, only to have the business fail and allow creditors to take those assets as repayment – that is exactly what can happen if you are a sole-prop or sole-proprietor. The government and us as citizens benefit from new businesses startups (More taxes and more competition, innovation, higher quality goods and services at a lower price, etc.).

So governments passed laws to protect business owners from lawsuits and promote new business development. These laws created what is broadly known as “limited liability,” “liability shielding,” or the “corporate veil” (hereafter referred to as the corporate veil). The corporate veil protects the business owners assets and prevents creditors and other parties damaged by the business from accessing the assets belonging to the individual owners of the business, thought the business itself will still be liable for the damages or repayment of loans.

Historically, governments pass laws to protect property and allow recovery of property when damages occur. Modernly, governments wish to promote business because it increases economic growth, productivity, and its peoples’ prosperity and enjoyment (not to mention its power). But conducting new businesses incurs lending and other operational risks to other citizens. People are less likely to start a new business if they risk everything if a business venture is unprofitable or fails. So different entities structures were formed to limit risk, offer investment opportunities, and grant tax benefits.

How many types of entities are there?

Generally, there are 5 main entity types:

• Sole Proprietor
• Partnerships (General Partnership, Limited Partnership, Professional Partnerships)
• Corporations (domestic, foreign, professional, etc.)
• Limited Liability Companies (“LLC”) (other specific types)
• Non-profit (501(c)(3))

What’s the difference between sole-proprietorships, partnerships, LLCs, and Corporations?

Sole-proprietorship, LLC’s, and Corporations/S-Corps/Corps, primarily differ in the liability protection they offer. Though there are many specific entity types, all fall into two (2) categories:

• (1) business structures that provide little to no personal liability protection; and
• (2) business entities that can substantially limit liability.

Sole-proprietorships and some partnerships do NOT provide legal liability protection (a corporate veil) to the owners. A Sole-proprietorship provides no legal protections to the owner because there is no legal difference between the individual and the business — so the individual is liable for all business obligations. However, formal business entities like LLCs, Corporations, and some other entity types DO provide limited liability protection to the owners.

Each business structure below has the following general characteristics:

• A “sole-proprietor” or “sole-proprietorship” is a business comprised of only one individual owner that has not been organized as any other entity type under state or federal statutes. (Essentially, the person is the business and he or she is personally liable for all business obligations, contracts, loans, claims, etc.) The individual can operate under their own name or business name/D.B.A.
• A “partnership” is a business comprised of two or more people that have agreed to accomplish a specific commercial endeavor for profit through verbal or written agreement. These can vary in shape and size and even amount of liability protections each individual partner has.
• A “Corporation” is a business that is formed under the specific state statutes (of a state and owned by individuals named “shareholders.” The owners/shareholders are not personally liable for the obligations of the corporation (so long as the shareholders and operators follow the corporate “formalities” like keeping separate bank accounts, holding board meetings, etc.).
• An “LLC” or “limited liability company” is an entity that is formed and organized according to state statute. (See the Utah Revised Unincorporated Business Entity Act, Utah Code Annotated §48-3a). LLCs are versatile entities that can be designed to fit the needs of the owners and a variety of business goals. LLCs are one of the newest types of entities historically. They can have a single owner (legally referred to as a “Member“) or multiple owners like a partnership or corporation. LLCs can be taxed just like a sole-proprietor or like a corporation depending on the owners desires for distributions and other tax benefits. An LLC can be managed/run/operated by the owners/members, or the members can appoint an employee (legally referred to as a “Manager“), like a CEO of a corporation. There are benefits. At the formation of an LLC, the owners/members must select a management structure – either, “Member-managed” or “Manager-Managed.”

Why are there so many different types of entities?

Different business entities provide different benefits at different stages of growth – just like different styles of homes provide different accommodations to different people at different stages of life (i.e., apartments, condominiums, duplexes, town-homes, single-family homes, retirement homes, etc.)

What kind of entity do I have?

Generally, if a specific business entity type is not specifically selected in the business documents and registered with the secretary of state (look at the Articles of Organization or Articles of Incorporation), then the default type is either a Sole-proprietor or Partnership, depending on the number of members that owner, contribute or work to build the business (i.e., if Bob – alone – starts a dog breeding company; or if Bob and Joe – together – start a dog breeding company).

What is the “corporate veil”?

The corporate veil protects owners/shareholders from personal liability for debts if the business venture is unprofitable or suffers a catastrophic event.

To obtain and maintain the liability protection offered by the corporate veil, a business owner must do three main things: (1) create a separate legal entity (LLC, Corporations, or other entity type) and (2) act separately from the business (sign documents “as the CEO or Member of _________ (business name); and follow some or all of the “corporate formalities,” like maintaining separate bank accounts. If the business owners do not follow the formalities, then the owners often lose the protections provided by the corporate veil.