Business FAQs

When you are first starting a business, operating it as a sole proprietorship may make a lot of sense. Sole proprietorships are simple and inexpensive to set up and maintain: they are operated by a single taxpayer and are the most common form of business organization. 

From a tax and legal perspective, businesses that are owned and operated by one person and have not been formed as a separate legal entity such as a limited liability company (LLC) are automatically considered to be sole proprietorships. 

Keeping things simple has its advantages in business. But as your business grows, matures, and becomes more complex, it may be beneficial to structure it as a separate legal entity, such as an LLC.

Sole Proprietorship versus LLC: The Basics

Successful entrepreneurs need more than luck—or a good idea—to succeed in business. You also need a plan. Part of that plan involves choosing a structure for your business. The following is some basic but important information you should know about sole proprietorships:

• For legal and tax purposes, there is no distinction between a sole proprietorship and the person who owns it. 
• Business profits and losses are passed through to the owner, making a sole proprietorship a pass-through entity. 
• Business assets and liabilities are not separate from the owner’s personal assets and liabilities. That means creditors can pursue the owner’s personal assets to satisfy the business’s debts, judgments obtained in a lawsuit against the business, or other financial obligations of the business. 
• The owner’s personal credit is also not separate from the business’s credit. This may make it more difficult to build business credit and obtain funding for the business. 
• The owner is not responsible for paying any separate business taxes, although they are responsible for self-employment taxes. 
• A sole proprietorship requires no state filing or annual paperwork. 

A sole proprietorship may be sufficient for a newly formed business with a single owner if there is no plan to add other owners and if the business does not need significant capital, has a low risk of being sued, and is not yet experiencing significant growth. It may also work for a new business when an owner wants to test the entrepreneurial waters prior to creating a separate legal business entity. 

One of the more formal business structures available to entrepreneurs is an LLC. An LLC can have a single owner (called a member) or multiple members. The former is known as a single-member LLC: it is an alternative to the sole proprietorship that should be considered. The following is some basic information about LLCs:

• LLCs are created and governed by state law and have state-specific filing requirements. States require the owner to file a certificate of formation (e.g., a certificate of organization or articles of organization) that meets the criteria established by state law. Typically, this includes providing the business name, purpose, address, owners, and other information about the business as well as paying a filing fee.
• Some states require LLC owners to file an annual or biennial report and pay an associated fee. 
• Although most states do not require it, business attorneys recommend that LLCs, including single-member LLCs, have an operating agreement that governs company ownership, management, and financial matters. Without an operating agreement, the default LLC rules set forth in state law apply. 
• An LLC’s members are typically not personally liable for the company’s debts or obligations. This is what is meant by a liability shield. Only in rare cases can a court pierce the veil of an LLC and disregard it as a separate legal entity. However, depending on state law, creditors of single-member LLCs may not be limited to a charging order entitling them only to distributions made to the member from the LLC. In some states, creditors may be entitled to foreclose the member’s interest or get a court to order its dissolution.
• The owners of a single-member LLC can be treated as a self-employed individual and taxed the same as a sole proprietorship. Unless an election is made to be taxed as a C corporation, profits and losses pass through to the owner’s personal income with no separate corporate taxes owed. 
• Because they are legal entities separate from their owner, LLCs have their own credit score and may be able to obtain funding more easily than a sole proprietorship.
• LLC ownership interests can be owned by a trust. Transferring a single-member LLC to a trust may provide estate planning benefits because the trustee may choose whether to continue or wind down the business. In contrast, sole proprietorships generally cease operations at the death of the owner.

As your business changes, it may be prudent to take steps to convert your sole proprietorship to an LLC. Here are some signs that it may be time to make the switch: 

• Your business is growing
• You are earning (or expect to earn) more profits
• You are considering hiring employees or bringing in other owners
• Your business needs a loan or investors
• You require greater personal asset protection
• You want more tax flexibility
• You would like to pursue bigger clients and deals
• You are getting closer to retirement

If you started a business that is currently organized as a sole proprietorship and you want to change the business structure to an LLC, you must choose a registered agent, file articles of organization with the appropriate state agency, pay any required fees, and comply with any other requirements under state law. As mentioned, it is prudent to create an operating agreement. You may also need to apply for an employer identification number (EIN), update any existing licenses and permits to reflect the new business structure, and open a business bank account to separate company and personal finances. 

Embrace Change with Help from Our Business Attorneys

Change in business is inevitable. Markets change, customers change, and your business must change to keep up. We can assist with all legal aspects of starting a business, changing a business structure, and preparing a business for sale, acquisition, or succession. To speak with a business attorney, contact Fred Simon Law. 

Limited liability is an important advantage provided by corporations and limited liability companies (LLCs). The personal asset protection that corporations and LLCs provide for their owners, however, is not absolute. To maintain the liability shield, owners must comply with certain corporate formalities required by state law or recommended as a best practice. In addition, observing these formalities is a means of providing the accurate documentation and records needed for a business to operate successfully.

Limiting Personal Liability 

Under some circumstances, the owners of a corporation or the members of an LLC can lose their limited liability protection and be held personally responsible for the obligations or debts of their business. This is known as “piercing the corporate veil.”

Without the liability shield that establishes corporations and LLCs as legal entities separate and distinct from their owners, many individuals would not engage in business due to fears of being held personally responsible for a business’s actions, debts, and obligations. 

LLCs are generally subject to fewer legal formalities than corporations. However, for both types of entities, following basic operating procedures such as holding meetings, keeping records, and establishing separate bank accounts for the business helps to maintain the liability shield. These formalities also help establish that a business is a distinct legal entity separate from its owners, which precludes creditors from pursuing the owners to satisfy the business’s debts or obligations.

Maintaining Accurate Business Records

While maintaining a corporation’s or LLC’s separate entity status is arguably the most important reason to observe corporate formalities, it is not the only reason. Corporate formalities also help create and maintain the body of information, data, knowledge, and experience that a company accumulates and needs to maintain for its future operations. 

These records are a valuable business asset with numerous applications, including the following: 

• Innovation and problem-solving: Corporate records can help organizations identify patterns and trends that could lead to the development of new products, services, and business models. 
• Informed decision-making: Business documentation can be used to make informed decisions based on data and records. 
• Improved collaboration: Good recordkeeping enables workers to share information and learn from each other. 
• Tracking progress and forecasting: Careful documentation is useful for tracking the long-term progress of prior plans and proposals and making more reliable predictions and forecasts. 
• Business continuity: Corporate records document insider knowledge, promoting continuity of operations when there is employee and leadership turnover. 
• Legal disputes: If a legal dispute arises between the business and an outside party or among owners, corporate records can provide key evidence (e.g., what was said in a meeting or the specifics of a financial transaction). 
• Tax matters: Detailed business records are indispensable for tax planning and payment. 
• Proof of compliance: A business may need to demonstrate its compliance with legal obligations to various governmental bodies, including local licensing agencies, the state attorney general’s office, and the Internal Revenue Service. 

How to Maintain Corporate Formalities

Corporations and LLCs are created by state law and must adhere to the rules established at the state level. The formalities required for corporations and LLCs are different, however.

Corporations

It is the responsibility of a corporation to observe the formalities required by the state(s) in which they operate. The following are some formalities that corporations typically must comply with: 

• Establish and follow bylaws, which are a set of internal rules that govern how the corporation is run 
• Hold annual shareholder meetings at least once a year to elect directors 
• Hold board of director meetings—usually on a quarterly basis 
• Keep meeting minutes, that is, an official record of who was at a corporate meeting, the topics discussed, and the decisions made 
• Maintain stock ledger and stock certificates listing each individual shareholder’s name, address, and contact information to account for the total equity in the company
• Open a corporate bank account that is separate from the business owners’ bank accounts 
• Register a business name, that is, a trade name or “doing business as” (DBA) name, that the business uses in addition to its corporate name 
• Maintain business records documenting all corporate activities, including notes from shareholding meetings, corporate tax filings, and corporate documents 

LLCs

Many corporate formalities are not required for LLCs but are considered best practices and are highly recommended. 

For example, most states’ LLC statutes do not require LLCs to hold formal meetings or record minutes when meetings are held. LLCs are also not obligated to have a board of directors or, except for a handful of states, to create an operating agreement—the equivalent of corporate bylaws for an LLC. 

If an LLC does not have an operating agreement, it is subject to the default rules set forth in the state’s LLC laws, which may not reflect the LLC members’ preferences about how to run the business. Failure to observe the following LLC best practices could threaten the liability shield and result in inadequate business records: 

• Conducting business in the LLC’s name and not in the name of the individual members 
• Maintaining a company bank account and not commingling personal and business funds 
• Establishing a capital account for each LLC member that documents their initial investment in the company, their subsequent contributions, the distributions they receive, and their membership interest percentage 
• Keeping accurate and detailed records of all financial transactions dating back at least three years, including paid bills, invoices, bank deposits, credit card statements, business contracts, income tax returns, and employee records 
• Creating an operating agreement that establishes how the company should be run and outlines the duties and responsibilities of the members to each other and the business 
• Holding regular meetings and taking minutes to document attendance, matters voted on and voting results, and topics of discussion

Call Us Today

A business attorney who understands the law and the risks that businesses face, internally and externally, can provide businesses with a professional, objective, top-level view of corporate formalities. We can help business owners to ensure they are observing the formalities necessary to protect themselves against personal liability for the business’s obligations and debts and maintain essential records needed for the business’s operations—whether legally required or recommended best practices. Call Fred Simon Law today to set up an appointment.