Just the Basics

Which business entity do I choose?

Your business has been doing so well you are amazed. For the last
couple of years it has continued to grow despite the severe recession.
You’re rather proud of the fact that you ran it on a shoestring budget
too, and kept just enough employees to do marketing and fill orders.
Now that business is beginning to show a profit and you can actually
take money out of it instead of plowing it back into the venture, you
are beginning to worry about the fact you’ve been doing business under
a fictitious business name. It’s time to make a call to a business
attorney and find out how personally exposed you are and what you may
do to protect yourself from business liabilities.

The first thing you find out is that you have been running the
business as a sole proprietor despite having registered a fictitious
business name. What that means is you have personal liability for all
the obligations and other liabilities of the firm. It gets worse yet.
The debts you’ve shouldered are business rather than personal or
consumer debts. Your lawyer explains many of the protections you enjoy
from consumer debts like credit cards or installment purchases don’t
apply when you incur the debt in connection with operating your
business.

Not without some trepidation, you ask the attorney if there is
anything you can do to change the situation because you don’t want to
start all over since you have a success on your hands. Fortunately for
you the answer is there are a number of options that will let you
change your company from a sole proprietorship to a business vehicle
like a corporation or limited liability company. If this is done
correctly, you can change the form of doing business tax free as well.

The attorney explains incorporating a going business or organizing
it into a limited liability company is permitted in California and if
properly done, neither the IRS nor the California Franchise Tax Board
will see it as a sale from you to the business. Specifically, you may
be able to contribute the assets of your business to the limited
liability company in exchange for your membership interest without it
being viewed as a taxable sale between you and your limited liability
company.

What do you choose? You find out that corporations are an older form
of business entity with less flexibility of operation over the limited
liability company, the more modern form of business entity. On the
other hand, when you do business in California in a limited liability
form, it may be subject to a gross receipt tax which can be significant
for a small business – if gross income attributable to California is
more than $250,000, the fee will be imposed from a low of $900 to
$11,790 if the total gross income exceeds $5,000,000.

Both entities are in common enough use that for most small
businesses, institutional lenders are available to provide financing.
For many tax professionals, the potential gross receipts tax is reason
enough to opt for the use of a corporation which elects to Sub-Chapter
S status. The advantage of an S election is that it avoids taxation at
the corporate level, permitting items of income and loss to flow
through directly to you, the shareholder. What is most important about
either form of doing business is that it affords protection against
personal liability.

Your lawyer says that as a practical matter, many lenders and
landlords require personal guaranties by the shareholders or members of
small business corporations or limited liability companies. Finally, in
order to transfer the business into the selected business entity, your
lawyer will work through each of your business assets and liabilities
transferring title from you personally to the new entity.

Some of your liabilities, such as bank loans, may not be so easily
converted into company obligations, at least without an accompanying
personal guaranty. The good news is that once completed and all
customers, vendors and other creditors are given notice of the change,
future obligations or liabilities should belong to the company and will
not be yours. Unfortunately, you learn that the legal and accounting
costs are significantly more when incorporating a going business, or
contributing the assets of a going business to a new limited liability
company.

It is easy to see that our friend would have been better served had
he spent a little more in the beginning to save significant legal and
accounting outlays later, not to mention the time he may have to devote
to gathering critical business information so that the process can be
completed……at least that is what this lawyer thinks.

Roni Balint writes for the Law Office of Alan M. Insul. The content
contained within this feature is not intended as legal advice and does
not constitute an attorney-client relationship. To learn more, contact Los Angeles business attorney and California corporate lawyer, Alan M. Insul by visiting Insullaw.com.