Many people begin a tech start-up or other small business as a sole proprietorship or simple partnership. But as a business grows, you may begin to wonder whether it is time to think about a more formal business structure, such as a limited liability company or corporation. Here are three questions to consider when deciding whether your business should become a limited liability company (LLC).
1. To What Extent Are Your Personal Assets at Risk if You Are Sued By a Customer, Creditor, or Employee?
Sometimes, the money starts flowing in a business and seems like it will never stop. But when your business spending or borrowing reaches six or seven figures, you need to think about what will happen if you run short of cash. You do not want to risk the chance of losing your home or other personal assets to creditors.
Another risk is that of civil litigation. Suppose a customer discovers a serious defect in a product that your business delivered, and the customer sues for damages. Or, you could become the target of a lawsuit filed by a current or former employee related to wrongful termination or discrimination.
One of the main benefits of a LLC is the separation and protection of your personal assets from the assets of the business. Creditors and liability lawsuits can only go after the assets of the business.
2. Do You Have Partners?
Another major benefit of forming an LLC is protection of the business from internal disputes amongst the partners. Partnership disputes are unfortunately common, and they can destroy a business just as fast as a negative cash flow.
Some, but not all, partners write up some kind of partnership agreement at the time they go into business together. But when you form a LLC, California and many other states require the business to have an operating agreement, either oral or written.
There are many benefits to developing and signing a formal, customized operating agreement–a legal contract designed to prevent disputes among the partners down the road. A well-written LLC operating agreement will spell out details such as:
- Each owner’s responsibilities for the day-to-day operation of the business.
- The formula for distributing profits and losses amongst the partners.
- A process for making key decisions if the partners cannot agree, for example, through mediation or arbitration.
- Procedures for handling a partner’s death, divorce, or desire to exit the business.
3. Do You Want to Avoid the Double Taxation Involved in Becoming a Corporation?
Taxation is one main reason that many small businesses choose to become LLCs rather than corporations. An LLC is advantageous when the owners want to take all or most of the profits out of the business each year.
A LLC has the option of being a “pass-through entity,” meaning that the business itself does not pay income taxes. The owners simply report all of the business’s end-of-year profits, as well as any separate salary payments they take throughout the year, as income on their personal tax returns.
In the case of a corporation, which is a unique legal entity, the corporation itself must file a tax return and pay taxes on its profits. And then, when the owners take profits out of the corporation, they must pay taxes for those profits on their personal tax returns–essentially causing the same earnings to be taxed twice. This means the owners may net substantially less from the business.
While most LLCs choose the “pass-through entity” approach to taxes, a LLC does have the option to handle their taxes the same way a corporation does. A business’s accounting and tax advisor can explain the various pros and cons of each option.
Consult a Skilled San Jose Business Law Attorney
As your business grows, you may want to consider implementing a more formal business structure. When it is time to take that next step, talk to an experienced Silicon Valley business lawyer. At SAC Attorneys LLP, we have extensive experience helping both start-ups and established businesses grow and thrive, and we can provide the advice and assistance you need to convert your sole proprietorship or general partnership into a LLC or corporation. Contact us today at 408-436-0789 to arrange a free consultation.