Personal Liability and Your Business Entity Choice

Although there are many things to consider when choosing what type of legal entity is best for your business, most people end up making the choice based on one legal issue: the personal liability of owners for business debts. It's true that the issue of personal liability can have a huge impact on successful small businesses a few years down the road. But business owners who are just starting out on a shoestring often care most about spending as little money as possible on the legal structure of their business. This is certainly an understandable approach. Far more new businesses don't make it because they don't control costs as opposed to getting into trouble over costly lawsuits. In short, for many new small businesses, incorporating or organizing as an LLC is as unnecessary an expense as a fancy downtown office or a high end gleaming chrome espresso machine in the lunchroom.

That said, owners of any business that will engage in a high-risk activity, rack up large business debts, or have a significant number of investors should always insist on limited personal liability, either with an LLC or a corporation. This is even more true if the business can't find or afford appropriate insurance.

Corporation or LLC?

If you decide that limiting your personal liability is worth the extra cost, you still need to decide whether to form a corporation or an LLC. With the LLC's arrival, many business owners who want limited liability protection realize that incorporation normally only makes sense if a business needs to take advantage of the corporate stock structure to attract key employees and investment capital. No question, corporations may have an easier time attracting capital investment by issuing stock privately or publicly. And some businesses may find it easier to attract and retain key employees by issuing employee stock options. But for businesses that never go public, choosing to operate as an LLC rather than a corporation normally makes the most sense if limited liability is the main concern. If the corporate stock structure isn't something you want or need for your business, the simplicity and flexibility of an LLC offers a clear advantage over corporations.

Analyzing Your Risks

Starting a business is always risky. In some businesses, however, the risks are particularly extreme. If you're planning to launch an investment firm or start a commercial building construction company, there is little doubt that you'll need all the protection you can get, including limited personal liability as well as adequate insurance. Other businesses are not so obviously risk-laden, but still could land you in trouble if fate strikes you a blow. When analyzing your business, note that red flags for riskiness include:

  • using hazardous materials, such as dry cleaning solvents or photographic chemicals, or hazardous processes, such as welding or operating heavy machinery
  • manufacturing or selling edible goods
  • driving as part of the job

  • building or repairing structures or vehicles
  • caring for children or animals
  • providing or allowing access to alcohol
  • allowing activities that may result in injury, such as weightlifting or skateboarding, and
  • repairing or working on items of value, such as cars or antiques.

If you've identified one or more serious risks your business is likely to face, figure out whether business insurance might give you enough protection. Some risky activities, such as job-related driving, are good candidates for insurance and don't necessarily warrant incorporating. But if insurance can't cover all of the risks involved in your business, it may be time to form an LLC or a corporation.

Keep in mind that insurance will never insulate you from regular business debts. If you foresee your business going into serious debt, an LLC or corporation may be the best business structure for you.

Where You Are Located May Impact Your Decision

Another important consideration in choosing your business structure may be related to the state you choose to locate it in, especially if you are going into business with people who do not live in your state. This is because states differ widely in how they tax different business entities and nonresident business owners. There can be big state tax complications when a business either operates in more than one state or has owners in more than one state. A tax attorney can tell you whether you can reduce your taxes and increase profits by choosing one state over the other as your headquarters.

Excerpted from The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo).

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