Starting a small business in Colorado can be incredibly easy, regardless of what form you wish your business to take partnership, company, or corporation. Many small business owners simply file Articles of Incorporation or Articles of Organization with the Colorado Secretary of State, pay their $50 fee, and operate with a shell of a company. In most cases, there is no requirement that individuals take the next steps in formalizing their business, such as drafting and adopting an operating agreement or bylaws, executing agreements for capital contributions made to the company, and passing initial resolutions. We had one client that came to us with a business litigation matter after six years of running their company without any operating agreement or other LLC documents that would guide their management, capital contributions, distributions, or other corporate issues. They were grossing over $3 million without any organizational documents!
What the owners of that company and many others don’t realize is that by failing to observe what lawyers and judges refer to as “corporate formalities,” they are not only hampering their future planning, but also in danger of losing protection from personal liability on debts and lawsuits. A prior post on this blog underlined the legal importance of having an experienced lawyer draft proper documentation to help avoid future litigation amongst partners in a business. This blog post serves as a follow-up to underscore the importance of proper business organization both in maximizing the financial flexibility of your company and in ensuring that you will not be held personally or individually liable for the actions you take in your capacity as a business owner, limiting such liability to the business itself.
I. Limited Liability Company/Corporations and Avoiding Personal Liability
The chief advantage to legal documentation is the ability to shield your personal assets from business creditors, claims, or lawsuits. Unless you personally guarantee a debt or obligation taken by your business, you should not be personally liable for it, and a creditor can only go after the assets held by your business (e.g. bank accounts, secured property, future distributions). In order to ensure that your personal assets are safe from debts and claims of your business, you need to observe corporate formalities, which essentially means that your business must be run as a business: corporate records must be kept, minutes must be taken on meetings, resolutions properly passed, and personal and business assets not intermingled, amongst other requirements.
What would happen if you didn’t have legal documentation and observe corporate formalities? In theory, a creditor or claimant could bring suit against your business and try to “pierce to corporate veil” to give them access to your personal assets to satisfy the obligation of your business.
Exactly what corporate formalities you must ensure you follow in your business dealings to maintain separation between your business and personal liability depends on how you organize your business. A corporation will generally have much more stringent and specific requirements than a limited liability company (LLC), which allows for great freedom in how a small business owner wants to manage and run his or her business day-to-day. For this reason, most businesses we draft documents for choose to organize as an LLC.
II. Tax and Financial Benefits of Corporations
In addition to shielding you from personal liability, how you choose to organize your business may have potential financial benefits. For instance, those who are self-employed generally pay more in Social Security and Medicare taxes than W2 employees. Medicare and Social Security combine to constitute 15.3 percent of most wages. Many forms of sole proprietorships and entities are “pass through” entities, meaning that all taxes are passed through the entity to the individuals, and the 15.3 percent is paid by the individual members of the LLC.
However, if your business is organized as a corporation, some income can be classified as reasonable compensation or salary, while other money you receive may be classified as distributions of company profits. In such a situation, a shareholder would only pay the additional Medicare and Social Security tax on the portion classified as reasonable compensation or salary. For example, if your business has $100,000 of income, as a sole proprietor or part of a single-member pass-through entity, such as an LLC, you will pay Social Security and Medicare taxes on the entire amount. If you form an S-Corporation, however, you may be able pay yourself a reasonable salary, for example, $75,000. The remaining $25,000 may, if determined to be proper by your accountant or bookkeeper, be classified as profits of the business, on which you would not pay the additional tax. This allows you to take advantage of the time value of your money as well as gives you an advantage in your tax and personal income planning if, for instance, your business income fluctuates yearly.
III. LLC With S-Corp Election for Tax Purposes: Best of Both Worlds?
If you’ve read the above closely, you may realize that new business owners are in a bit of a conundrum: organizing your business as an LLC allows you the most freedom insofar as business management and dealings, while organizing as a corporation allows potential tax and financial benefits. Luckily, in Colorado, a company that is organized with the Secretary of State as an LLC may elect to be treated as an S-Corporation for tax purposes. Thus, a business owner can get the organizational benefits of the LLC and the financial benefits of the S-Corporation. Proper planning with both your CPA and your attorney is key to maximizing your financial potential and minimizing your headaches. We’re happy to help you decide what is best for you.
Limited Liability Company vs. S-Corporation
Limited Liability Company
- Personal assets are secured from business creditors
- Owners are “members,” who may or may not have an active role in management. In a member-managed LLC, owners have management authority over decisions. In a manager-managed LLC, the authority to control tasks is held by managers.
- Allow foreign members and investment.
- Do not require annual meetings.
- More flexible in requirements for issuance of stock or ownership, obligations of managers and members, and corporate formalities necessary to maintain separate entity status under the law.
- Clear division between “control” of the LLC and ownership of the LLC, e.g. a manager-managed LLC.
- Pass-through entity: all income of a member is subject to FICA/Medicare taxes.*
- If a member guarantees a debt of the company, LLC gives member the ability to deduct more losses than that of an S-Corporation.
- Personal assets are secured from business creditors.
- Owners are “shareholders.” They elect a board of directors (which can be only one person), who then hire officers for the company.
- Do not allow foreign members and investments.
- Require annual meetings.
- Less customizable.
- Owners have control of the company in proportion to their ownership percentage.
- FICA/Medicare taxes only paid on “reasonable compensation” set by directors. Other business profit allocated to shareholders is not subject to that amount.
*LLC can make S-Corporation election for tax purposes.