For example, if
you owned a plumbing supply business and some rental properties,
you may want to put the plumbing supply business into a
corporation and the rental properties into a limited liability company
or LLC. If someone sued your plumbing supply business, it would
not affect your rental properties and vice versa.

The disadvantage
of using separate legal entities for different businesses is that the
amount of bookkeeping and tax reporting requirements always
increases. From a practical standpoint, you have to weigh the benefit
of the protection of separate entities against the increased work and
cost to operate them.

The law also allows you to operate a business in one of several different forms or entities such as a corporation or limited liability company (LLC), etc. If the business is operated as a separate legal entity, then the business is considered separate and apart from its owners. Therefore, if the business is sued, only the business assets can be taken to satisfy or pay a judgment. Your personal assets are protected. This is called limited liability protection. This protection is valuable and a good reason to do business as an entity. However, the protection is not absolute or 100% guaranteed, but is conditioned on the proper organization and operation of the corporation.

When a lawyer sues a business entity, he or she will usually sue both the entity and the owners individually. This is because lawyers know the entity often does not have sufficient assets to satisfy or pay the claim. However, the law requires the person suing to prove that the entity, the corporation or LLC, was not properly organized and operated as a separate legal entity. The legal terminology is called “piercing the veil.” If the court allows “piercing the veil” then a judgment can be obtained against the entity and the individual owners. However, if the court determines that the party suing has not proven their case, then the limited liability protection applies. The person suing might still be entitled to a judgment against the entity but not against the individual owners and their personal assets.

The key is to organize and operate your entity, corporation or LLC, properly so that you have a strong argument, if you are ever sued, so that you are entitled to the limited liability protection. Organizing and operating the entity properly is not difficult, but there are certain steps or procedures that should be taken to help insure your protection.

It has been suggested that the liability treatment of S
corporations (which are treated just like regular C corporations for
liability purposes) is more predictable than LLC’s because they have
been available for many more years than LLC’s and have a
substantial body of legal cases which act as precedents in
determining issues of liability. LLC’s are relatively new and there are
fewer legal cases to help predict issues of liability.

Both S corporations and LLC’s are pass-through entities for tax
purposes. The entities file an informational tax return but the
individual owners, which are called shareholders in an S corporation
and members in an LLC, report income and/or losses on their
individual tax returns.

There are some differences in the way basis is determined for the
purpose of determining losses. A discussion of tax basis is beyond
the purpose of this book but can be discussed with your tax advisor.
Just keep in mind that if you are expecting substantial losses in the
early stages of the business or if you are borrowing substantial sums
of money for your business, the LLC may allow you to write off
greater losses than you could if operating the business as an S
corporation.

Sole Proprietorship – Occurs when a singleindividual engages
in business (in some states a husband and wife business might
be considered a sole proprietorship). The advantage of the
sole proprietorship is the ease of starting. There are usually no
formal requirements to do business as a sole proprietor, except
that some states require a general business license for all
businesses, regardless of the form or entity. The big
disadvantage of the sole proprietorship is the risk of liability. If
someone sues the business and gets a judgment, they are
entitled to satisfy (collect) on the judgment by going after not
only the business assets but also the personal assets or
property of the individual owner of the business.

Partnership – Is generally defined as the operation of a
business for profit by two or more individuals. The advantages
and disadvantages of a partnership are similar to that of a sole
proprietorship. A partnership is fairly easy to start with few
formal requirements in most states. A written partnership
agreement is not required but is certainly recommended.
However, the risk of liability becomes more pronounced in a
partnership because each individual’s personal assets are at
risk for the actions of the other partners as well as their own.

Regular or C Corporation – This basic corporation is another
legal form or structure for conducting business that is
authorized by all states. Corporations have sometimes been
called legal fictions, meaning they exist only because the state
law authorizes their existence. Corporations were first
authorized by state laws to provide a form of doing business
where a person could invest money in a business venture
without subjecting their personal assets or property to liability.
Corporations are considered separate legal entities from the
people who own them, the shareholders. Thus, if a corporation
is sued and a judgment from a court is rendered against the
corporation, the law allows the judgment holder to satisfy the
judgment (collect or get paid) only from the assets of the
corporation and not the private property of the shareholders.
This is called limited liability protection. In a sole proprietorship
or partnership, a judgment can be satisfied from the personal
property of the individual owners of the business if there are
insufficient business assets to satisfy the judgment. A
corporation is a taxable entity and must pay income taxes on its
net income each year. The corporation must file a return on IRS
form 1120.

S Corporation – An S corporation is initially formed as a
regular or C corporation and is operated and treated like a C
corporation for all purposes except for taxes. An S corporation
provides the same liability protection as a regular C
corporation. The shareholders can elect to be taxed similar to
a partnership by filing the S election form (form 2553) with the
IRS. An S corporation possesses the important characteristic of
being a “pass-through” entity for federal and (most) state
income tax purposes. A pass -through entity is one in which
the profits or losses are not paid by the entity but rather are
reported by the owners (shareholders) on their individual tax
returns. This is done on a prorata basis depending on the
shareholder’s percentage of ownership. An S corporation is
required to file an informational tax return on IRS form 1120S.
The S corporation offers the two main benefits that most small
business owners seek; 1) limited liability protection and; 2)
pass-through of income and losses for tax purposes.

Limited Liability Company (LLC) – The limited liability
company or LLC is a non-corporate business entity formed
pursuant to authority by a state statute that provides its
owners protection against personal liability from creditors and
other third parties. While other business entities like
corporations also provide protection from creditors, an LLC
possesses the important characteristic of being a “passthrough”
entity for federal and (most) state income tax
purposes. A pass-through entity is one in which the profits or
losses are not reported by the entity for tax purposes but
rather are reported by the owners (members) on their
individual tax returns.

The LLC form of business offers the two main benefits that
most small business owners seek; 1) limited liability protection
and; 2) pass-through of income and losses for tax purposes.

Corporations have sometimes been called legal fictions, meaning they exist only because the state law authorizes their existence. Corporations were first authorized by state laws to provide a form of doing business where a person could invest money in a business venture without subjecting their personal assets or property to liability.

Corporations are considered legal entities, separate and apart from the shareholders or people who own them. Thus, if a corporation is sued and the court rules against the corporation, the law allows the judgment holder to satisfy the judgment (get paid) only from the assets or property of the corporation and not the private property of the individual shareholders. This corporate attribute is called limited liability protection. In a sole proprietorship or partnership, a judgment can be satisfied from the personal property of the individual owners of the business if there are insufficient business assets to satisfy the judgment.

Not only do corporations owe their existence to state law, but they are also governed and regulated by the corporate laws of the state in which they are incorporated and/or in which they choose to do business.

Note: If a corporation sells stock, it may also be regulated by state and federal security laws.