Starting a business is exciting, but it also involves important legal and financial decisions that will affect your company for years to come. One of the most critical early decisions North Carolina entrepreneurs face is choosing the right business structure and properly establishing that structure to protect both the business and personal assets. Understanding your options for entity formation, the differences between various business structures, and the importance of proper setup helps you build a strong foundation for business success.
Separating Business Life from Personal Life
When starting a business, you really want to consider whether you are going to operate this business alone or with co-owners or partners. Regardless of whether you have partners, you really want to give some consideration to making sure that you are successfully separating your business life from your personal life.
This separation is not just conceptual. It has real legal and financial implications. Operating a business without proper structure means you are personally liable for all business debts and obligations. If the business is sued, your personal assets including your home, personal bank accounts, and investments are at risk. If the business incurs debt it cannot pay, creditors can pursue your personal assets.
Really, the best way to effectuate separation between business and personal life is to consider building a company around your operating business activities. This means forming a legal entity, a separate legal person in the eyes of the law, that conducts the business activities. This entity can enter contracts, own property, incur debt, and be sued, all separately from you as an individual.
Choosing Between LLC and Corporation
For that type of exercise, attorneys will usually work with clients to analyze their particular situation to determine whether, for instance, a limited liability company is a good fit or perhaps a corporation. A subchapter S corporation or subchapter C corporation might be a better fit for some businesses. There are really a number of factors that go into this analysis, so the decision is determined on a case by case basis.
Factors that influence this decision include the number of owners and their relationship to each other, the type of business activity, plans for raising capital or bringing in investors, tax considerations and the owners’ overall tax situation, plans for growth and potential sale of the business, and the owners’ preferences for formality and governance structure.
Understanding Limited Liability Companies
Most frequently, clients will form a limited liability company, and quite often that has to do with some of the flexibility that is allowed there with respect to tax filing status of the company. LLCs have become the most popular business entity choice for small businesses and professional practices because they offer significant advantages with minimal complexity.
One of the key differences between an LLC and an S corporation, for instance, is that with a corporation, an S corporation, you are going to be taxed as a corporation. Whereas with a limited liability company, whether you are an individual owner or you own it with a group of partners, you have the option of being taxed as a sole proprietor or partnership or being taxed as an S corporation.
This flexibility is powerful. A single member LLC can be taxed as a sole proprietor, with business income and expenses reported on the owner’s personal tax return on Schedule C. This is simple and straightforward. Alternatively, that same single member LLC can elect to be taxed as an S corporation, potentially providing tax savings on self employment taxes for profitable businesses. Multi member LLCs have similar flexibility, defaulting to partnership taxation but able to elect S corporation status if beneficial.
Understanding the Terminology
This tax flexibility can get a little bit confusing when you get accountants and attorneys talking to each other, because accountants will always look at this as the tax filing status, and they may call it the S Corp, when in fact it is legally filed as a limited liability company or an LLC.
This confusion is common and worth clarifying. When your accountant refers to your S Corp, they are referring to how your business is taxed, not necessarily how it is legally structured. You might have an LLC that is taxed as an S corporation. Legally, for purposes of liability protection, governance, and state filing requirements, you have an LLC. For tax purposes, the IRS treats your business as an S corporation.
Understanding this distinction helps prevent confusion and ensures you are communicating clearly with your advisors about both the legal structure and tax treatment of your business.
Working With Your Advisory Team
In any event, the most important takeaway is to be sure that you are talking with your team of trusted advisors to understand which business organization structure is right for you and your company. No article or general information can substitute for advice tailored to your specific situation.
Your advisory team should include an attorney who understands business formation and entity selection, a CPA or tax advisor who can analyze the tax implications of different structures, and potentially a financial advisor who understands how business structure fits into your overall financial planning. These advisors should communicate with each other and with you to ensure all perspectives are considered.
The decision about business structure is not just a legal decision or just a tax decision. It affects liability protection, tax obligations, operational flexibility, administrative requirements, and costs. Making this decision with input from qualified advisors helps ensure you choose the structure that best serves your overall goals.
Corporate Governance Documents
Once you have determined the appropriate business structure and formed your entity, the next critical step is establishing proper governance documents. Depending on the business structure or the corporate entity that has been built around the business, that will give some direction as to what types of business documents you want to have in place.
Generally speaking, these business documents are called corporate governance documents. They are the documents or the papers, if you will, that govern the actions of the company, of the corporation. These documents kind of give you a playbook or a detailed sort of schematic on how to operate or run your business.
For a company forming an LLC, a limited liability company, the governance document there that is going to be key is the operating agreement for the company. If it is a corporation, either subchapter S or subchapter C or something like that, the company’s governance documents are typically a shareholder agreement and bylaws.
What Governance Documents Cover
Things that are covered in these agreements are everything from the purpose of the company and why it has been founded to what is the ownership makeup and how many owners are there. For limited liability companies, we call the owners members. For corporations, we call the owners shareholders.
Beyond identifying owners, governance documents establish each owner’s percentage interest, initial capital contributions, obligations for additional capital contributions if needed, and how profits and losses are allocated among owners. These provisions prevent disputes by clearly establishing the financial arrangement from the beginning.
The operating agreement for the LLC or the shareholder agreement and bylaws for the corporation will also help outline the operating structure of the company. In other words, are there managers of the company or are there directors of the company? Is there a board of directors? Are there officers like a president, a vice president, a treasurer, and so forth?
These documents will give direction as to what types of authority these people have. Can they sign and bind the company to legally binding contracts? Are they able to borrow money on behalf of the company? Are they able to hire and fire new employees of the company? Establishing clear authority prevents situations where third parties are uncertain whether someone has authority to act on behalf of the company.
Governance documents will give some direction as to certain tax considerations and tax filings, and the way that money gets distributed from the company to the ownership group. Distribution provisions are particularly important because they establish when and how owners receive money from the business. This might be based on ownership percentage, or there might be different classes of ownership with different distribution rights.
Buy Sell Provisions
The governance documents will also often cover what happens in the event of death or disability, or insolvency, or divorce of one of the owners. These are triggers that we refer to as buy sell triggers. Buy sell provisions are among the most important provisions in any multi owner business, yet they are often overlooked or given insufficient attention.
These provisions answer critical questions: What happens if one owner dies? Can the deceased owner’s spouse or children become owners? Or must the business or remaining owners purchase the deceased owner’s interest? What happens if an owner becomes disabled and can no longer work in the business? What happens if an owner gets divorced and their spouse might be entitled to a portion of the business interest?
Really there are a lot of particulars that go in governance documents that serve to set the stage or set the chessboard so that if an event happens later, this is where we look to understand how it plays out, who is affected, who has the legal rights, and what types of notices and actions have to take place in order to effectuate operations and or changes of the business.
The Belt and Suspenders Approach to Protection
Business owners often come to attorneys with legal needs, and legal counsel can absolutely help structure and implement corporate organization around the operations of the business. That does a lot to separate the business operation from the personal owner’s day to day lives. It helps to insulate around liability and mitigate risk. But it is not always enough.
Really, there is almost sort of a belt and suspenders approach. Insulate your company by building a corporate structure around it, the belt, but then also exercise the appropriate suspenders, if you will, with the appropriate business insurances.
Business insurance includes things like property and casualty insurance, which covers damage to business property and liability for injuries that occur on business premises or result from business operations. Workers compensation insurance is required in most states once you have employees and covers medical expenses and lost wages for employees injured on the job. Depending on where the business might be located, you may need flood insurance or perhaps insurance on certain particular assets of the business.
Because remember, while you can forecast and plan for a lot of risk around your business and protect for it by constructing a corporate organization, there are still some events that are just going to happen as a part of life and a part of business that the company is not going to shield you from. You are going to need insurance products there to insure over it and make sure that if there is a claim made against the business, there is an insurance policy there to defend and or pay in the case of a valid claim or settlement.
Financial Setup and Banking
The most critical financial concern around a business when starting out is making sure that you are establishing the appropriate types of bank accounts for your business. This may sound basic, but it is an area where many business owners make critical mistakes that can undermine all the protection and structure they have carefully built.
Business owners, particularly successful ones, quite often start out very quickly. They have not done a whole lot of incorporating or formation of an LLC. They are just kind of working on it from their garage or from home. Then before you know it, boom, they are successful. All of a sudden this is a business and it is providing a service or a good that people want and need, and then that business becomes something of value.
At that point, you have to work to build a corporate structure around the business. While the business owner has been becoming a successful entrepreneur, they may or may not have stopped to think about whether they are paying for business expenses with the right type of account or the right money from the right place.
One of the things advisors always encourage and like to work with clients on is to make sure they understand that as you incorporate your new company or as you form your new limited liability company, make sure that you are utilizing the federal Entity Identification number that comes along with that company to go ahead and open company bank accounts now, and make sure that you are funding that company account with revenue from the company and you are paying expenses from that company.
Working with a strong CPA team and bookkeeping team to make sure that financial management is done correctly is highly encouraged. Proper bookkeeping is not just about tax compliance. It is about maintaining the corporate structure that protects you.
The Danger of Co-Mingling Funds
One of the quickest paths to defeating the purpose of your company is co-mingling of funds. You helped form the company to insulate your business activities from your personal life and mitigate liability and risk. One of the quickest ways to pierce that liability shield around the company is if there is what is called a co-mingling of funds. In other words, business dollars that are inaccurately or inappropriately co-mingled with personal dollars.
Piercing the corporate veil is a legal concept where courts disregard the separate legal existence of the company and hold owners personally liable for business debts or obligations. Courts do this when the company has not been treated as a separate entity, and co-mingling of funds is one of the primary factors courts look at.
You really want to make sure that your books and your records are clean and that you are keeping finances from the company separate from your personal finances. This means never paying personal expenses from business accounts, never depositing business revenue into personal accounts, maintaining separate credit cards for business and personal use, and keeping meticulous records that clearly distinguish business and personal transactions.
Building Your Advisory Team
If you are a business owner or you are thinking about starting a business, just know that you are not alone. People are doing it all the time. The most successful folks understand that they cannot do it all by themselves, and they should not do it all by themselves.
As the business owner, you should think of yourself as the president or the CEO of your organization, and what you should be doing to make the most effective decisions is gather information from teams of advisors, people that are in places and areas that you may not be as strong.
Whether it is your CPA team or your financial advisory team or your legal advisory team, you want to make sure you are assembling that team around you to give you the best advice possible to set you up for success.
Starting and running a business involves countless decisions, and having advisors who understand business formation, tax strategy, financial planning, and legal protection helps ensure those decisions support your long term success. These advisors are investments in your business, not expenses. The value they provide in helping you avoid costly mistakes and structure your business properly far exceeds their fees.
If you are starting a business in North Carolina or need to ensure your existing business is properly structured and protected, NC Planning can help.
