Reasons to Incorporate: From a Lawyer’s Perspective
Most people think that increasing their tax efficiency is the reason to discuss business formation with a professional. Although tax considerations are important, from a lawyer’s perspective, several other reasons to incorporate exist and should be at the forefront of any new business owner’s mind. Protecting your personal assets, understanding your contributions to the business and your authority within the business, considering your exit strategy, and thinking about ways in which your specific business creates areas for liability should be at the forefront.
In this article we’ll discuss the reasons to form a business entity from a lawyer’s perspective.
(1) Limit your liability
In the United States, legal entities are considered people under the law. So in the same way that you can’t be sued for your brother’s debts because he’s a separate person than you, an individual can’t be sued for his business debts because the business is a separate legal entity. Now, to be clear, there are scenarios where that doesn’t hold true such as if you’ve made a personal guaranty on behalf of the business or if you don’t properly observe the separateness of your business (a concept known as “piercing” which we’ll discuss in another post). But generally speaking, the two are separate and your personal assets are protected from your business debts.
(2) Clarify who owns what and when
Business partners can be a lot like siblings. They love each other deeply but disagree on some fundamental things. In business, this manifests itself when partners begin to disagree about each other’s contributions and the value thereof. Inevitably, there will be uneven contributions. One person will be the brains of the operation. One person may be the brawn. And a third person may be the bank. Well, what happens when the brains, brawn, and bank disagree about the value of their contributions? If there’s no formal business entity, everyone owns an equal share. Forming an entity, if done correctly, forces the parties to discuss the value of their contributions and how those contributions will be represented in ownership and management of the business. It also gives the parties an opportunity to discuss and decide how and when partners may exit the business. These are important things to discuss early. When it is discussed too late, it is very reminiscent of the most bitter of sibling rivalries.
(3) Set rules for operation and governance
When a business entity is formed, usually a governing document follows and it spells out the rules of how the organization will be governed. Each business entity has a default statute where if there is no agreement, the statute governs the business. A specifically tailored agreement provides order and structure for a business so that it can operate with rules rather than running like the Wild Wild West.
Although a new business owner should discuss these issues with a lawyer, it is also important to discuss the tax consequences of their formation and entity choice with a tax professional.