Forming Your Business Entity

Posted on October 17, 2018
Sola Salon Studios

In our 5 Business Tips from an Attorney blog, attorney Christopher Matthew, and owner of Dillinger’s Hair Company touched on the importance on why you should form a separate business entity, either a corporation or an LLC. We asked him to explain those reasons in more detail because, let’s face it, not everyone has the opportunity to get free, helpful advice from an attorney!

“As a business owner, there is little reason to operate without a forming a separate entity,” Chris shares. “There are three main reasons to open a separate business entity such as a corporation or LLC. The first is to protect your personal assets against liability. The second is to minimize some of your tax liability. And the third is to communicate credibility to third parties and the public. There are other benefits but we are chiefly concerned with these three.”

Liability Protection

The most important reason to form a separate entity for your business is to shield your personal assets from liability. Liabilities are claims against the assets, or legal obligations of a person or organization, arising out of past or current transactions or actions. If you open your shop by yourself, you are a sole proprietorship. If you open with one or more co-owners, you have formed a partnership. No paperwork needed.

As a sole proprietor, you have unlimited personal responsibility for the debts of the company. As a partnership, you also have unlimited responsibility for the debts of the company.

Further, partnerships have joint and several liability, meaning debts are not necessarily satisfied on a 50-50 basis. This means if your partner is personally worth $36.45 and lives in his station wagon and you are worth $4.2 million and have three homes and a pet leopard named Sven, all of those assets can be used to satisfy the entire debt, even if it was your partner’s fault. A lawsuit could bankrupt you while your partner would just be $36 lighter in the purse.

Additionally, a judgment can follow you and attach to future earnings. If you were to get a job down the road, your paycheck may be used to satisfy past judgments.

*NOTE: If you share a suite at Sola, you may be operating as a partnership in the eyes of the law, even if you work as individuals.

Certain entities such as corporations and limited liability companies (LLC) have built-in protections known as the corporate veil. Generally, creditors cannot go beyond or pierce the corporate veil and hold the individual shareholders responsible for obligations of the company; even if the company only has one shareholder. This means that business owners can protect their personal assets (house, car, Maltese Falcon) in the case of a judgment against the company.

Essentially, by forming an entity with your state and following a few formalities, such as keeping a separate business account, getting a separate Employer Identification Number (EIN) and keeping good corporate records, you get yourself the same robust protection that the big boys and girls get. Thank you, Apple and WalMart lobbyists!

Tax Benefits

Forming an S Corp or LLC gives you certain tax advantages over sole proprietorship or partnership. They are what are known as pass-through entities. At the corporate level, these entities are not taxed by the federal government. The income and losses flow through to the owner’s personal tax returns. This is helpful in the startup phases of your company. For instance, if you make $100K at a day job as an educator and your new salon loses $20K on its books, you can subtract the loss from your taxable income.

I generally choose an S Corp for non-real estate deals because aside from the traditional write-offs available to the business (rent, travel, meals, supplies, etc.) you can also save big on self-employment taxes. You see, being that you own shares in the corporation, you can get dividends or distributions. These distributions are not subject to self-employment tax as they are categorized as passive income. As such, you can take a “reasonable salary” (no hard rule on how to calculate this) based on your vocation and income, and take the rest as distributions. These distributions are taxed at a lower rate, thereby saving you more money in taxes.

NOTE: The S Corp does have certain restrictions on ownership (most will never affect us). There can only be 100 or fewer owners, which all must be individuals that are US citizens or residents (or their living trusts). This means another entity, like an LLC, cannot own shares in the S Corp. If the restrictions aren’t followed, the IRS will decide the corporation is C Corp and tax them accordingly.

Also, the S Corp has only one class of stock and certain record keeping requirements. As business owners, we should be keeping these records anyway, so it is not a reason to not choose an S Corp.

Credibility

Credibility is another reason to form an entity. When you operate like a real business, people treat you like one. When clients write a check to XYZ Hair, LLC or get a receipt for ABC Lashes LTD., it signals to them that they are doing business with a professional.