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  • Writer's pictureDavis Yu

Consequences of Improperly Forming a Business Entity

March 29, 2024


With many options to select from, determining which legal entity is right for your business may be difficult. It is important to thoroughly research and understand your options to ensure that you are not exposing yourself or your business to potential risks and lawsuits. The following are a few of the consequences that may result from improperly forming a legal entity or selecting the wrong entity for your business.


Personal Liability Exposure


Some but not all business entities provide liability protection preventing any personal assets from being at risk for the business’ debts and obligations. Unlike a limited liability company (LLC) for instance, a sole proprietorship offers nearly no protection against personal liability. If a customer gets injured on the premises or a court judgment to recover funds is enforced, your personal assets can be accessed. Your wages and bank accounts can be garnished, and liens may be placed on your property.


With entities that insulate personal assets, your business is separate from the owners of the business. There are corporate formalities that must be met, which include filing documents with the Secretary of State. However, these entities are not completely foolproof if the owners fail to treat the business like a separate entity. Acts that include commingling personal and business assets, falsifying documents, or engaging in fraudulent misconduct can eliminate these protections, resulting in your personal assets being at risk.


Taxes


The different types of business entities tend to have different tax consequences. For instance, a partnership is a pass-through business. This means that any income or loss of the business will be reported on the owners’ individual tax returns. Conversely, a C-corporation (C corp) is subject to double taxation; once on the corporation’s tax return and second on each shareholder’s individual tax returns when profits are distributed through dividends. Depending on the business’ financial circumstances and long-term goals, a C corp structure may be advantageous for some. However, it is crucial that you speak with your own attorney and tax advisor, as each set of circumstances vary.


Limitations on Business Ownership


Each business entity will have different rules on who can own or have a share in a business. With a sole proprietorship, there can only be one owner whose ownership cannot be transferred, and the business will dissolve upon that owner’s death. With a corporation, generally shares are transferable. An owner can elect for their corporation to be an S corp, which is a specific tax designation. An S corp cannot have more than 100 shareholders, and the shareholders are required to be US citizens or residents. On the other hand, C corps have no such restrictions.


Suspension or Termination of the Business


After forming a business and filing required documents with the Secretary of State, some business owners may think that their job is done and they can solely focus on their business’ profits and growth. This is certainly far from the truth! Some business entities require strict compliance with corporate formalities in order to remain an active business in the state. For instance, business owners will need to create and abide by their bylaws or an operating agreement, designate an individual or entity for service of process, hold and keep minutes of annual meetings, and more. Failure to maintain such practices may put the owner’s personal assets at risk for the business’ debts or legal fees or recovery arising from lawsuits. Additionally, the state may require the business to temporarily suspend its operations or terminate indefinitely for failing to comply.


Conclusion


Doing research on which business entity will work for your business is extremely crucial. The formation of an incorrect business entity can prove to result in more detrimental consequences impacting your business’ reputation, increasing exposure to lawsuits, and leading to additional expenses. If you are contemplating creating a legal entity for your business, careful planning and preparation is essential to avoid costly mistakes. Consult with an experienced business attorney to guide you through this process.


All information provided is strictly educational and does not constitute legal advice. Any past or previous results do not guarantee future outcomes as results may vary. For legal advice, please consult with a licensed attorney.















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