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Should You Be Switching Your Business Entity To Protect Your Business From Further Loss?

by Dustin Ray of Incfile

The COVID-19 crisis has caused many businesses of all sizes to re-evaluate their plans and pivot their business models. If your company has been suffering from losses or is exposed to risks because of this pandemic, you may want to consider changing your business entity.

Switching your business entity can help you mitigate risks and losses by providing better options for filing taxes, managing your personal risks and more. Here are a few reasons changing your business entity can help protect your company from losses during these uncertain times.

Better Personal Liability Protection.

If you are currently operating your business as a sole proprietorship, this means that your business doesn’t really “exist” as a separate legal entity from yourself. You as the business owner are also “the business.” If you make a mistake or cause harm to someone while doing business, you might get sued and be held personally liable for the damages. If your business is unable to weather the current economic storm and has to close or file bankruptcy, you can be held personally liable for any outstanding debts.

Switching your business entity from a sole proprietorship to an LLC, a C Corporation or an S Corporation can reduce your personal liability for business-related lawsuits and losses. Setting up a legal business entity for your business creates a “company” that is different from your personal identity and separate from your personal finances.

Of course, the personal liability protections are not 100% impenetrable; you will still need to manage your business and personal finances separately. But without the personal liability protection of the “corporate shield” provided by a legal business entity, your personal finances might be vulnerable to a lawsuit or bankruptcy.

Easier Access to Capital, Business Credit and Loans.

The COVID-19 crisis has shown the importance of having a solid financial foundation for your business, with good access to credit and at least a few months of cash reserves. Many businesses – small and large – have seen their vulnerabilities revealed by this crisis. Many do not have an adequate amount of cash to weather the storm and have to scramble to apply for government emergency loans and grants.

Applying for a business loan as a sole proprietor is often categorized as a personal loan by the lender because of the lack of distinction between business and personal finances. This leads some banks to see sole proprietors as a riskier investment, and they may limit your terms or approval amount. Switching your business to an LLC, S Corp or C Corp lessens the risk barrier for banks and can help you get a business bank account, loan or credit card more easily.

If you want your business to grow faster by taking on investors and raising venture capital, you might want to switch your business entity from an LLC to a C Corporation. The C Corporation is often the best choice for companies that want to take on capital from investors or sell shares of stock.

Sell Shares/Take On Business Partners.

If the current crisis has reminded you that you don’t want to be in business by yourself, setting up a legal business entity can help you bring business partners, shareholders or co-owners on board. It’s not possible to sell or divide ownership of a sole proprietorship. But if you set up a legal entity for the business, such as an LLC, you can write a clear, valid partnership agreement that lets you keep doing business while protecting everyone’s legal rights and financial interests.

What if you want to sell shares of stock, take on investors or have more flexibility in the ownership of your business? In that case, an LLC might not be the right fit for your longer-term growth plans. Setting up your business as a C Corporation, or converting your LLC to a C Corporation, can let you publicly sell shares of stock or take on financing from venture capital investors.

You can also convert your LLC to an S Corporation to bring other owners into the business. But keep in mind that an S Corporation must have less than 100 shareholders, and the S Corporation’s shareholders must be U.S. citizens. If you want foreign shareholders to be able to own part of your business, you need to set it up as a C Corporation.

Manage Tax Burdens.

If your business is currently a sole proprietorship, you are potentially paying a lot more money at tax time than you need to be. Sole proprietors have to pay a double portion of self-employment tax — both the employee and employer’s portion. This could amount to 15 percent of your total income, even before you pay state or federal income tax.

You can reduce this tax burden by creating a legal business entity, such as an LLC, and then electing to be taxed as an S Corporation. This changes the tax treatment for part of your business income; instead of paying double self-employment taxes on your entire business income, you only have to pay that tax on the salary you pay yourself. The remaining amount of your business income is treated as a “distribution,” which is not assessed for self-employment tax.

There might also be tax-related situations where it makes sense to switch from a C Corporation to an LLC or from an LLC/S Corporation to a C Corporation. For example, if you currently have a C Corporation and your co-owners want pass-through taxation, you could switch to an LLC.

Or if you currently have an LLC that is owned by multiple members who have high income and are paying a high marginal tax rate on their income from the LLC, it might make sense to switch the company to a C Corporation so they can pay a lower corporate income tax rate on the business income.

Check with your accountant or tax professional before deciding to make a change in your business entity; not every company or business owner will be better off under a certain type of business structure. Choosing the right business entity can be complicated, and you may want to change your business structure to suit the changing needs of your business. Whatever happens next with the economy, having the right business entity can help your business maximize your growth potential while managing your risks.

 

Dustin Ray leads business development and growth initiatives at Incfile, a national online incorporation service company specializing in business formation and small business services. At Incfile, Dustin’s primary focus is to grow revenue and secure strategic partnerships that compliment a set of robust services to help entrepreneurs launch new businesses.

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