Entity Formation Mistakes to AvoidStep 4: Corporate Formation Strategies

When to Form Another Entity?

There are a lot of steps to properly protect your business and your family. 

Here’s a common question that is important that comes up often: “When should I form another entity for my business?”

Actually, the more I think about it, that question is not as common as it should be. It is like the quote on common sense: “It is not as common as it used to be”!

As you know, lawsuits are filed at an epidemic rate these days, and it’s only predicted to get worse.

As uncertainty in the stock market is increasing again, global tensions, trade wars heating up… you’d be well advised to prepare yourself to hold onto your net worth!

When should you consider a second entity for your business? Should you wait until after your first year… two years… a certain revenue landmark of a $1 million? No. The answer is based on your risk tolerance and some basic common sense.

First, the longer you have been in business, the riskier it is to operate under one legal entity. If your business has been around for 10-15 years and is operating entirely out of one legal entity, that’s an extremely dangerous position to be in. Why? Just one lawsuit against that single entity can destroy 10-15 years of hard work. The saying, “Don’t keep your eggs all in one basket” would be well applied to your business assets!

Perhaps your domain names are responsible for a great amount of traffic to your website. In that case, you may want the ownership of your domain names held by another legal entity separate from that of your operating business.

Operating as a C corporation? Who owns the stock of your company? If you do personally, that could be an enormous problem. Why? Consider this true story:

One business owner’s 17-year-old son had a DUI and seriously injured someone in a car accident. The family was sued personally for $4 million, and though their insurance covered $1 million, they were PERSONALLY on the hook for the other $3 million. Their biggest asset? Ownership in the C corporation that ran their $3 million business. That business was lost entirely — a devastating situation that could have been prevented had the owner put another entity in place.

One way to protect your business is to have an LLC hold the ownership of the stock of the C corporation. (See the diagram below.) The LLC has an extra layer of protection called the “charging order” which makes it more difficult to lose control of the operating business. (By the way, a living trust does NOT protect assets from liability, only from probate and estate taxes. This mistaken belief is the number one reason in my opinion that so many Americans have almost no asset protection.)

1. C corporation with stock owned by LLC taxed as a partnership: 

When used: When the C corp has a high net value or grows enough to need protection from personal lawsuits.

Even if you have an LLC for your operating business, if one partner is sued for something unrelated to that business, a “charging order” will help protect the ownership of the LLC (though it still may be very disruptive to the operating business.)

A “charging order” makes it more difficult for the creditor to get access to an ownership interest of the operating LLC. But the suing party may subpoena bank records of the operating business to gain access to more financial information.

This especially happens when two people start a successful business together. It’s amazing to see how quickly people come out of the woodwork looking for handouts! How can you prevent this from happening?

Have both partners form a second LLC to own the ownership interest in the operating company. Now if there is a legal issue with one owner, it will only affect that person at their own personal LLC level, not at the LLC that’s operating the business.

Most partners ask me, “Can we do this second layer later?” Yes, but you run the risk of putting it off until it’s too late.

Sadly, once most partners are of the planning and foundation stage, most never return to take that second crucial step, which is a big mistake.

2. LLC with members also LLCs

When used: When an LLC does a high enough net profit that it’s worthwhile for the entity to be protected from any of the members’ personal liability. You would prefer these LLCs to only own a safe asset, which is the membership interest in the main operating LLC, not own real estate or other risk assets.

Do you need support to form another entity to prevent any of the above costly mistakes? If so, click on this link to learn more about our complete formation packages. State fees are separate and we do incorporate in all 50 states (not just Nevada).

What do others say about working with NCP? Go to this link to watch, listen, and read feedback from our valued clients.

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