What Is a Legal Entity, Anyway?
If you are a sole proprietor, you are your business. Even if you adopt a name for your business as a branding strategy, you’re just wrapping yourself in a label. From every meaningful perspective there’s no division between a sole proprietorship and its owner.
Perhaps the most important thing distinguishing sole proprietorships from legal entities like LLCs and corporations is that legal entities have a separate existence from their owners. They come into being by complying with state laws, and once they’re organized they are treated, in a strange way, like people. In fact, legal entities have a wide range of rights and privileges that living, breathing people enjoy. These rights and privileges are why people often speak of corporate personhood. Although a legal entity can’t feel pain, get sick, or get thrown in jail, it can enter into contracts and own property, and even enjoys constitutional rights like free speech.
You can think of a legal entity as a fictional person who lives in a three-ring binder. A few things that go into the binder are dependent on state law and tax rules, but many of the details are left up to the business owner. It can be useful to think of legal entities as legal fictions because like fictional characters their qualities are largely up to the person drafting their paperwork. Many corporate lawyers earn their living shaping the “character” of their clients’ business entities. The right words can lower your tax bill and reduce or eliminate your personal liability. But this raises a final point about the fictive nature of business entities: even though they only exist on paper, they can have very real effects on their owners’ financial wellbeing.
Although business entities are subject to wide range of rules, from federal taxation to local licensing, they are first and foremost creatures of state law. Specifically, to exist at all, a business entity needs to be formed according to the rules set out in a state’s business-related statutes. The steps required to create a legal entity depend on the form the entity will take.
Forming a legal entity requires filing paperwork and fees with a state’s business regulator, typically a branch of the secretary of state’s office.1 The paperwork can be filed in person, by mail or, in some states, online. Once the entity’s formation paperwork is on file, it becomes a “person,” able to enter into contracts, own property, sue or be sued, and accumulate tax obligations.
Can I Form a Legal Entity Outside of My Own State?
Although you can form a legal entity in any state, it’s unlikely to be a good idea for most freelancers to organize outside of their home states. Large organizations often form entities in distant jurisdictions for various reasons. For example, Delaware is a popular place to incorporate in because its corporate laws are flexible, simple, and favorable to business, especially businesses that plan to go public.
Every state requires companies that are formed elsewhere and do business within the state to register as a foreign business entity. Such registrations cost money, both at the time of filing and on an annual basis. These are in addition to the fees to maintain the company in the state where it is organized, which probably will include a special service fee paid to a local service agent to accept service of process on behalf of the company. Depending on your situation, there can also be tax consequences for being located, or simply working or selling products, in multiple states. These costs aren’t likely to make sense for a freelance business that otherwise might want to take advantage of some legal technicality available in another state’s laws but not available where the freelancer lives. Of course, freelancers who work in multiple states, such as those who split time between two homes, will need to address this issue to stay in compliance. If you think you may be subject to more than one state’s rules, it might be helpful to talk to a legal professional to find out what’s involved.
Getting Organized
Organizing a legal entity involves more than just submitting paperwork with the state. It also requires attending to the formalities of governance. Each kind of legal entity has a different set of formal requirements, determined by state laws and the company’s organizing documents. Some of these arise when the company is formed, while others crop up over the course of the business’s existence. Some, such as business licenses and periodic reports, are public documents that get filed with local and state authorities. Others, like the company’s operating rules and business records, are kept private. Taken together, the formation documents and the ongoing governance documents form the “person” of the legal entity. We’ll take a detailed look at how these things work for limited liability companies and corporations in the next two chapters. For now, it’s worth looking at a few ideas that apply across the board.
•Documenting approvals
Newly formed business entities customarily need the approval of their owners or management to complete the organization process. This might include approving the owner’s initial investment in the company, the appointment of a manager or officers, or establishing the company’s tax year. Documenting these formal approvals is important to ensure that no one can question the validity of the company’s formal organization. You don’t want to skip this step only to discover that you have been signing contracts on behalf of your company without having given yourself the right authority. Some organizations accomplish these approvals with meetings, while a freelancer is probably going to use written consents instead.
The ownership of a legal entity needs to be carefully documented. In some cases, evidence of ownership may be integrated into the company’s organizing documents. In others, it gets written down in a simple document that sets out basics like what the owner owns (say, 100 shares of stock, or 100 percent of an LLC’s membership interests) and how much it’s worth. If your state requires companies to issue a physical representation of ownership, there’s no need to buy fancy certificate paper unless you’d like something to hang on your wall. Ordinary paper works just fine.
•Business licenses and local tax registrations
Every business needs to hold a license issued by local authorities, usually the county where the business operates. Some cities impose additional licensing or tax rules for businesses operating within city limits. The new entity will need to hold its own licenses and registrations. If you already have a business license for your sole proprietorship you will need to get a new license for the legal entity. Depending on the rules of your jurisdiction, you may want to cancel your old business license, or allow it to lapse. Be sure to understand local requirements before making any business structuring decisions.
Keeping Up the Fiction: Corporate Separateness
Respecting the separate existence of a legal entity is vitally important for preserving its liability protections and avoiding tax problems. Intermingling personal and business assets is awfully easy to do when you are the only person involved in a business. Maintaining the distinction between your personal and business matters takes a little effort, especially when the company is first getting organized, but it’s important.
The following important steps are necessary to preserve separateness. If doing these things ever starts to feel tedious or inefficient, remember that they are all helping to maintain a legal fiction. The story might be dull, but it needs to be complete to do its work.
•Separate money matters
Mixing personal and business finances is one of the cardinal sins a business owner can commit, even as a sole proprietor. This is because the Internal Revenue Service (IRS) can use mixed finances as an excuse to disallow deductions for all business expenses paid out of a mixed account, on grounds that the deductions were personal expenses. For an owner of a legal entity, mixing finances can also undermine the owner’s liability protections. To avoid these expensive pitfalls, every business needs to have its own bank account, preferably at a separate bank from the owner’s personal accounts. It should also have its own cash management tools if the business needs them, such as a separate account with an online payment service (such as PayPal or Venmo) and a separate credit card, if your business needs one.
•Separate financial records
In addition to keeping scrupulous records of the company’s earnings and expenses paid from its own account, including receipts and other documentation, the owner needs to track any costs the owner incurs on behalf of the company as a reimbursable expense. For example, a freelancer might buy office supplies using her personal credit card and later reimburse herself through a transfer from the company’s account to her personal account. Both the purchase of the supplies, with receipts, and the expense reimbursement should be recorded on the company’s books. This not only avoids a question of intermingling funds but it also avoids the reimbursement being treated as salary that is subject to income and employment taxes. Ideally, the business avoids this problem by buying supplies using its own cash.
•Separate assets
The company should own the equipment and supplies that it needs to run the business, and the owner should avoid using these assets for personal purposes. If the business requires a computer, ideally the company owns a separate machine from the owner’s personal computer. This will let the business deduct more of the computer’s cost as a business expense, and ensures that the owner’s personal computer doesn’t inadvertently end up being treated like an asset of the business if the company gets into financial trouble. Making too much personal use of business assets is one way creditors can show that you aren’t treating the business as separate from yourself, which can undermine your legal entity’s limited liability protections. We’ll get into this more in Chapter 5.
Keeping the company in compliance with state and local laws is crucial. Compliance means filing required reports, fees, and taxes when they are due, maintaining business licenses, and documenting any required corporate governance procedures. Most jurisdictions mail out reminders of important reporting and licensing deadlines, but it’s always a good idea to keep these dates on your business calendar. If your company needs to go through some internal motions to satisfy state law rules, such as the annual re-election of a corporation’s director, you’ll need to remember to document those actions.
•Recordkeeping
The business entity’s formal records (state and local filings and reports, written management approvals, business licenses, and so on) should be kept together in a minute book. The minute book can be a binder or a file folder. Some states still require companies to retain original hard copies of certain things, but it can also be useful to keep digital copies of everything, in case someone (a bank or credit card company, for example) asks for an electronic copy of a business record.
•Adequate capitalization
The company should have sufficient funds available to it to pay its debts as they come due. Funds can be in the form of capital held by the company in a bank account, or as a reserve of funding such as a line of credit or an explicit obligation of the owner. Be careful about the last option: it can be treated as a personal guarantee that gives rise to personal liability.
What “adequate capitalization” means in practice depends on many factors, including the type of obligations the business has, the standards appropriate to the company’s field, and state-specific rules, but the amount is generally much smaller than you might think; a business doesn’t literally have to have cash on hand to pay for every conceivable debt it might face. Many states measure adequate capitalization at the time the company is first organized, when it has no assets. In states that follow this rule, it can be enough to deposit a small sum of money (say, $10) into the business’s bank account as consideration for ownership in the business. Other states may have stricter rules that expect businesses that take on substantial risk to have taken steps to manage that risk, whether by having cash on hand, a source of financing available, insurance, or a combination of these.
•Visibility
The legal entity needs to be the public face of the business. Its name should appear on stationery, business cards, and other promotional materials. The legal entity also needs to be the “person” entering into contracts related to the business. We’ll get into contracts in Chapter 9.
The good news about corporate separateness is that it needn’t take up a lot of time once it is part of your normal routine. Get into the habit of treating your company as something separate from yourself, and in no time it will be second nature.
Financing and Ownership
When you form a legal entity you become its owner. A few important ideas intersect with ownership, including how the business will be financed. Most freelancers will have to spend some of their own money on their business’s expenses, especially in the beginning when the company doesn’t have any revenue. Some may also want to explore taking out a loan for large expenses like equipment or training. Let’s look at a few legal considerations about how these forms of financing work.
Debt
Debt financing is exactly what it sounds like: taking out a loan from a bank or a supportive individual, with a contractual obligation to pay back the borrowed money at a future time. When it comes to debt, remember that your interest payments to an outside lender are probably deductible business expenses at tax time. It’s always a good idea to document a loan arrangement, even if it’s with someone close to you, so both sides are clear about the basics of the deal, like how much interest will be paid, how often payments are to be made, and how long you will have to pay back the principal. It also protects both your business and the lender in case something goes wrong.
If you don’t have a rich uncle to lend you money for your business, but you need some operating cash, you can always try getting a small business loan from a bank. Even if your business will be housed in a limited liability entity, and that entity will be the borrower, a bank that lends to a newly formed small business entity will always look to the entity owner’s personal assets and credit history to make its lending decision, and will require the owner to personally guarantee the loan. We’ll look at some of the consequences of personal guarantees in Chapter 5.
Equity
Equity is shorthand for the amount of money or other valuable assets that the business’s owners contribute to it. Usually, the personal liability of an owner of a limited liability entity is limited to the amount she has contributed to the company as equity; in other words, what you put into your company becomes the company’s property and can be lost if the company fails. In a freelance business, the most likely approach will be to treat everything the freelancer contributes to the company—cash, equipment—as an equity contribution. You might have also heard of “sweat equity,” which refers to the uncompensated time a business owner puts into making a business a success. Unfortunately, sweat equity isn’t the sort of thing that gets counted on a company’s books. It’s the price of building a successful business.
A legal entity keeps track of its owner’s equity in what accountants call a capital account. The capital account changes as the owner contributes money to the company, the company’s balance sheet changes, or the company distributes money to the owner. The capital account of a company owned by one person is relatively easy to deal with, since the owner has 100 percent of everything. For now, the important thing to remember is that the money you put into or take out of your business needs to be carefully recorded. It factors into your company’s substance as a separate entity and is important at tax time.
In theory, a business can raise capital by selling ownership interests to outside investors. You should approach financing your business this way with a great deal of caution. With ownership comes control. Sorting out how much say the investor will have over the direction of your business is not always easy. A lawyer will almost certainly be needed to protect yourself and your business. By the time the lawyer has put together an investment agreement, sorted through changes to the company’s governance documents to reflect the new ownership structure, and complied with federal and state securities laws, you might have been better off just borrowing the money you needed.
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1 Massachusetts, Pennsylvania, and Virginia refer to their secretary of state as the secretary of the commonwealth.