What should I consider, including insurance, when changing my business entity type?

A Different Type of Business Entity

The vast majority of businesses in the US are small businesses. Thus, it’s common for the owner of a business to start out as a single entity, and to conduct business solely through themselves. However, as your company evolves and grows, it might be time to consider changing from a sole proprietorship to a different type of business entity, such as an LLC. Changing your business structure can come with a variety of benefits, but it’s not something that can be done without consideration and precautions.

Growth isn’t the only reason businesses change entities. Whether you’re adding partners or changing ownership, facing a financial crisis, changing your goals, or reacting to a shift in the market, re-examining your entity can provide you with a new way to tackle challenges. If your personal assets are at risk because of your company’s financial health, you might consider restructuring the business to protect your own assets.

To weigh your options, start with the basics: a sole proprietorship is the simplest way to set up a business. There is one owner, but the owner can hire employees to assist in running the business. All the profits from the business are declared on the owner’s tax return. However, there is a self-employment tax that is applied to the owner. Unfortunately, the law does not protect the owner’s assets from the business’s debts.

Partnerships work well for small firms with several owners and for professional practices. There are two common kinds of partnerships: a limited partnership (LP) and a limited liability partnership (LLP). In a limited partnership (LP), one partner retains unlimited liability and control, while the other partners have limited liability and limited control. A limited liability partnership (LLP) is where all the partners have limited liability.

A limited liability company (LLC) is something of a hybrid of a corporation and a partnership. It is good for smaller, riskier firms. The owners are called members. In most cases, the members are shielded from personal liability for the acts and debts of the business. LLCs often are taxed at a lower rate than a corporation. Gains and losses can pass through to the members’ personal tax returns.

A corporation is a bit more complex and is legally separated from its owners. This structure provides owners with strong liability protection. They are generally eligible to attract more outside investment and to change ownership more easily. On the other hand, they generally are taxed at a higher rate and must do heavy reporting.

Once you decide to restructure, it’s important to review not just current operations and infrastructure, but the goals that you hope to accomplish with the new structure. Next, review your insurance policy coverage for your business’s new structure and plan future coverage. If ownership changes are part of the restructuring, policies are likely to be cancelled and reissued under the new owners’ names.

Your review should also cover a buy-sell agreement, a contract that secures a business succession in case a principal retires, dies or becomes incapacitated. It protects the remaining partners and the principal’s family and can prove wise when adding partners. In some cases, such an agreement can be funded by life insurance.

Shaking up leadership or ownership can leave gaps. That’s where directors and officers (D&O) insurance comes into play. D&O coverage applies to people who can be sued over leadership roles in nonprofits or private corporations. If management, controlling partners or the entity changes in a reorganization, D&O can shield leaders where coverage gaps exist.

Closing the book on your old business doesn’t eliminate its mistakes. Tail coverage provides the new entity with protection against unknown liabilities of the old one. In some industries, such as professional services, potential risks from services carried out in the past can catch up with you later. For example, a company with a professional liability policy can access a former policy’s Extended Reporting Period or buy a tail policy for the former entity. Tails often last for a year, three years or longer.

One step likely unique to mergers and acquisitions is arranging Representation and Warranties (RW) insurance. This is usually for very large mergers or acquisitions. RW covers losses caused by unintentional, unknown breaches of the seller’s representations. RW can supplement or replace seller indemnity and is a valuable tool for helping the seller “exit.” The idea is that buyers are more likely to win claims since the seller has less incentive to dispute them.

Renewing a business’ structure can give it a new lease on life, but also carries new challenges. Use the skills of a lawyer, financial adviser and insurance agent to help with the transition.