If you’re starting a small business, you’ll have the option of operating under your current name, or operating as a basic partnership with another person. As a sole proprietorship or a partnership, you’ll have a handful of unique advantages, including flexibility, speed of operations, and simplicity—not to mention lower taxes than you’d face as a corporation.
However, if you’re not careful, operating as a sole proprietor or partner could leave you legally vulnerable. And if you take on too much personal debt, or are held liable for a business-related issue, it could eventually force you to file for bankruptcy.
The Benefits of Creating a Business Entity
If you create a separate business entity for your organization, like a limited liability company (LLC) or a corporation, you’ll see a plethora of benefits.
These organizational types are treated as separate entities from a legal perspective, and can therefore take on debts and responsibilities of your own.
For you, there are many advantages:
- Loans and debts. For starters, separate business entities can take on their own debts and loans; in fact, they even have their own credit score. If you take out a $50,000 personal loan to get your business started and the business eventually goes under, you’ll still be on the hook for that $50,000. However, if an LLC takes out a $50,000 loan to cover its equipment costs and eventually goes under, the financial ramifications will be limited to the LLC—not typically extending to the people who own it.
- Operating liability. Additionally, separate legal entities can take on liability for their operations. For example, if you own an LLC that functions as a handyman business, and a botched repair job leads to an injury by the homeowner who paid for it, any legal action they take would apply to the LLC—again, not the people who own it.
- Financial control. As an added bonus, LLCs and corporations are treated as “pass-through” entities, giving you more control over your finances, and thus, the taxes you owe. For example, LLCs track their own income and expenses; as an owner, you can elect to take a salary, or choose to withdraw profits at your own discretion, paying taxes only on what you withdraw.
Types of Separate Business Entities
There are several main types of business entities, including sole proprietorships, partnerships, LLCs, and corporations, but among these, only LLCs and corporations are considered separate legal entities.
Let’s look at some of the differences.
In an LLC, the organization is owned by one or more individuals. In a corporation, the organization is owned by a collection of shareholders. This is the main difference between these organizational types, and what most people consider heavily when deciding which path to take. In the realm of corporations, there are S-corporations (limited to 100 shareholders), and C-corporations (with practically unlimited shareholders), but either way, shareholders hold fractional ownership of the organization, and may be entitled to profits, depending on how they’re distributed. Understandably, corporations tend to be more complex. This makes LLCs the favored option for small business owners, or for those who wish to keep things simple.
In an LLC, there is no federal-level corporate tax; however, in a corporation, you’ll owe corporate income taxes on whatever income the corporation generates. Because you’ll also pay taxes on your salary and/or profits from the business, this results in a kind of double taxation. Note that both LLCs and corporations may owe state-level taxes on income.
Corporations are also subject to more rules and restrictions under U.S. law. However, they also afford their shareholders greater legal protections.
Forming Your Chosen Business Type
Once you’ve chosen a formal business entity for your organization, all that’s left is to officially form it. In most cases, you’ll be able to register your business with a specific state, and submit a handful of forms with a bit of money to make your business official. It’s a simple process that doesn’t take long, but some states require you to file paperwork each year (or other periodic interval) that your business remains active.
Are Sole Proprietorships and Partnerships Bad?
For most business owners, the protective benefits afforded by LLCs and corporations makes them advantages over sole proprietorships and partnerships. However, some businesses may do just fine as a solo endeavor or under a partnership agreement. It all depends on the nature of your business, the size of your business, and how much risk you’re willing to personally take.
There isn’t a single, comprehensive business strategy that will work for every business. However, every business needs some way to shield its owners from risk. Consider forming a separate business entity for your organization, and/or investing in additional liability insurance to financially and legally protect yourself.
Interesting related article: “What is Bankruptcy?“