Question:

Do I really need a business entity?

Answer:

Look, if we have our lawyer hat on, we’re going to say that anyone doing business should have some kind of business entity to protect their personal assets from business liability. But what the heck does that mean? If properly maintained, a business entity, like an LLC or corporation (along with the other two of the “three lines of defense“), can protect your personal finances, your home, your car, your personal assets from being subject to any liability that may arise from the business – pretty important! 

But, technically, nobody needs a formal business entity; a business can run as a sole proprietorship or a general partnership, both of which require very few formalities and are totally legally compliant. Let’s break down sole proprietorships, general partnerships, and the advantages of LLCs and corporations a bit more.

General Partnerships and Sole Proprietorships.

Sole proprietorships (flying solo; one person only) and general partnerships (teamwork; more than one person) initially seem appealing to a lot of business owners. They have a “pass-through” tax structure, their structure is flexible, they require no setup fees (other than whatever you might want to pay to an attorney to assist you in drafting agreements amongst the partners of a partnership), and they are formed without any paperwork filed with the state. In fact, most people inadvertently form these kinds of businesses by simply working together and don’t even realize it; you might already be part of one! All it takes is the intent to act as a business for profit, a wink and a nod. Okay, so actually the wink and nod are optional…. 

BUT, there are some downsides to General Partnerships and Sole Proprietorships.

Unlimited liability is a thing and it’s the biggest issue to consider for these “informal” ways of doing business. As a sole proprietor or a general partnership, your assets and the business’s assets are indistinguishable. What does that mean? It means if someone at your business slips and falls, or is injured using your products, not only will your business be on the hook for any potential judgment against you if they sue, but you personally will be on the hook as well.

Forming a general partnership can make this even more risky because you can also be held responsible for the actions of your partners. If your partner goes rogue and ends up costing your business more than it can pay for, your house, your car, and maybe even your firstborn child are on the line. Basically any risk taken in a sole proprietorship or general partnership can affect your personal assets. 

We were only joking about the firstborn child thing, this isn’t Game of Thrones! More good news: you can limit this liability we are describing if you form the right kind of entity with your state.

The Advantages of LLCs and Corporations.

As the name would suggest, an LLC, or Limited Liability Company, offers a “liability shield” for your personal assets; a corporation works similarly. Under either of these business entities, as long as you observe the required corporate formalities (recording decisions, keeping separate bank accounts, treating this entity as separate from you, etc.), even if someone slips and falls at your business, you can’t be held personally liable for any judgment against the business. This means that you, and any other members or investors you convince to join you, can only lose whatever you have put into the business.  

Great, right? But there are even more advantages to LLCs and corporations. Here are a few:

• In a general partnership, any partner’s withdrawal from the partnership for any reason triggers a dissolution of the company; this is not an issue with LLCs and corporations. They can survive just about any change, unless the governing documents say otherwise.
• Another advantage you’ll likely enjoy by forming an LLC or corporation is ease of outside funding. If you need to raise outside capital, creating an LLC or corporation gives investors a sense of security that they wouldn’t have with an unlimited liability operation like a general partnership or sole proprietorship. You can also sell shares of an LLC or corporation, which allows for easier and more predictable ownership tracking.
• Pass-through taxation is not limited to general partnerships; LLCs can also utilize this tax structure, which can be useful to some business owners.

To Wrap Up….

LLCs and Corporations aren’t one-size-fits-all, but generally the limitation on liability makes them better for most businesses than general partnerships or sole proprietorships. That said, LLCs and Corporations are “formal” businesses and carry some additional costs, some of which are ongoing and annually required, so it’s important to understand what you’re getting into if you go the formal business entity route! Of course, that’s what we’re here for and we offer free consultations, so hit us up by emailing bertie@inbetterwetrust.com!