Most entrepreneurs are understandably anxious to start doing their “Great Business Idea.” But that excitement also makes many entrepreneurs dive right in without doing some of the less glamorous, behind the scenes work. And a great example of this is not forming a business entity before launching the business.
Properly forming a business entity can reduce your personal exposure to liabilities of the business, minimize taxes, ensure that business is being conducted efficiently, help you obtain financing for your business, and prevent misunderstandings among the various stakeholders (your business partners, investors, managers, etc.). You should form your business entity before you take on any significant business obligations, i.e. before (1) signing any contracts or leases, (2) entering into any type of agreement with a third party, or (3) raising funds from others, even family and friends.
So what type of entity is right for you—sole proprietorship, partnership, limited liability company, S Corporation, or C Corporation? Let’s examine each.
Sole Proprietorship
A sole proprietorship is a business owned by one person. It is the default option when you start a business without any business partners and without filing anything with the Secretary of State. But as a sole proprietor, you are personally responsible for everything, including all of the debts and obligations of the business. A sole proprietorship is not a separate legal entity, and for that reason alone, it really isn’t an entity anyone should choose. You’ve started a business, but you haven’t limited your personal exposure should anything go wrong.
General Partnership
Like a sole proprietorship, a general partnership is the default entity for two or more people who go into business together for a profit. Each partner is still liable for everything that goes on in the business, including anything the other partners do or fail to do, whether you knew about it or not! Like the sole proprietorship, this default choice of entity is really no choice at all.
Limited Liability Company (LLC)
Forming a limited liability company is probably the most common choice of business entity for entrepreneurs and small business owners. The reason is because every member (the legal term for owners of an LLC) enjoys limited liability for the debts and obligations of the business, while still being able to participate in the management of the business (at least to the extent allowed by the LLC’s operating agreement).
Corporations
The corporation is the traditional form of business entity, and like the LLC, is a legal entity or “person” separate from its individual owners (called shareholders). Corporations raise money by selling stock in the corporation, even small closely held corporations. Shareholders have the same limited liability as members of an LLC. If a corporation is sued or owes a debt, the shareholders generally can’t lose any more than their investment in the corporation.
So Which Entity is Right for Your Business?
While the details of your situation may vary, an LLC is the right way to go in most situations.
