Why Does a Small Business Need a Business Entity?

The right business entity can empower a small business operation.  The entity will grow and evolve with the business.  It will protect the owner of the business, and the owner’s personal assets, but it has to be done correctly to get the full legal and tax advantages.

Personal vs. Business Assets

The business entity, properly formed and kept current, will help protect the business owner’s personal assets. All businesses have liabilities, whether its payments to suppliers or employees that are due, or something more drastic, like a lawsuit if an employee or customer gets hurt by the company’s product.

If a person is operating a small business, but hasn’t filed for a business entity, then by default, the person created created a sole proprietorship (one owner) or a general partnership (multiple owners).  The operator is personally liable for the debts and actions of the company. If the company gets sued, or owes money, then the owner’s personal assets (bank accounts, car, house, etc.) are now at risk.

So How Does a Business Owner Protect Personal Assets?

  1. Incorporate the business entity correctly and keep it active
  2. Observe corporate formalities
  3. Keep personal and business assets separate
  4. Operate honestly and with integrity

Correct Incorporation

Instead of letting the state pick, identify the correct entity for the business, usually an LLC (limited liability company) or a corporation.  The legal protections are similar, but there are different tax consequences to consider.  Once the business entity is formed, the business is liable for its debts and actions, and the owners are not personally liable, if the owners observe the corporate formalities

Observe Corporate Formalities

Different business entities have different obligations.  Forms (and sometimes payments) have to be filed, meetings may have to be held, and the business must have governing documents.  It might seem a little silly to have a governing document for a single-member company, but if the owner wants to sell the company, sign a contract, or doesn’t want to be personally liable in a lawsuit, it’s important to have proof that the business assets are separate from the owner’s personal assets.

Separate Business and Personal Assets

Having separate accounts for business and personal assets is one way to demonstrate corporate formalities are being observed.  If the business is sued or has to pay a debt, the business entity formation means the owner’s personal assets are not at risk, unless the corporate veil is pierced.

Piercing the Corporate Veil

No matter what, the business still has to operate ethically and in accordance with the laws.  If not, the entity is disregarded for legal purposes. That means all of the business entity protections are unavailable, and the owner’s personal assets are exposed. This tends to happen when business owners either:

  • don’t observe the formalities of separating business and personal assets;
  • they defraud or mislead their customers or creditors;
  • taxes aren’t paid on time; or
  • business owner signs a personal guarantee (very common for commercial real estate leases and franchises)

This post originally appeared on Hire Effect™ : https://hireeffect.com/index.php/2019/02/01/protect-your-business/


This article does not create an attorney-client relationship. This article is for general education purposes only and is not legal advice. You should consult with a qualified attorney before you rely on this information.