Reason #1 – Your personal assets are protected
Without a formal business entity, your business is considered one of the following for legal and tax purposes:
- Sole proprietorship where you are the only business owner.
- General partnership where you share ownership with one or more partners.
The legal system and the IRS make no distinction between sole proprietorships, general partnerships, and the people who own them.
If someone sues your business and wins a judgment, they can access your personal and business assets. Depending on state law, this could include your personal bank account, retirement account, automobile, and even your home. If you are part of a general partnership, every partner’s personal assets could be susceptible. Forming an LLC or corporation protects you from personal liability for business debts.
A corporation or LLC is a separate legal entity, completely distinct from your personal property. If someone sues your LLC, they do not sue you as an individual. They cannot get to your personal assets because their claim is against the LLC, not you. This is especially important for homeowners, heads of household, or anyone with personal assets or property.
Similarly, making an LLC or corporation shields your business from your personal liabilities. If something happens in your personal life that leads to a lawsuit against you as an individual, the person suing you cannot gain your business assets. This can help if you are looking for investors who might want assurances that your business is secure from claims of personal creditors.
Reason #2 – You can save money
Certain types of business entities can save money on taxes. If you form an LLC, the IRS lets you choose pass-through taxation. This means that the business does not pay any federal income taxes. Instead, the profits pass through to the owner or owners, who pay personal income taxes.
A corporation that meets certain criteria may take advantage of pass-through taxation by forming an S-corp. LLCs may also elect to be taxed as an S-corp. Federal tax law limits eligibility for S-corps to:
- Only domestic corporations or LLCs.
- Only one class of stock or equity.
- Companies with fewer than 100 shareholders or members.
- Only U.S. citizens, legal resident aliens, and nonprofit organizations.
The vast majority, as much as 95%, of all businesses in the United States use pass-through taxation. These companies also earn the bulk of business income.
Reason #3 – More opportunities to raise funding
Businesses need money to make money. An LLC or corporation gives your business far more options when it comes to financing or raising investments. They can also help you create distance between your business and yourself, which helps protect you from personal liability for business debts.
A business entity, such as an LLC or corporation, can establish its own credit history to secure business loans and be more appealing to potential investors. If you form a corporation, you can issue Stock Certificates. LLCs and other business entities can grant equity to people who invest. A person who invests in a sole proprietorship becomes a partner in a general partnership, which comes with many vulnerabilities.
Venture capitalists, angel investors, and other investors may have strict standards for the structure of your business. In exchange for investing in your business, they may want the kinds of legal protections that come with a formal business entity. For example, state corporation laws contain provisions affecting shareholder rights. Laws governing LLCs and other entities have similar provisions.
Reason #4 – Improve your reputation among customers and clients
A formal structure provides your business with legitimacy. Customers and clients prefer established businesses. They want to know that the business is run properly and will be around for years to come. The more official a business appears, the more appealing it will be to potential customers.
Other businesses may be even more selective than individuals as clients. Some will prefer to work with other businesses that understand how to protect themselves from liability and make long-term commitments.
Reason #5 – Open doors to opportunity
Forming an LLC or corporation can lead to opportunities otherwise unavailable to sole proprietors or general partnerships:
- Government contracts can be lucrative, but local, state and federal contractors may be required to form a separate legal business entity to secure those contracts.
- Some sources of financing might require your business to operate as a separate legal business entity.
- Many investors will only consider businesses with carefully prepared structures, so shareholders, members, or partners can receive protections offered by state law.
- Businesses with distinct legal structures can raise funds by selling stock or equity shares.
- Strategic partnerships provide businesses opportunities to work together as reliable partners.
- If a corporation experiences enough growth, it could pursue an initial public offering (IPO) through a stock exchange listing.
If you are unsure which type of business entity might work best for you, a Business Entity Planning Worksheet can help you understand your options. If you have more questions about your options as a small business owner, reach out to a Rocket Lawyer network attorney for affordable legal advice.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.