Every year, hundreds of thousands of businesses are formed in the United States. Every year, there is a new wave of people who must navigate all of the essential questions involved in beginning a new for-profit enterprise. These include:
- Should I have a brick-and-mortar location or operate from home?
- Do I have to collect sales tax?
- What permits do I need from the local government?
- What the heck is a “franchise tax?”
- How do I get financing?
One of the most common questions our office hears is: do I really need a business entity like an LLC? The answer to that question depends on your personal circumstances, goals, industry, and on several other factors. In short, it really requires an individual assessment.
With that said, some basic information can be helpful in making that decision. This article will explain generally what a business entity is, why they can be helpful, and situation where they may not be a good fit. As with most articles on my blog, this article is intended to be general education only; because business association law varies so much from state-to-state, it would be impossible to make a definitive guide on the subject.
What Exactly is a “Business Entity.”
Broadly speaking, a business entity is a formal legal organization created for the purpose of engaging in economic activity. They come in several forms, and the most common are Limited Liability Companies (LLCs) and corporations. In contrast, a person who just begins engaging in economic activity without operating through a business entity is by default either a sole proprietorship or general partnership, depending on whether they are doing so alone or with other people.
In order to form a business entity, one usually must complete a form or file its equivalent with the Secretary of State in the state in which you want to form your business. Some states are better than others based on your specific goals; the choice is not limited to only what state you will be doing business in. There is generally a filing fee which can range from $40 to $4,500 with an average fee of approximately $132.[1]
What Are Some Good Reasons for Operating Through a Business Entity?
Liability Limitation
Potentially the most important reason for forming a business entity to operate through is that most limit who can reach beyond the business and potentially take your personal assets. In law school, we referred to this as a “liability shield.” An example may help illustrate this principle.
Example: You operate a brick-and-mortar pizzeria as a sole proprietorship. You do not have general liability insurance, and a customer slips on a wet spot on the floor caused by one of your staff members. The customer sues and obtains a judgment against you for $1 million. That customer can now reach into both the pizzeria’s bank account AND your personal bank account because you are, legally, the same entity.
Example: Same facts but you are operating through an LLC instead. Now, that customer can reach into the pizzeria’s bank account BUT probably not your own. Your LLC may have to file for bankruptcy or close up because of the debt but you are not personally liable. Your personal assets are at far less risk of garnishment or levy.
This protection is not absolute. If you misuse a business entity, a potential debtor may be able to “pierce the corporate veil” and reach your personal assets. This discussion is beyond the scope of this article, but I mention it because the concept itself is important.
Favorable Tax Treatment
As of this writing, corporations enjoy a 21% tax rate while individuals are taxed on a progressive system that changes based on their total income per year. This includes LLCs who meet the requirements for an Section S Corporation election. If a sole proprietorship generates above roughly $200,000 in taxable income, their effective federal tax rate will begin to exceed 21%. Beyond that point, they are voluntarily paying more in tax.
Also, if one wants to form a non-profit corporation and enjoy the tax benefits offered by federal and state governments for their philanthropic work, a business entity is necessary. An individual — for obvious reasons — cannot elect to become tax-exempt.
Business Credit
Businesses require investment, both upfront and throughout, to grow. A separate business entity can build business-specific credit based on payment processes in place. Dun & Bradstreet is probably the most well-known business-specific credit bureau; both Experian and Equifax also provide credit reporting for businesses as well.
While lacking a business entity does not disqualify you from obtaining business credit, it will likely prevent you from obtaining credit based solely on your business’s credit score. This makes some intuitive sense. If you and the business are the same entity, then your personal credit is always going to be involved in determining credit worthiness.
Legitimacy
Let’s face it: most people view business entities as “legitimate” and sole proprietorships as less serious businesses. This is not always the case in reality but perception matters when marketing to potential clients/customers or hiring additional staff. Operating through a business entity avoids this pitfall by adopting the veneer of legitimacy people have come to expect.
Exit Strategy
Unlike a sole proprietorship which is tied to the owner personally, a business entity can be bought and sold very easily. If you want to build a business you can later sell for a profit, a business entity is going to make the process infinitely easier. Some potential buyers may not even be able to get loans to purchase your business if you do not use a business entity because of the perceived risk.
Why Might I Not Want to Operate Through a Business Entity?
Illegality
As far as I know, all states prohibit forming a business entity in order to engage in business which is illegal within the state. There is a reason you do not see drug dealers and brothels operating through an LLC or corporation.
Uncertainty re: Business
If you are just experimenting with offering a service or product to see if it is marketable, it likely is not a good idea to form a business entity. A period of limited sales will help solidify your idea behind your business and help you settle in on a name, strategy, and so forth. You should, however, keep in mind all of the positives listed above so that you are educated and ready when you feel it is time to commit fully.
Low Profit Potential
If you are engaged in business but doing so in a way that you will likely never be able to support yourself fully AND your risk of legal liability is very low, it may be better to remain a sole proprietorship. The only example I can think of is selling low-cost handmade goods on Etsy or other marketplaces. This is closer to a hobby than a business and, while fulfilling and profit-generating, you likely would not benefit from organizing as a business entity.
Anonymity
While some states do allow for you to form a business entity anonymously, most states require that the names of owners of a business entity be available to the public. Certain businesses involve a heavy risk to personal safety, such as online adult content creation and social media influencing. If you lack the funds or ability to meet the requirements for forming an anonymous business entity in states that support them, your personal safety is paramount. Do not jeopardize your safety simply for a better tax rate.
Are you wanting to start a new business but have no idea where to begin? Feel free to reach out at (903) 221-9180 and we’ll be happy to speak with you about your options.
[1] Nolo.com, How Much Does It Cost to Start an LLC? (last accessed 11/01/2022), https://www.nolo.com/legal-encyclopedia/how-much-does-it-cost-to-form-an-llc.html
