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Why
form a business Entity?
Doing business as a legal entity, such as
a Limited Liability Company (LLC), Corporation or Limited Partnership (LP)
can give business owners several benefits, including;
- organizational structure
- access to potential tax advantages
- increased credibility in the marketplace
- ability to obtain a greater
variety of financing
- a method for reducing personal
liability for business debts and obligations
While many businesses take the form of sole
proprietorships in their early stages, most successful businesses start out as a
legal entity or eventually covert into one.
However, it is not always necessary for a
business to take the form of a legal entity. The following factors should be considered
to determine if formation is necessary.
- Do you need protection from personal liability?
An entity such as an LLC or Corporation can provide owners with protection
from the debts, obligations and liabilities of their business. While
limited liability can be an incentive to form an entity, small business owners must compare the
likelihood of their business being sued or defaulting on financing to the cost of setting up and
administering a legal entity.
- Does your business plan on borrowing money?
Many new businesses need capital to stay afloat in the first few months of
operation. Operating as an entity can provide a business with more
alternatives for raising capital. For example, an entity may take out
a bank loan guaranteed by the Small Business Administration (SBA). While
owners may have to
personally guarantee loans that an entity receives (especially in the early
stages of a company), the owners' credit as opposed to their assets will be at risk.
- Will your business have more than one owner?
If a business begins
with more than one owner or expects to expand beyond one owner, formation of an
entity may be necessary. The formal
structure of a Corporation, LLC or Limited Partnership provides, not only a means for ownership interests
to be divided and documented, but a set of guidelines for resolving conflicts and
designating duties. In a way, the "bylaws" or "operating
agreements" of these entities serve as contracts between the owners as to
how the fundamental administrative matters of the business will be run.
- Does you business plan on reinvesting profits in the near term?
As a
corporation, there are certain tax advantages for small growth companies. For example, a
C Corporation may take advantage
of lower tax rates than a sole proprietorship. See Tax Splitting under C
Corporations.
- Will your business need to offer employees fringe benefits?
A business may want to offer health benefits, stock options or pension plans to
its employees. Certain entities such as corporations are better suited
than sole proprietorships to provide these benefits to employees.
- Does your business plan to sell ownership interests to investors in the
future? If you plan on raising money to expand your business, a sole
proprietorship may be prohibitive. The sale of securities (ownership
interests) in a business is a fairly complex legal matter, best facilitated by entities
such a Corporations, Limited Partnerships and LLCs. Entitles allow for
investors to protect their
personal assets from liabilities incurred by the business into which they
invest.
- Will your business be offering a professional service? Certain
professional services, such as law firms or dental practices, must form
corporations in order to qualify to do business. If your business will be
offering a professional service, it is imperative that you contact the licensing
organization in your field to find out if there are any such requirements.
Otherwise, your business may have to go through the incorporation process more
than once.
- Will owners need to split profits unconventionally? If your business
has owners with "passive gains" from other investments, such owners
may wish to use passive losses from your business on their tax
returns. For example, an investor may want a right to 25% of your
business's profits and 50% of its losses. Certain
entities, most notably Limited Partnerships, will facilitate this profit/loss
splitting better than others.
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