When an entrepreneur starts a new business, one of the first decisions he or she is confronted with is the choice of business structure. This decision can be ongoing. As your business grows and changes, you may struggle with what is the best business structure at each stage.
There are a wide variety of business entities to choose from and they vary from state to state. Which type of entity you choose will have a significant impact on your exposure to liability, your responsibilities as the business owner, and the taxes you and the business will be responsible for paying. Each type of structure has advantages and disadvantages, and should be chosen with care after consulting a business or legal professional.
Regardless of business structure, one of the most common mistakes business owners make is to believe that the entity they choose will provide unlimited legal protection. Yes, many of the business structures offer legal protection in the abstract, a sort of legal shield, so to speak. However, reality can be quite different. Your legal protection is dependent on whether you honor the structure. Simply filing the requisite documents establishing the business is insufficient to truly protect the business owner. The business owner also must operate the business as a distinct entity from him- or herself.
To start with, a basic rule of business ownership is the rule against the co-mingling of personal and business funds. It is vitally important for the business owner to keep his or her personal funds separate from the business accounts. This sounds so simple and, yet, many entrepreneurs co-mingle funds, rendering legal protection meaningless in the extreme. There is a legal doctrine called “piercing the corporate veil,” which allows a litigant to actually pierce the business structure of the entity being sued, and make a claim against the individual owner and his or her personal assets. This doctrine is only applied in the extreme, but it is an important doctrine to use as a litmus test when operating a business. One of the biggest factors a court will consider when deciding whether to “pierce the veil” is whether or not the business owner has co-mingled his or her personal and business funds. Rule of thumb: Keep them separate!
Another common mistake made by business owners is the failure to adhere to the legal formalities required of whatever type of business entity they chose. If you do not treat the business as a separate entity, then a court may not do so either. Alas, the protection you thought you had been entitled to may no longer exist! One of the easiest ways to treat the business as separate is to maintain great business records. If you are required to keep minutes or show proof of an annual meeting for your corporation, do so. If you are required to maintain proof of business expenses, make sure you have those documents and can find them (a good professional organizer can work wonders here!). In other words, create the paper trail required by law. That paper trail serves as strong evidence that the business is, indeed, a real business.
Choosing a business entity that offers valuable tax advantages and protection from personal liability is important. However, make sure you go beyond that and treat your business as the distinct entity it is in order to maintain the privilege of protection from liability that the law offers. As they say, it is better to be safe than sorry, or worse, personally liable.