Business Entity Basics Part I: What is a Business Entity and Why do I Need One?

By Andrew Randol - January 9, 2019 - Corporate & Business

What is a Business Entity?

At its core, a business entity is a fictitious person invented by the law in order to allow people to conduct business. Like a natural person, a business entity can own property and assets, purchase and sell things, enter into contracts, break laws, pay taxes, and sue and be sued in court. The entity exists separately from its owners.

To illustrate with two simple examples – Corporation A purchases a dump truck, the truck is owned by Corporation A and not by the business owners of Corporation A. If the dump truck is stolen, the insurance money is paid to Corporation A and not to the business owners. If the insurance company refuses to pay under the policy, then Corporation A would sue the insurer in court, rather than the business owners of Corporation A suing personally.

Example two – The business owners of Corporation B are two financial advisors who provide financial consulting services. If one of the business owners wants to purchase telecommunications equipment for the office, that partner would sign a contract with the telecom service provider in the name of Corporation B and not in the one partner’s personal name.

Are the Owners of a Business Entity Personally Liable For its Debts?

Maybe. This depends on what type of business entity you created to organize your business. Generally speaking, business entities can be divided into two categories, limited liability entities and non-limited liability entities. The two simplest examples of non-limited liability are a partnership and a sole proprietorship.

A partnership is a type of business entity that can do all of the things discussed above, such as owning property and suing in court. However, because a partnership does not provide limited liability protection, its owners are personally liable for the debts of the partnership.

One of the most well-known examples of a partnership is a general partnership. A general partnership is made up of two or more partners. The partners can potentially have unlimited liability for the debts and liabilities of the general partnership.

For instance, let’s assume Company A is a partnership and it buys one dump truck as in the example above. The dump truck is involved in a car accident and an injured motorist sues Company A and wins a judgment for $100,000. Even though the $100,000 judgment is a debt of Company A, its owners are responsible for this debt.

A sole proprietorship is where an entrepreneur chooses not to incorporate with a corporation or form an LLC. In this case, the entrepreneur would have personal liability for any operational, legal, or tax issues associated with the sole proprietorship. Although operating as a sole proprietorship may offer some advantages, such as a simpler approach to the tax return for the entrepreneur, most lawyers will advise against a sole proprietorship.

Limited Liability Entities

The most common examples of limited liability entities are corporations and limited liability companies (LLC for short). Like a partnership, corporations and LLCs are fictitious persons who can own property and sue in court. However, unlike partnerships, the owners of corporations and LLCs are generally not personally liable for the debts of the entity.

Whether an entrepreneur wants to form an LLC as a sole member or a partnership wants to form an LLC as a multi-member LLC, the requirements to form an LLC are dictated by state law. With an LLC, the entity offers some flexibility when it comes to tax treatment – LLC partners would elect to stick with pass-thru taxation or could elect to be taxed like an S-Corporation.

If business partners choose to incorporate and form a corporation, state law also speaks to how the corporation is started and operated. When done correctly, corporations can shield the founders from personal liability. If you want to form a corporation, most lawyers will advise that you work closely with your accounting professionals as the tax treatment of certain corporations can substantially impact the personal tax returns of the business partners. Further, corporations, depending on the desired structure, can feature very complex bylaws or a code of regulations. Be sure to very carefully the powers, abilities, and limitations of the key players in a corporation, such as the directors, shareholders, and officers.

Other Alternatives

Another, lesser-known alternative for a limited liability entity is the limited partnership. In particular situations, business partners may want to consider filing for a limited partnership, depending on the goals of the company and the desired tax treatment. A limited partnership is comprised of at least one general partner and one or more limited partners. Generally speaking, the limited partners will not have personal liability to the partnership, and this type of partnership can be attractive to investors.

Regardless of whether business partners choose to file for an LLC, corporation, or a limited partnership, let’s continue the example from above. Suppose Company A is a corporation or an LLC. The owners would not be personally liable to pay the $100,000 judgment. The injured motorist would be able to collect against all of the assets of Company A, but even if they cannot cover the entire $100,000 judgment, the owners are not personally liable for this debt.

This is assuming the injured motorist does not have another legal theory under which the owners of Company A may be liable. If one of the owners of Company A was behind the wheel in the accident and found liable, then the driver-owner could in fact be liable for some of those claims. But this would be the owner’s personal debt, not the debt of Company A. If an employee of Company A is the driver, then employee A may be held liable for the accident as well as Company A. But in this example, Company A’s partners are not personally liable.

If you haven’t already deduced the lesson from this very simple example, any competent Columbus business lawyer would advise a client to opt for a limited liability entity, such as a corporation or an LLC, over a non-limited liability entity. For all intents and purposes, non-limited liability entities are antiquated, and most lawyers will not recommend this route.

Why Do I Need a Business Entity?

While there are a number of important reasons to organize your business under a business entity, a competent Columbus business attorney would stress the vital role business entities play in shielding owners from the debts of the company itself. Leaving your job to start your own company is a huge risk for most. Don’t compound this risk by failing to take simple steps to protect yourself from being personally liable for the debts of your business. Contact our Columbus business law attorney to learn more about organizing your company under a limited liability business entity and other steps that are needed to financially protect yourself. Our lawyers will advise on everything necessary to start a corporation or LLC, including your articles of incorporation or organization, your EIN, and your code of regulations or operating agreement.

Some important notes for when you start a business

Regardless of what form your business takes, be it a corporation or an LLC, there are a number of important legal and non-legal considerations to keep in mind. Good accounting for your business is imperative; be sure to keep separate your personal accounting from your business accounting. Good business books can make or break a business in the future, especially when it comes to tax time. Additionally, depending on the applicable state law for your business, the other partners in your business may have the legal right to inspect the books and related information of the business at any time.

Another best practice relates to credit for the business and the personal credit of the partners. Early on in the life of a business, the partners will have to make various personal guarantees and be subject to background and credit checks as such relate to the individual partners’ personal assets. At a broad level, as the business grows, do your best to separate the personal components of the individual partners from the business itself. Well maintained business entities want to remember that businesses are their own legal entities. In other words, the business should strive to avoid comingling business assets with the personal assets of the business owners.

When you go to form your business, also keep in mind specific considerations that should be taken into account when your business brings on investors. Potential investors will be very concerned with how the entity is structured from a variety of perspectives, including governance, capital accounts, loans, distributions, and accounting. Your business should be very clear on repayment terms and all relevant information when it comes to loans. When it comes to equity, inventors will want to know what kind of protection their investment may have, if any, and how profits and losses are applied to all of the partners in the business.

How do you choose between a corporation and an LLC?

Part II of Business Entity Basics will focus on how LLCs and corporations are taxed. Differences in taxation, and associated pros and cons, is how most choose between these two limited liability entities.

At the end of the day though, most lawyers will advise that, in general, there are no categorical recommendations for what the best business entity is. The type of entity that you form for your business should reflect the goals, priorities, and needs of the partners who form the business.

For some businesses, the best entity might be a corporation. Depending on the owners (or owner), certain needs might dictate that a corporation, with its higher degree of formality and governance, may be the best entity for the business. Corporations can be tailored to account for intricate and specific needs for both shareholders and management.

For other business ventures though, an LLC might be a better fit for your business needs. Contrary to the belief of some, LLCs can be structured to be as complex as the needs of the business owners and investors dictate. For one, similar to a corporation, an LLC can be structure to have a board of managers, similar to the board of directors for a corporation.

Contact Us Today

If you feel that you need to contact one of our Columbus business lawyers to ascertain which is the best legal entity for your needs, contact our firm today.

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