You’ve got to spend money to make money. While the old adage may be true (to an extent), what you most want to avoid when starting your business is setting yourself up for a loss before you even have a chance to turn a profit. Choosing the right business entity is critical to your business’s future success, and avoiding common pitfalls will add a layer of protection to your burgeoning business’s financial situation.
Right now, business formation in the U.S. is at an all-time high, peaking in July 2020 and lifting again after the start of 2021. While LLCs remain the most popular entity among first-time small business owners, there are numerous considerations that factor into making the best financial decision for your business. Here, we’re outlining the five mistakes that could cost your new business money when selecting a business structure…and how to avoid them.
Top 5 Mistakes When Choosing a Business Entity
Mistake #1: Failing to Form a Legal Entity for Your Business
First off, yes, you can absolutely start a business without forming a legal entity. However, this is a choice that could affect your business’s financial future significantly. While sole proprietors may get started without filing a structure, it’s something you’ll want to carefully consider before going it alone. Why? Forming a legal business entity offers you numerous advantages, and foregoing a legal structure opens you up to many risks, including:
- Risk to Personal Assets: The biggest upside to having a legal business entity is that it provides a buffer around your personal assets, which would otherwise be jeopardized in the case of financial hardship or litigation. A limited liability company (LLC) is one of the simplest ways to protect your assets and reduce your financial vulnerability.
- Risk to Business Credibility: Vendors, investors and consumers alike typically prefer to work with established, reputable businesses, but that’s much harder to prove when you don’t have a legal business entity. Forming an LLC or corporation makes it easier for you to get a business bank account, business credit, EIN and more to show that your business is on the up-and-up.
- Risk to Your Brand: Choosing to file a legal business entity means your business is registered with your state and is able to be marketed and advertised. Without legal formation, any marketing efforts you make could be waylaid by other legal businesses choosing to use the same name or by legal action due to trademark infringements.
How to Avoid This Mistake: While it may feel overwhelming, this is an easy pitfall to avoid. For most businesses, filing an LLC will offer you the protection and legitimacy your business needs to keep you and your assets protected. A $0 LLC from Incfile makes the process simple and cost-effective.
Mistake #2: Not Considering the Tax Implications
Your taxes can vary widely depending on the business structure you choose, so it’s important to carefully weigh your options and know before you form exactly how and what you’ll be required to pay. Lack of planning and research into tax implications for your business entity could be a costly error, but it’s easy to overcome when you keep a few of these considerations in mind:
- Understanding Pass-Through Taxation: LLCs and S Corps are both subject to pass-through taxation, which means your income is filed through your personal tax return. However, it’s important to keep in mind that while LLCs do not pay corporate tax, you will need to pay self-employment taxes, which are typically around 15 percent of your profits. Understanding exactly what you’ll need to pay as an LLC owner is key to minimizing your financial burden and preparing for tax time.
- Understanding S Corp Election: There is a way for LLC owners to potentially reduce their tax burden, by electing to file as an S Corp. S Corp election with Form 2553 can lower the amount you’ll pay in self-employment taxes by dividing your profits by salary and distribution.
- Understanding Taxes for S Corps and C Corps: A C Corp may be appealing due to write-offs and lower tax rates; however, it is also subject to “double taxation,” with all profits being taxed as both corporate income and dividend income. S Corps provide the same pass-through structure as LLCs and do not require corporate income tax. It’s important to understand the difference when choosing your business entity.
How to Avoid This Mistake: Do you research ahead of time, and be sure you know the tax implications of each business structure. If you aren’t sure, seek the advice of an accountant or tax professional.
Mistake #3: Not Allowing for Future Growth
You may be a solopreneur now, but do you expect your business to grow, and potentially take on partners or shareholders? Are you hoping to find investors to back your business goals? If so, the entity you choose could play a large part in the future growth of your business, and it could also have a major impact on your bottom line. Keep these considerations in mind:
- S Corp Ownership Limitations: S Corps are not permitted to have more than 100 shareholders, and foreign owners are not allowed.
- Multiple LLC Members: You can certainly add members to your LLC, but you’ll need to consider their role and percentage ownership. This could have major financial implications if the company goes under or if there are disagreements in how to operate the business.
- C Corp Ownership: While C Corps are generally structured to allow for greater long-term growth, they are also more complex and subject to greater regulatory and compliance standards.
How to Avoid This Mistake: Before you choose your business entity, sit down and create a business plan that details your goals and expected growth. Based on how you see the business evolving, you can choose the structure that will grow with you.
Mistake #4: Not Putting Proper Protections in Place
A legal business entity will help protect your personal assets, but that alone isn’t enough to mitigate all the risks that come along with business ownership. You’ll need to consider other ways to reduce your business’s vulnerability and protect it from legal and financial risks, including:
- Business Insurance: No matter the size of your business, an insurance policy is critical in protecting it from unplanned events. Your coverage needs will vary based on the business type and size, but a quality insurance provider can customize a plan that fits your needs.
- Trademarks: While forming a legal entity is the first step in protecting your business and registering its name, it is not fool-proof. Businesses in other states could also register your business name or use elements of your logo. The surest way to protect your brand and eliminate the risk for future legal costs is by registering a trademark.
- Business Licenses: While a business license isn’t always required to operate your company, you may need one depending on your industry and the state of formation. It’s important to keep business licenses current to keep your doors open and avoid fees or even closures.
How to Avoid This Mistake: As mentioned above, having a business plan in place before you form will help you understand everything you need to keep your business legal, compliant and protected.
Mistake #5: Failing to Separate Personal and Business Finances
Using your personal finances for your business is a misstep, no matter which entity you choose. It may be tempting to manage your finances from a single account, but that causes a number of issues that could impact your business’s growth and success, including:
- Risk of Tax Audits: Taxes are hard enough to manage anyway, but when you don’t have a clear delineation between your personal and business finances, it’s going to get even messier. Separate finances make tax time easier and also reduce your risk of being audited by the IRS.
- Difficulty Establishing Business Credit: If you don’t have a business bank account, you’re going to find it nearly impossible to take out a business loan or line of credit. You may also find it more difficult to receive business financing and loans when you're coming to the table with only your personal credit history.
- Lack of Financial Insight: Most importantly, if you don’t have separation between your personal and business finances, you’re going to have a much more difficult time getting a clear picture of how your business is performing. This leads to confusion, headaches and mismanagement of both personal and business funds.
How to Avoid This Mistake: Learn how to establish your business’s credit and separate your finances by taking these steps.
There are many mistakes you could make as a starting business owner, but you don’t have to. Careful planning and preparation when forming your business will get you started on the right foot. And if you do make some mistakes along the way, learn from them and keep your business growing. Need some extra help deciding on the right business entity? Our entity comparison will help you map out the pros and cons and make the best choice.