From Sole Proprietor to Business Owner: When To Form a Legal Business Entity

By Jessica Bledsoe

Are you currently running your side hustle or business venture as a sole proprietor? Being a sole proprietor is a fantastic way to dip your toes into starting your own venture; however, as your business grows and thrives, it’s crucial to think about something incredibly important: legal protection for yourself and your business.

You might be wondering, “Why do I need to formalize my business?” The short answer is: liability. As a sole proprietor, your personal assets (your house, your savings, your car) are legally intertwined with your business. This means if your business faces a lawsuit, debt, or other financial trouble, your personal assets could be at risk. That’s a scary thought, right?

Or maybe you’re not sure when to formalize your business. There’s no hard rule as to when you should form a legal entity for your business, but as a general rule of thumb, if you notice your business is growing steadily, your income is increasing substantially, or if you’re taking on more significant risks or liabilities, it’s a good time to seriously consider transitioning from a sole proprietorship to a more structured entity. Also, if protecting your personal assets becomes a major concern, that’s a key signal that the time is right to explore your legal entity options.

The good news is, there are several business structures designed to create a legal shield between you and your business. Let’s dive into some of the most common ones and why they’re so vital:

Understanding Your Options: Beyond the Sole Prop

Here are some popular business structures that offer varying degrees of personal liability protection:

Limited Liability Company (LLC):
- Think of it as: A hybrid that offers the personal liability protection of a corporation with the simplicity and tax advantages of a sole proprietorship or partnership.
- Why it’s great: This is often the go-to for many small businesses. It protects your personal assets from business debts and lawsuits. It’s relatively easy to set up and maintain compared to corporations.
- Who it’s for: A wide range of small businesses, from freelancers and consultants to brick-and-mortar shops.
Limited Liability Partnership (LLP):
- Think of it as: Similar to an LLC but specifically designed for professional services (like law firms, accounting firms, or medical practices) where partners are involved.
- Why it’s great: It protects individual partners from the liabilities of other partners, while also offering general personal liability protection from business debts.
- Who it’s for: Businesses with multiple partners in professional fields.
S Corporation (S-Corp):
- Think of it as: A special tax election you can make for an LLC or a traditional corporation (C-Corp). It avoids the “double taxation” that C-Corps face (where both the company’s profits and the shareholders’ dividends are taxed).
- Why it’s great: It can offer significant tax savings by allowing owners to be paid a reasonable salary and receive the remaining profits as distributions, which are not subject to self-employment taxes.
- Who it’s for: Businesses that are profitable and where the owner wants to optimize their tax strategy. You’ll typically want to consult with a tax professional to see if an S-Corp election is right for you.
C Corporation (C-Corp):
- Think of it as: The traditional corporate structure. It’s a completely separate legal entity from its owners, offering the strongest liability protection.
- Why it’s great: Ideal for businesses that plan to seek venture capital funding, go public, or have a complex ownership structure. It allows for unlimited shareholders and often provides more credibility to investors.
- Who it’s for: Larger businesses with significant growth potential and those looking for external investment. For most small businesses, an LLC or S-Corp is usually a better fit due to simpler compliance and tax structures.

Why This Matters: Protecting Your Future

The primary reason to choose a formal business structure is personal liability protection.

Protect Your Assets: Without a separate legal entity, a business lawsuit or significant debt could mean losing your personal savings, your home, or other valuable possessions. An LLC or corporation acts as a barrier, safeguarding your personal wealth.
Enhance Credibility: Having a formal business structure can make your business appear more professional and trustworthy to clients, suppliers, and lenders. It signals that you’re serious about your venture.
Tax Benefits: Different structures offer various tax advantages. While an S-Corp is often lauded for its self-employment tax savings, even an LLC can provide flexibility in how you’re taxed.
Easier Funding and Growth: If you ever plan to seek loans, attract investors, or even sell your business, having a well-defined legal structure makes the process smoother and more appealing.

What’s Your Next Step?

The best next step is to consult with a legal professional (like a business attorney) and a tax advisor/accountant. They can help you understand the nuances of each structure, consider your specific business goals, and recommend the best fit for your unique situation.

Subscribe to our impact investing newsletter

Processing…

Success! You're on the list.

Whoops! There was an error and we couldn't process your subscription. Please reload the page and try again.