Separate Legal Entities for Small Business: Small Business Tips

Many small business owners choose to create a separate entity for the business in order to gain specific benefits. However, if you are new to the world of small business, you may wonder what it means to create a separate entity, as well as what advantages you can expect to gain. Below is a guide to help you understand this complicated topic and make the best decision for your unique situation.

What does legal entity mean?

The phrase “legal entity” simply means that your business has its own independent existence, separate from you both legally and financially. This provides multiple benefits for business owners. The primary benefit of creating a separate legal entity for your business is protection from liability. 

Important: When your business exists as a separate legal entity, you won’t be held liable for its debts, nor will you be liable in the event of a lawsuit related to accusations of negligence or illegal actions. Likewise, having a separate legal entity for your business can also provide protection for business assets in the event of a personal lawsuit or bankruptcy.

Which form of business organization is established as a separate legal entity from its owners?

As a small business owner, you can choose to organize your business in different ways. However, not every business structure will be considered a separate legal entity. For example, if you choose to structure your business as a sole proprietorship, the business will not be considered a separate legal entity, and you will be vulnerable to business liabilities. General partnerships also leave members vulnerable to the business’s liabilities, as they are not considered separate entities either.However, limited partnerships and limited liability partnerships may provide some protection.

Business organizations that are always considered separate legal entities include:

• All types of corporations, including S corporations and C corporations.
• Limited liability companies, or LLCs.

What are some of the most common legal entities used by small business owners?

Small business owners may choose from any type of business organization. However, many small business owners opt to structure their businesses as limited liability companies (LLCs). An LLC arrangement provides a flexible option for business owners, providing them with limited liability protection while still allowing them to elect to be taxed as a partnership. This means that owners will be protected from debts and lawsuits related to business activities, but they will not pay extra taxes simply because of their business structure. Although the owners of an LLC can elect to be taxed as a corporation instead, few business owners use this approach.

Small business owners who want to ensure they have maximum liability protection may opt to structure themselves as a corporation in spite of the higher taxes required. However, this structure is not as common among small businesses as the LLC.

Which legal entity provides the least flexible legal arrangement for owners?

The separate legal entity with the least flexible legal arrangement for business owners is the corporation. Like an LLC, a corporation provides protection from liability. When a business is structured as a corporation, however, there is no option to be taxed as a partnership. Instead, income earned by the business will be subject to a corporate tax rate. Dividends distributed to members of the corporation will be taxed again as individual income. In addition, corporations come with a long list of formal requirements in order to maintain the status of the business, such as regular meetings and the filing of specific documents on a regular basis.

Single members vs multiple member LLC legal liability protection

Both single-member and multi-member LLCs offer some level of liability protection. However, in general, the protections offered by a multi-member LLC are greater than those of a single-member LLC. For example, in the event of a bankruptcy of one member in a multi-member LLC, business assets would typically be protected because they are also the property of members who are not involved in the bankruptcy. On the other hand, if the individual filing bankruptcy is the only member in a single-member LLC, the business assets may not be protected from the bankruptcy.

A similar situation would arise in the event of a personal lawsuit against one of the members. While a single-member LLC may be vulnerable to the lawsuit of its only member, a multi-member LLC would offer more protection.

Setting up a separate legal entity for your small business

Choosing the right legal entity for your business is the first step in establishing a business structure. Each of the different structures available offers different advantages and disadvantages, so it is important to learn about your options before you make a decision. In some cases, it may also be a good idea to consult with an attorney so you can be sure you fully understand the ramifications of your choice.

Once you have selected the type of business structure you want to establish, you need to follow your state’s procedures for establishing the type of business structure you have chosen. In most cases, this process will involve registering the business with the state. For example, most states will require a business owner establishing an LLC or a corporation to file Articles of Organization or Articles of Incorporation. You will also be required to choose an acceptable business name and complete any other tasks required by your state. If you aren’t sure what steps will be required, contact your state’s government to learn more.

Keeping your business separate

Setting up a separate legal entity for your business comes with a number of protections and benefits. However, registering the business as its own separate existence with the state is only part of the process when it comes to maintaining a full separation. It is also important that you keep your business separate from your personal life and finances as it operates. Otherwise, you may not be entitled to the same benefits. Below are some tips to help you maintain a separate legal entity for your business successfully.

1. Understand your legal requirements.

Many states will require business owners to continue to follow certain regulations even after they have filed the initial paperwork to establish their new business. In addition, some businesses must file separate tax documents on an annual basis. Upon establishing your new business organization, make note of all the requirements you must meet at the local, state and federal level each year. Be sure to keep careful track of deadlines so your business can remain in full compliance with these regulations at all times.

2. Register for an EIN.

Another step you need to take to make sure your business remains a separate legal entity is to register for an EIN, which is a business tax identification number that works similarly to the social security number issued to individuals. Use this EIN to maintain the separation between your business and your personal finances.

3. Open a separate checking account.

Regardless of the size of your business, it is always a good idea to open a separate business checking account to keep your business and personal finances well separated. Intermingling of business and personal transactions can put the protections and benefits your separate business entity provides at risk. After you have opened a separate account, be sure that you are using the account strictly for business purposes. Do not use the money in this account to pay personal expenses, and avoid transferring your personal funds into the business account as much as possible. Make sure any withdrawals made from this account are properly documented.

4. Use a separate business credit card.

Another important strategy you can use to maintain separate finances for yourself and your business is to open a business credit card that will be used exclusively for business purchases. Be strict about the way you use both your business and personal credit cards, avoiding any intermingling of transactions.

5. Keep careful, detailed records.

One of the most important things any business owner can do to keep personal and business finances separate, as well as to ensure that they can take advantage of the maximum protections and advantages available under the law, is to keep detailed records. Keep written records of every transaction made by your business, whether you are making purchases or receiving income. Be sure that your records show the amount of the transaction, the date and the transaction’s purpose.
Keeping careful records is also important for tax purposes. Having clear records of all your expenses and income will make it much easier for you to complete required tax returns, calculate the tax you owe and pay no more in tax than you need to. In addition, having these records on hand will be essential in the event of an audit. Furthermore, detailed financial records can help you to better evaluate your business’s financial position, minimize expenses and maximize profits.

6. Get help from professionals.

If you are concerned about satisfying regulations and maintaining a separate entity for your business without making mistakes, seeking help from professionals is recommended. Business attorneys, professional accountants and/or professional tax preparers may be able to help you simplify these complex aspects of running a small business. Professionals can also answer any questions or address any concerns you may have along the way.

Separate Entities: The bottom line

As a small business owner, you have a variety of options when it comes to choosing a structure for your business. While some business owners may elect to structure the business as a partnership or sole proprietorship, establishing a separate entity for your business offers several notable advantages. With a separate entity, you won’t be subject to the same level of liability for business debts or incidents. Likewise, your business assets will be protected from personal liability and debt problems. Establishing a separate entity for your business requires you to complete several important steps. You must also manage your business as a separate entity to gain the full benefit. For additional assistance with this process, consider consulting with legal and/or tax professionals.

Disclaimer: Please keep in mind that the content of this post is not intended as tax, accounting or legal advice. The information presented here is for informational and educational purposes only. Before engaging in any transaction, be sure to discuss these matters with a trained, licensed professional.

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