Why And When Should I Form a Legal Entity?

Why And When Should I Form a Legal Entity?

Why and when should I form a legal entity for my business? A lot of people start a business as a sole proprietor. It’s just them and they don’t have any employees. They’re just starting a new business, so that is fine. But at some point, as the business grows, there are reasons you should form a corporation or a limited liability company, an LLC, for your business. 

You need to protect yourself

Why do you form a legal entity? It’s because the business might have liabilities. It could get sued. An employee sues for something, or a vendor sues for something. There might be an accident on a job site and there could be a lawsuit. Those are pretty common in California; they happen all the time. People get sued. 

And you want to protect your personal assets from your business assets. The owner of the business shouldn’t be forced to pony up their personal assets if something happens in the business and it gets sued. To protect yourself, you form a legal entity to limit the personal liability of the owners and the management. 

More advantages of having an entity

In addition, the legal entity becomes a party to any contract. Whenever you sign a lease or a contract with a vendor, a manufacturer, or a supplier, the actual party signing the contract and being liable for the obligations and any debts involved in that contract is the corporation or the LLC and not the individual owner. That becomes very important to help protect you from personal liability as well. 

Often, when you want to hire employees and limit liability, forming a legal entity also helps. That way, the employee can sue the legal entity and not you personally because that’s who the employer was. There can also be tax deductions and other tax reasons if you have a legal entity rather than a sole proprietorship. 

Privacy and image

Privacy can also be an issue people are worried about. “We don’t want everyone to know who the owners of the business are.” And so you set up a corporation or an LLC, and whatever name is being used for that corporation is the official owner. Also, setting up a corporation or LLC provides a brand or creates the image of a bigger company than an individual like Joe’s Plumbing would. 

When to form a legal entity

When do you form a legal entity? It’s always good to do it early on in the process of setting up a business, but obviously, there are some costs involved. So when you hire employees, it’s a good idea to set up a legal entity if you don’t already have one. 

Let’s say you have partners or other owners. In that case, you want written instructions on how things are going to be managed and operated. All those things, including ownership, should be in writing, and typically, a legal entity is the best way to do it. 


More signs that it’s time to form an entity

It also prepares the company for what I call a business divorce if one of the two or three or four of you wants to walk away, gets divorced or dies. It’s easier in a corporation or an LLC. Anytime you start having significant operations, or you start making a couple of hundred thousand dollars in revenue per year, then your exposure along with your potential liability becomes greater. 

Just like when you start gaining more assets, if you have more money in the bank, you are a potential target to creditors and their attorneys for lawsuits. These could range anywhere from injuries on the premises of a business to employees’ lawsuits for wrongful termination or wage and hour violations. 

If you want to buy real estate, it’s a good idea to put it in the name of a legal entity, whether it’s for business or even for personal reasons. If you want to raise capital or expand your business, most financing sources are going to expect that your business is a corporation or an LLC, or at least that you form one before they’ll actually give you the money.

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