Starting a business is exciting, but don't overlook the details. It's important to think through which type of business entity makes the most sense for your company today and down the road.
As you make your decision, you'll also want to steer clear of these five common mistakes that entrepreneurs make when selecting a business entity.
1. Not forming an entity
There's an old saying that not making a decision is a decision in itself. Similarly, not choosing an entity structure leads to the default of operating as a sole proprietorship. Sharon Winsmith, founder and owner of Winsmith Tax, cautions against this.
“This is the single biggest mistake I see," she says. “You should always have an entity in place ... A legal entity provides you with asset protection to ensure any future claims from creditors can only be satisfied with the assets in the legal entity," she explains.
2. Failing to research your options
Rick Hoskins, founder of Filter King, offers a slightly different mistake to avoid—not researching all your options at the start, which could put you and your business on a path that doesn't match your goals.
“For example, if you do decide to have shareholders down the road, do not make your company an LLC," he says. “LLCs are owned by partners who share the profits. Partners are more involved in the business plan and operations, whereas shareholders are simply investors. Often shareholders have a voice, but they usually only take up 49% of the shares, max."
3. Focusing on short-term, rather than long-term plans
Paul Sundin, CPA and financial consultant with Emparion, points out another potential pitfall: “Structuring your business for the short-term and not considering the future, such as the potential for investors or new owners."
Ryan Maxwell, COO at FirstRate Data is a case in point. “We decided that we would need to raise funds for growth in the early years of the business, so we needed an investor-friendly structure," he says.
Although he and his team had originally planned on filing as an LLC, they quickly realized it was not advantageous from an institutional investor's perspective, “since any losses from the company would be reported and accumulate in their investment fund," Maxwell says.
“We elected to choose a C corporation, where profits and losses are kept within the corporation for taxation purposes. The C corporation also allows us to issue multiple classes of shares, which is also a requirement for investors who usually request a separate share class be issued for each investment."
4. Considering tax advantages alone
“It's a huge mistake to select your filing type solely because it offers certain tax advantages," says Jim Pendergast, senior vice president of altLINE Sobanco, a division of The Southern Bank Company. “For instance, you'll see some niche organizations in their early days avoiding C corporation status at all costs, even when it's clearly the most functional entity for their business model, growth goals, and industry."
Pendergast notes that tax treatments are complicated and fluid. “These tax considerations have to be balanced with liability concerns, government requirements, and, ultimately, your vision for the business' future," he says.
5. Keeping it casual with multiple owners
When forming a partnership or LLC with people you know well, you may be inclined to skip the official paperwork. After all, you're friends, right?
This is a big mistake, says Lewis Mayhew, CEO of South Scaffolding. “Long-term ownership situations, or in case of separation, all need to be accounted for," he says. “The more specific the agreements and terms, the better."
The good news is that it's fairly easy to avoid these common mistakes simply by exploring all your options, thinking about where you see your business going—and growing—in the years to come, and being sure to formalize any business relationships.
Find out more about Starting a Business