Short Answer: Set up a Legal Entity for your business so your personal assets are not at risk of being used to cover business debts and liabilities.
As entrepreneurs, we’re often told to think big and move fast.
Thinking big is very important to success…
But moving too fast can often be dangerous. Especially in the beginning.
Many new entrepreneurs jump into their business way too quickly, overlook important details, and then they make costly financial and legal mistakes.
These mistakes could seriously jeopardize the long-term success of your business.
#1 Newbie Mistake
The biggest “newbie” mistake is not setting up a Legal Entity for your business.
If you don’t create a Legal Entity, the law will view your business as a Sole Proprietorship (if there is 1 owner) or a Partnership (if there are 2 or more owners).
Both Sole Proprietorship and a Partnership leave your personal assets exposed.
If a Sole Proprietorship or Partnership is sued, the owner’s personal assets (home, cars, bank accounts, etc.) are at risk of being used to settle business debts and liabilities.
So what kind of options do you have for setting up a Legal Entity?
The most common Legal Entities that people form are LLCs and Corporations.
But, before we get into the details, it is important to first understand their foundation.
Let’s discuss what a Legal Entity really is.
Legal Entity/Business Entity
A Legal Entity is the same thing as a Business Entity, and we’re going to jump back and forth between the two terms in order for certain paragraphs to make more sense.
In the eyes of the law, a Business Entity is a “Legal Person”.
In the eyes of the law, you and I are “Natural Persons”.
A Natural Person is a living, breathing human being that functions independently and makes decisions on their own.
A Legal Person is only functional through the work and actions of Natural Persons acting on its behalf.
A Legal Person is considered by law a separate and distinct “person” from its owners.
This separation is what creates a “protective wall” between your assets and the assets of the business…therefore, the LLC keeps your personal assets safe if your business was to be sued.
Think of a Natural Person as a regular human being like you and I.
Think of a Legal Person as a Corporation like Microsoft or IBM, or even companies like your local grocery store or bike shop.
Although a Business Entity is not an actual living, breathing person, it shares many of the same rights and responsibilities as you and I do.
What Can a Business Entity Do?
– make money
– own property (such as real estate, boats or aircraft)
– enter into contracts and agreements
– open bank accounts
– it can sue and be sued
– pay taxes
Basically, the only thing a Legal Entity can’t do is vote in an election, run for political office, or do laundry.
By setting up a Legal Entity, you are creating a business organization that can interface with customers, clients, vendors and more.
Safeguarding Your Assets
And most importantly, by setting up a Legal Entity you are keeping your personal assets safe.
In the event of a lawsuit, creditors can only go after the assets of the Legal Entity, and that is all they can get…
They cannot get to your personal assets.
Personal Liability Protection
Again, personal liability protection is the #1 reason that people set up a Business Entity.
If you don’t create a Business Entity, the law will view your business as a Sole Proprietorship (if there is 1 owner) or a Partnership (if there are 2 or more owners).
Neither a Sole Proprietorship or a Partnership will protect your assets.
Remember, if a Sole Proprietorship or Partnership is sued, the owner’s personal assets are at risk of being used to settle business debts and liabilities.
If you first create a Business Entity and your business is sued, then the courts can only go after the assets of the business (not your personal assets).
Forming a Business Entity creates a “shield of protection” between your business and your personal assets.
The two main types of Business Entities that people form are Corporations and Limited Liability Companies (LLCs).
We compare these in more detail in the “Sole Proprietorship vs. LLC vs. Corporation” section.