Key takeaways:

• Most small businesses in the US operate as sole proprietorships, which means there is no legally separate entity. 
• A business entity like a limited liability company (LLC) or corporation creates legal separation between the owner’s personal finances and the business.
• Creating a business entity is more expensive and takes more work than operating as a sole proprietorship but offers a number of advantages. 
• Learn how to evaluate the option that makes sense for your business. 

When you’re starting a business, you may want to get down to business, and bring in money as fast as possible. That makes sense, especially if you don’t have a lot of startup funding or experience running your own business.

The fastest path to getting started is to start your business as a sole proprietorship. That’s how the majority of small businesses operate. For the most part, you just start your business. You may need a business license or a fictitious business name, but for the most part, there are few formalities. 

Forming a  separate business entity means you create a business that’s legally and financially separate from its owners. There’s a cost to forming a business entity, and additional paperwork and legal requirements to follow. 

Learn about the pros and cons of creating a separate business entity. 

What is Business Formation?

Business formation is the legal process of creating a separate business entity. While you can start doing business immediately as a sole proprietorship, forming a business entity requires specific steps and documentation with state and federal authorities.

The two most common types of business formations are:

• Limited Liability Company (LLC)
• Corporation

An S corporation is essentially a tax choice: an LLC or C corporation may be able to choose to be taxed as an S corp. 

General partnerships and limited partnerships don’t provide the same level of asset protection that LLCs or corporations do. 

When you form a business entity, you’re creating a distinct legal structure that separates your personal assets and activities from your business operations. This separation affects:

• How your business pays taxes
• Your personal liability for business debts
• The way you can raise money for your business
• How you manage and transfer ownership
• Your ability to build business credit

Unlike a sole proprietorship where you and your business are considered the same entity, a formal business formation creates boundaries between your personal and business activities. These boundaries must be maintained through proper accounting, documentation, and business practices to keep your legal protection.

The formation process typically includes:

• Choosing a unique business name
• Filing formation documents with your state
• Obtaining an Employer Identification Number (EIN) from the IRS
• Opening separate business bank accounts
• Setting up proper accounting systems

While forming a business entity will cost money, and require more upfront work and ongoing compliance than operating as a sole proprietorship, the benefits you get may be worth it.

Why Would You Incorporate Your Business?

Liability protection is one of the main reasons entrepreneurs form a legal entity. Even a very small business can carry a lot of risk:

• Debts that aren’t repaid
• Product or service liability
• Contract disputes 
• An accident on a client’s property
• Customer data leaks

With a business entity that’s correctly formed and maintained, a business owner may avoid personal liability for the business’s debts, or lawsuits against the business. 

There are additional benefits to operating under a business entity:

Credibility

Operating as a corporation or LLC often carries more credibility with customers, vendors, and partners. Some larger companies won’t work with businesses that aren’t set up as a separate entity, and that’s often the case with government contracts as well. 

Business Financing

As a sole proprietor, there’s no legal separation between you and the business. You never truly separate your personal finances from that of the business. 

And some small business loans and financing are only available to business entities. 

Business Credit Building

A separate business entity can establish its own credit profile, separate from your personal credit. This separation allows you to build business credit and potentially access better financing options as your business grows.

While you can build business credit as a sole proprietorship, again, there’s no legal distinction between you and your business. 

It’s better, if possible, to establish business credit as a separate business entity. 

Transferability

If you hope to sell your business, it is often much easier if the business is an LLC, S-Corp or other corporation (although in some cases, you can transfer specific assets to another sole proprietorship). 

Sole Proprietorship vs Business Entity

Feature	Sole Proprietorship	Business Entity (LLC/Corporation)
Formation	Simple – just start doing business	Requires state filing and documentation
Cost	Minimal -possibly licenses and/or name registration	Higher – state filing fees, possible legal fees
Personal Liability	Full personal liability for business debts and lawsuits	Limited personal liability if properly maintained
Credibility	May appear less professional	More professional; may be able to get larger contracts
Compliance	Minimal	Corporate records / business structure must be maintained
Taxation	Business income and expenses are reported on Schedule C with personal tax return	Several options, including ability to elect S corporation status to potentially save on payroll taxes
Business credit	Possible to build business credit as a sole prop, but more limited	Can build business credit separate from personal credit
Business financing	No separate entity for truly separate financing	Business may be able to get financing solely in the name of the business
Raising Capital	Unlikely to get investors outside of friends or family	May be able to attract outside investment
Transferability	May be able to sell business assets but difficult to sell entire business	Can sell business
Banking	Some business bank accounts available	More options for business banking
Complexity	Simpler to run but more liability	More involved to maintain, but with less liability
Contracts	Owner must enter into contracts	Business can enter into contracts
Growth potential	Often limited to owner/family members	More potential to grow business

Despite the benefits of forming an LLC or incorporating, there are times when it makes sense to operate as a sole proprietorship. A few examples of times when it might make  sense to consider operate that way:

Low-Risk Businesses

If you provide personal services where the risk of lawsuits or major business debts is minimal, a sole proprietorship might be sufficient. Examples include:

• Freelance writing or editing 
• Virtual assistant
• Small consulting practices
• Online teaching or tutoring

Be sure think through the risks. If you are writing about personal finance topics, for example, that carries more risk than writing about a topic like crocheting. 

Side Hustle

When you’re testing a business idea or running a small side hustle, starting as a sole proprietor can be practical. This includes:

• Selling handmade items online
• Stock photography
• Social media management for a few clients

Just because your business isn’t making money, that doesn’t mean you shouldn’t form a business entity, though. If the products you sell online could injure someone, you probably won’t want to sell it this way. 

Low Cost Startup

When your business doesn’t require significant investment or equipment, and you don’t plan to take on debt, a sole proprietorship offers simplicity. Examples include:

• Home-based businesses with low overhead
• Service businesses using existing skills and equipment
• Businesses with pay-as-you-go expenses
• Direct sales or network marketing

Again, different businesses carry different levels of risk. If your service business will take you onto customer property, or even require you to deliver your products or services, it will likely be better to form a business entity. 

Early-Stage Startups

Sometimes it makes sense to start as a sole proprietor while you:

• Test your business concept
• Build your customer base
• Learn your market
• Determine if the business is viable
• Generate enough revenue to justify incorporation costs

Again, the type of product or service your new business offers can make a difference here. Creating a Youtube channel about your travel adventures is lower risk than starting a tour business where you transport clients or collect and store personal information, for example. 

As your business grows, takes on more risk, or increases revenue, reassess. Many successful businesses start as sole props but later incorporate as they expand or as liability increases. But don’t wait until it’s too late. 

Business Set Up Steps

Regardless of which way you decide to operate, there are a few fundamental steps worth considering: 

Select a Business Name

Choose a unique business name and check its availability through your state’s business filing website. Most states require your business name to be distinguishable from other registered businesses and there may be specific name requirements for LLCs or corporations. Make sure the name you want won’t conflict with an already registered trademark.

Sole proprietorships will often want to register their name with a fictitious name registration (“doing business as” or “dba”). 

Get Your EIN

Apply for an Employer Identification Number (EIN) from the IRS. Not all businesses need one, but it can be helpful when you file business taxes, apply for business credit cards, and  build business credit. At a minimum, an EIN helps protect your personal Social Security number by giving you a different tax id number to use for business purposes. 

Get Business Licenses

Business licenses and permits aren’t just red tape – they’re legal requirements that vary by industry and location. Start by checking requirements at three levels: city, county, and state. Your city or county may require a basic business license to operate legally. 

States often require additional licenses for specific industries like restaurants, childcare, or professional services. For example, a restaurant might need a health permit, food service license, and liquor license, while a home-based consulting business might only need a basic business license. 

Don’t forget industry-specific permits – contractors need construction permits, beauty salons need cosmetology licenses, and financial advisors need professional certifications. 

Many businesses also need a Seller’s Permit (or Sales Tax Permit) if they sell physical products. The best approach is to check with your local Small Business Development Center or SCORE chapter, where you can get free business mentoring to help you set up your business correctly. 

Operating without required licenses can result in fines or even get your business shut down.

Set Up Business Banking

Open a separate business checking account. This is required for business entities to maintain legal protection, and often a good idea for sole props. A separate bank account will make it easier to track your business income and expenses, and your business financial health. 

Get a Business Credit Card or Charge Card

Consider getting a business credit card or business charge card both to track expenses and to help build business credit. Credit cards are also among the safest ways to pay due to the ability to dispute unauthorized charges, or charges where purchases aren’t delivered as agreed. 

Set up Payment Processing

Think about how your customers or clients will pay you. If you need to accept debit or credit card services, for example, you’ll want to consider getting a merchant account. Services like PayPal, Venmo, or Cash App may give your clients more options. Set up an ACH service if you plan to invoice clients. 

Establish Business Credit

Good business credit scores can help your business qualify for more financing options and, potentially, larger contracts. 

Set Up for Taxes

Every business needs a system to track income and expenses for tax purposes. It’s not fun for most entrepreneurs, but if you set up the right systems it will be a lot easier to organize receipts, document income, and track business expenses. 

While spreadsheets might work when you’re starting out, think about using accounting software to help automate this work and reduce the likelihood of mistakes. 

Unlike employees who have state and federal income taxes withheld from each paycheck, business owners need to plan ahead for tax payments. A good rule of thumb is to set aside 25-30% of your income for taxes, though the actual amount depends on your tax bracket and business structure. (Check with your tax advisor.) Keep these funds in a separate savings account so you have the funds to pay taxes when they are due.

Most business owners need to make quarterly estimated tax payments, due in April, June, September, and January. These payments cover both income tax and self-employment tax. Missing these payments or underpaying can result in penalties, so work with a tax professional if you’re unsure about the correct amount to pay. Keep all tax records for at least three years, and maintain important documents like business formation papers permanently.

Going from a Sole Proprietorship to Business Entity

If you decide to go from a sole prop to a separate legal entity, additional steps will be involved. 

Choose Your Business Structure

Start by deciding between an LLC or corporation. You’ll also need to decide whether to elect S-corporation tax status. Get professional tax and legal advice to understand which structure best fits your situation. The wrong choice could cost you money in additional taxes or limit your growth options.

Get a Registered Agent

Every business entity needs a registered agent, which is someone authorized to receive legal documents for your business. This can be you, but many businesses use a professional registered agent service to ensure they never miss important legal notices or communications.

File Formation Documents

File your Articles of Organization (LLC) or Articles of Incorporation (corporation) with your state department of corporations, Secretary of State, or similar office. These documents establish your business entity legally. 

Each state has different requirements and fees. Some states require additional documents like operating agreements or initial reports.

Set Up Payroll

If you are going to pay yourself payroll (required for an S corp or C corp), or if you are going to hire employees, consider working with a payroll service provider. These companies can help you comply with payroll requirements, and are often quite inexpensive when compared to hiring someone to run payroll for you. 

Final Word: Separate Business Entity

Creating a separate business entity isn’t the right choice for every person or business. Some business owners can operate indefinitely as sole props, while others would benefit from forming an LLC or incorporating. 

If you’re thinking about making your company a separate business entity,  take some time to look at your options and choose the right type of business entity for your business needs and goals. 

Whether it’s an LLC or C corp, and whether you elect to have either type of entity taxed as an S corporation, think through the long-term implications. 

While many entrepreneurs don’t think they’ll need the protection of forming a separate business entity, lots of businesses stand to benefit from operating this way. If you wait until you are sued, for example, it’s too late to form an entity and get the benefits of a business entity.

Regardless of the service or product you offer, remember that your company is a business and take steps to make sure it operates that way. 

Nav can help. With Nav Prime, you can build and monitor business credit. Track your cash flow and get financing recommendations for every stage of your business.