Many small businesses start as a part-time effort that grow over time, and eventually become a profit generating venture. One of the difficult questions for a small business owner is, “When do I need to form an entity?” A follow-up question is which type of entity to form such as a corporation (sub-chapter S or C Corporation), limited partnership (LP), limited liability partnership (LLP), or limited liability company (LLC).

The business person who is a sole proprietor should be aware that his/her liability is virtually unlimited. When you do not have the protection of an entity under which your business operates, it is your personal assets that are at risk. Therefore, if a party were to sue you, your personal assets would be exposed. Many states, such as Texas, offer homestead protection so that creditors cannot foreclose on an individual's home, but such laws vary from state to state.

The formation of a legitimate business entity offers varying forms of protection for a business person's personal assets. Entity formation is the process wherein one establishes an entity authorized to conduct business within a certain jurisdiction. In Texas, one would file entity formation papers through the Secretary of State's office. Each state has a government office that handles entity formation. Generally, an entity can be created for as little as $50-$250 per application. Though this step often occurs later as a business grows, it is a small financial investment to make early on. Creating an entity also gives your business credibility in that you have taken the steps to define it as a functioning entity. The most common entity formed by a new start-up business is the LLC (Limited Liability Company). Limited liability companies are designed like partnerships, and therefore suitable to small businesses, but have asset protection similar to a corporation. When your entity is set up you will also receive a tax ID from the state comptroller. Therefore, you will likely have to file a franchise tax return in your state(s) of operation. You should also request a federal tax identification number (FEIN). You may want to consult a CPA to determine which type of entity offers the most tax advantages in your state.

The other component in protecting personal assets is to purchase business liability insurance. Most insurance carriers have business divisions which write general liability insurance polices. Contact your current carrier and see if you can obtain insurance this way. Additionally, you may be covered under your homeowner's policy depending on the business you are in, anticipated revenues, and the potential exposure. Speak with your insurance carrier to find out what you need to do to protect yourself.

You can apply for the entity yourself or with the aid of an attorney. As mentioned earlier, you should speak with a tax attorney or CPA about which entity offers you the best tax advantage in your state.