The 6 Most Costly Mistakes Made by Business Owners: Choosing the Wrong Entity Type

Running a business is hard.  Anyone that has ever run a small business knows that there are a multitude of mistakes to be made and each one offers its own series of lessons about how to do things better the next time.  However, it’s good to know that someone else has already paved the path to success and you can learn from the mistakes they made along the way.  Since nearly 50% of businesses fail after five years, it’s worth exploring some of the biggest mistakes small businesses make so you can avoid that same fate.  Over the next few weeks, we’ll be covering the top six most costly of these.

Without further ado, the first potentially costly mistake made by business owners is in selecting the wrong entity type for their company. Choosing the correct structure for your business will have long term implications on how the owners are compensated and how the income of the business gets taxed.  It’s easy to make a short-sighted decision in the early years when the company isn’t producing much income that could cost you dearly years later when the business becomes successful.  For example, if the company (Company X) has real estate or other assets of value, it might make sense to set up a separate company to own those assets (Company Y).  Then Company Y rents the assets back to Company X.  Later, if the primary business (Company X) becomes the target of an acquisition, the founding owner could potentially maintain ownership of the rented assets in Company Y, thus maintaining the ongoing cash flow from the rental activity.  However, this arrangement could create taxation issues in that the rental activity would be considered passive income.  With passive income, the owner might not be able to fully utilize the depreciation benefits flowing from the rental activity.  There are multiple other factors that will come into play, but suffice it to say, it takes a lot of thought and planning to determine the ideal structure for a business.

There are also legal and liability implications to be considered. Your ultimate exit from the business will be affected by the type of entity you choose, so choose wisely.  Selecting the right entity may mean spending some money in the early days on legal and accounting fees, but those fees will more than pay for themselves in the long run. In other words, it is highly advisable to consult a trusted financial advisor in making such an important decision about your business. Stay tuned till next time when we take a look at the risks of a business not understanding what its services and products are truly worth.