Back when times were simpler and lawyers weren’t as abundant, all you really needed to do to go into business was to hang a sign outside your shop and tell the world that you were open. Then, when you finally decided to shut the doors for good, you simply didn’t come to work. There was very little distinction between the entrepreneur and his business.
Times, tax laws, and legal precedents have changed, and people going into business for themselves in the 21st century have also had to change how they go about creating a business entity. Simply hanging the sign outside your door today will probably result in exposure to taxes and legal liability that shouldn’t apply to you. To select the business entity that best suits your need, new entrepreneurs should first consider what is most important to them.
- Cost: Cost not only refers to the cost of creating your business entity, but also the cost of maintaining it. In some cases, there are annual fees you must pay to the state so they will continue recognizing you as a business and not just someone illegally collecting money. Other fees may also be required depending on state requirements.
- Maintenance: This refers to how much work needs to go into maintaining your business. Some entities don’t require maintenance once they have been established. Others require serious record-keeping effort in order to comply with state regulations.
- Tax Liability: Some business entities will allow you to save money on your income taxes by passing the income directly to the owner. This way, the owner avoids his money being taxed twice (once when paid to the company and once when paid to the owner through a paycheck or dividend.)
- Legal Liability: Some business entities protect their owners from personal liability when a client has a claim against the business.
- Ownership: Different entities have different rules for how many owners it can have. This is important to think about if there is a possibility of going public at some point.
Business Entity Types
Today, there are several business entity options available for entrepreneurs. Like anything else, each of them has advantages and drawbacks.
A sole proprietorship is a business entity that is virtually indistinguishable from its owner. The cost to create it is frequently only a small one-time fee to the state or county officials to register a fictitious business name and the cost of placing an ad in your local paper to notify the public that you are doing business under that name (i.e., Joe Public is now doing business as “Joe’s Coding Shack”). You may also need a state, county, or city business license, so check withyour local authorities to ensure compliance.
A sole proprietorship has few recurring costs. Since the business and the individual are identical, there is no special maintenance required to keep the business alive, so there should be few recurring costs beyond any state business license fees and fees to maintain your fictitious business name. As long as you continue to call yourself a business, you are one.
There is a price for this easy set-up, though. Sole proprietorships cannot take advantage of special business income tax rates since all income is considered individual income. Sole proprietors are also not protected from personal liability if they get into trouble with a client. If an upset client decides to sue, they sue the proprietor personally. If the proprietor must declare his company bankrupt, he files for bankruptcy personally. And, by definition, a sole proprietorship can have only one owner, and that owner must be a “natural person” (i.e., not a corporation, trust, LLC, or other such entity.) Finally, a sole proprietorship cannot be sold or passed to one’s inheritors.
General partnerships are formed by two or more legal entities (any kind of legal entity can be partner), and each of those entities are individually responsible for the partnership. This means that each partner is personally liable for the partnership’s debts and legal liabilities. If one rogue partner makes an enemy of a third party, all partners will come under fire.
For tax purposes, all partners are considered self-employed and claim their share of the partnership’s income on their individual tax returns (the partnership itself pays no taxes). General partnerships are relatively easy and inexpensive to create and maintain, although the state where the partnership is established usually requires annual renewal filings and fees. A partnership agreement usually accompanies the formation of a general partnership, though it is not legally required. Partnership agreements generally cover topics like transferability, duration, and management control.
A limited partnership is much like a general partnership in structure. The main difference is that in a limited partnership, there are two different kinds of partners: general and limited. A limited partner does not take part in the management of the partnership and is not liable for any more than his individual capital investment. This distinction is made to encourage investors to become limited partners and so they can share in the profits but not lose more than their own contribution.
A “C” corporation is a standard state-formed corporation. It is a legal entity once it is formed, so it files its own taxes and is responsible for its own dealings. A “C” corporation can have unlimited numbers of shareholders, and those shareholders can be any kind of legal entity.
Corporations are the most expensive kind of business to begin and maintain. Not only do they require significant annual filing fees (which, in some states, can add up to several hundred dollars per year,) but they require a good deal of effort on the part of the director(s) to maintain. A board of directors must be elected, annual meetings must be held, minutes of corporate meetings must be kept, stock must be issued. And all this applies even if you are the only shareholder in the corporation. If these formalities aren’t followed, you run the risk of losing your personal liability protection if a court decides that your corporation was just an alter ego of yourself created to keep you safe (sometimes referred to as “piercing the corporate veil”).
Additionally, since corporations are taxed on their income and shareholders have to claim dividends as taxable income themselves, shareholders of a “C” corporation are “double taxed” on their dividend income. One way to avoid this is to not issue dividends and simply re-invest your income back in the company. Spending your income on items that are tax-deductible is another way. You could also look into forming an “S” corporation.
An “S” corporation is much like a “C” corporation in that it is also its own legal entity, protects its shareholders from legal liability, and requires a significant amount of effort and money to start and maintain. However, an “S” corporation allows shareholders to claim their share of the corporation’s income directly on their personal tax return. This gets around the “double taxation” problem of a “C” corporation. The only drawbacks of an “S” corporation are that they may cost a little more to form and they are generally limited to a maximum of 75 shareholders. This makes going public with an “S” corporation practically impossible. However, if your intention is to keep your business relatively small, this is an excellent option.
Limited Liability Company
A limited liability company (LLC) is essentially a hybrid of a corporation and a partnership. An LLC provides the same kind of tax and liability benefits as a corporation, but has the same management structure as a partnership. In the past, LLCs have had more restrictions on them than corporations. For example, at least two people were needed to form an LLC and an LLC’s duration was specifically limited. However, in the last few years, states have started loosening these restrictions.
Forming an LLC is about as complicated as forming a corporation. The LLC comes into existence when the Articles of Organization are submitted to the state (and the appropriate fee is paid.) The LLC members must also have an Operating Agreement, but it is not necessary to file it with the state. In fact, in most states, it can be verbal.
It’s as easy as one, two, three
Regardless of the entity you choose, the steps to forming it are essentially the same:
- Decide which state you want to form your company in. Some states are more business-friendly than others. You’ll need to either be physically present in the state you choose, or hire a registered agent who is.
- Choose a name for your company. You’ll need to pick something that isn’t already taken in the state you have chosen. The attached Excel workbook has links to every state’s Secretary of State website, most of which have online name-search abilities. It’s probably a good idea to also check with the Patent and Trademark Office to make sure that your company name doesn’t infringe on someone else’s trademarked catchphrase.
- Follow the instructions for your state to form your company!
Congratulations, you’re in business. Reward yourself and purchase that sign to hang outside your shop now.
And after you spend the money on your sign, you’ll need to record that expense somewhere. Which is why we’re going to discuss accounting software next time.