This article is part of our “Business Startup Guide“—a curated list of our articles that will get you up and running in no time!
How you form your business, and its legal structure, is one of the most important decisions you will make in the process of launching your venture.
The business entity
The pros and cons of different business formations are worth understanding. They vary by state—consequently this is not a good area for guesswork, and not a good place to save money, so please go through this with a local attorney you can trust. The following is for background information.
Although the details vary, it starts with the choice between sole proprietorship, partnership, corporation, or the more trendy Limited Liability Company, LLC. Within the corporation classification you have additional choices, between the standard corporation or the small business S corporation.
The simplest form is the sole proprietorship
The simplest form is the sole proprietorship. Simply put, your business is a sole proprietorship if you don’t create a separate legal entity for it.
This is true whether you operate it in your own name, or under a trade name. If it isn’t your own name, then you register a company name as a “Fictitious Business Name,” also called a DBA (“Doing Business As”). Depending on your state, you can usually obtain this through the county government, and the cost is no more than a small registration fee plus a required newspaper ad, for a total of less than $100 in most states.
The main disadvantage of the sole proprietorship is the lack of a separate entity, which means you have personal responsibility for it. If the business fails then its creditors can go after your personal assets.
Tax treatment is quite simple, your profit and loss goes straight through to your personal taxes. Your business income is normally on Schedule C of your tax return. This can be good or bad for your tax situation, depending on where you stand with other income.
Partnerships are harder to describe because they change so much. They are governed by state laws, but a Uniform Partnership Act has become the law in most states. That act, however, mostly sets the specific partnership agreement as the real legal core of the partnership, so the legal details can vary widely.
Usually the income or loss from partnerships pass through to the partners, without any partnership tax. The agreements can define different levels of risk, which is why you’ll read about some partnerships that have general partners and limited partners, with different levels of risk for each. The agreement should also define what happens if a partner withdraws, buy and sell arrangements for partners, and liquidation arrangements if that becomes necessary.
If you think a partnership might work for your business, make sure you do this right. Find an attorney with experience in partnerships, and check for references of present and past clients. This is a complicated area and a mistake in the agreement will cause a lot of problems.
Corporations are either the standard C corporation or the small business S corporation. The C corporation is the classic legal entity of the vast majority of successful companies in the United States.
Most lawyers would agree that the C corporation is the structure that provides the best shielding from personal liability for owners, and provides the best non-tax benefits to owners. This is a separate legal entity, different from its owners, which pays its own taxes. Most lawyers would also probably agree that for a company that has ambitions of raising major investment capital and eventually going public, the C corporation is the standard form of legal entity.
The S corporation is used for family companies and smaller ownership groups. The clearest distinction from C is that the S corporation’s profits or losses go straight through to the S corporation’s owners, without being taxed separately first. In practical terms, this means that the owners of the corporation can take their profits home without first paying the corporation’s separate tax on profits, so those profits are taxed once for the S owner, and twice for the C owner.
In practical terms the C corporation doesn’t send its profits home to its owners as much as the S corporation does, because it usually has different goals and objectives. It often wants to grow and go public, or it already is public. In most states an S corporation is owned by a limited number (25 is a common maximum) of private owners, and corporations can’t hold stock in S corporations, just individuals.
Corporations can switch from C to S and back again, but not often. The IRS has strict rules for when and how those switches are made. You’ll almost always want to have your CPA, and in some cases your attorney, guide you through the legal requirements for switching.
LLC (Limited Liability Company)
Be careful with this one, because the LLC form is different for different states, with advantages in some states that aren’t relevant in others. An LLC is usually a lot like an S corporation, a combination of some limitation on legal liability and some favorable tax treatment for profits and transfer of assets. This is a newer form of legal entity.
Why would you establish an LLC instead of a corporation? That’s a tough legal question, not one we can answer here. Since the advisability and advantages varying from state to state, here again, this is a question to take to a good local attorney with small business experience.
See an attorney
Make sure you know which legal steps you must take to be in business. I’m not an attorney, and I don’t give legal advice. I do strongly recommend working with an attorney to go through the details of your company’s legal establishment, licenses, and other items covered here. By including this information in this book, I don’t mean to imply you should do it yourself.
The trade-offs involved in incorporation vs. partnership vs. other forms of business are significant. Small problems developed at the early stages of a new business can become horrendous problems later on. The cost of simple legal advice in this regard is almost always worth it. Starting a company should not involve a major legal bill except in special cases. Don’t skimp on legal costs.
Licenses and permits are usually local issues
It’s hard to generalize on licenses and permits, because some of these depend on where you are, and some depend on what you do. When in doubt, you should check with local sources. If you don’t want to go straight to the local government and ask your questions directly, then ask at a Chamber of Commerce, or Small Business Development Center (SBDC).
For example, many cities have zoning laws that define where you can put retail stores, office space, and industries. Few of these affect the small home-based business, but it’s not unusual to have zoning laws prohibit signs on lawns or houses.
Some types of businesses require local or state licenses. This depends on where you are, but businesses including daycare, hair care, food service, and of course bars and nighclubs often require special licenses.
Resale licenses and sales taxes
In states that have sales tax, state authorities manage a system that sets reseller businesses into a special category, so they don’t have to pay sales taxes on items they buy for resale.
The required paperwork and the state offices that manage it are different in many states, so you’ll have to ask state offices for your state as you establish your business.
Taxpayer ID and employer numbers
Employer ID numbers (EIN) are assigned by the IRS and state tax authorities. If you don’t have employees and you haven’t established a corporation, then your Social Security number is your federal taxpayer ID.
If you’ve established a corporation or you have employees, then you must have a federal EIN, which is assigned by the federal IRS. In most states, the state assigns a separate state number.