No matter what type of business you plan to start, it’s important to understand the legal and financial requirements before you make your first moves. You may be able to begin without filing paperwork for licenses or permits, even though it’s not, strictly speaking, legal. But if you have any kind of success, you’ll need to get legal at some point, so you need to have a firm grasp of what “legal” means.
One caveat: Although you can apply for licenses and permits on your own, it’s smart, and probably less expensive in the long run, to hire a lawyer or an accountant to help with the structure or financial management of your business.
Most state governments provide a number of ways in which your business can be organized. Each has certain advantages and disadvantages. Some have to do with how much tax you pay and how you pay it. Some have to do with who controls the business, who’s accountable to whom, and how. And some relate to specific issues like succession, liability, or capital structure.
However you start your business, one of the first major decisions you must make is how to structure it. Generally, there are six alternatives:
- sole proprietorship
- general partnership
- limited partnership
- closed (Subchapter S) corporation
- open corporation
- limited liability company
The simplest form of business, a sole proprietorship, doesn’t have much structure. A large percentage of sole proprietorships belong to people involved in the so-called cottage industries–businesses operated wholly or in part out of their owners’ homes, often as part-time pursuits rather than the owners’ sole source of income.
Sole proprietorships are inexpensive and easy to organize. Required record-keeping is minimal, and the owner pays no business taxes. However, sole proprietorships have serious drawbacks, including:
They are taxed at higher rates. All income from the business must be reported as personal income and will therefore be taxed at a much higher rate than business income usually is. Also, there are no tax breaks for fringe benefits and insurance.
They have a harder time getting financing. To grow, most businesses borrow money at one time or another, and it is generally much harder for a sole proprietorship to get a loan. If the company is incorporated, it can sell stock (give up equity in the business) to raise capital, if necessary.
The owner is exposed to unlimited personal liability. A lawsuit can attach everything you own–not just the assets of the business. And although liability insurance is available, it can be very expensive and may not cover all potential losses.
An important note: You can purchase liability insurance if you are in a sole proprietorship or (see below) a partnership to limit the scope of your financial responsibility. However, it is always advisable to discuss these issues with an attorney.
They have a hard time building equity. From a succession standpoint, it is hard to build equity for the next generation of a family-owned sole proprietorship. If you die, the business is automatically dissolved. What is left to the heirs is a personal estate.
The disadvantages of a sole proprietorship usually begin to outweigh the advantages when the income from your business reaches about $100,000 a year (that number can vary dramatically). Above that level, the protections offered by a more formal structure are probably worth their higher costs.
Many businesses start as a sole proprietorship but eventually incorporate.
If you are going into business with someone else, you might want to consider forming a partnership. In fact, many modern companies shun sole proprietorships and start out as partnerships between people who have different sorts of skills. In a general partnership, two or more people join together to conduct a business, and each is jointly and individually (or “severally”) liable for its operations.
Partnerships are almost as easy to form as sole proprietorships. Like a sole proprietorship, a partnership does not require any special registration or structure. A written agreement isn’t even required, although it’s a good idea.
Assets, including cash, business-related deeds, and bills of sale–as well as anything else the business will need in order to function–must be transferred into a partnership.
A partnership also can borrow money, often benefiting from the creditworthiness of its members.
A partnership becomes a separate legal entity, but it does not pay income taxes. Instead, it files a partnership tax return that allocates its income (or loss) to each partner, who then must report it on his or her individual income tax return.
One disadvantage, as with a sole proprietorship, is that a partnership makes all partners jointly and severallyliable for the debts and obligations of the business. A creditor can seek the assets of any or all partners. And any agreement among the partners to share that responsibility, although binding on them, is not binding on the creditor.
Partnerships often are formed by professionals, such as doctors, dentists, lawyers, and accountants. They have a limited life, usually specified in the partnership agreement. If a partner dies, becomes incapacitated, goes bankrupt, or simply withdraws, the partnership automatically terminates unless otherwise specified in the agreement.
Partners can transfer their interests to someone else or pass them along to an heir unless forbidden to do so by the partnership agreement. A sound partnership agreement should provide for a buy-out in the event of a death or if the partnership breaks up. When the agreement gives the remaining partner(s) the right of first refusal and specifies that the interest in the company cannot be sold to anyone who offers a lower amount, a fair price and a satisfactory buy-out generally can be arranged.
Remember: A written contract between the two or more partners is important. If you are forming a partnership, sit down with your partner(s) before you start the business and put the details in writing. Go over everything from how you will start your business (who is supplying funds to get it started, what ideas might be proprietary, etc.), and how you will run it (who is responsible for handling the accounting, for dealing directly with clients, etc.), to how you will end it (how will profits be split or debts be handled).
Estimates show that partnerships break up as frequently as marriages–about 50 percent of the time and perhaps more often. As with a marriage, a partnership breakup can be amicable or devastating. The careful selection of a partner is critical.
If you are forming a partnership, look for a partner who:
- stimulates enthusiasm
- stimulates new ideas
- is easy to work with, not egocentric, autocratic, or stubborn
- can offer a different perspective and has talents or experience that complement yours
- uses logic rather than emotion
- shares your goals
- is a good team worker
In a limited partnership, one or more general partners manage the business and are personally responsible for its debts, while the limited partners have no role in day-to-day business operations and are liable only to the extent of their investments for the company’s financial obligations.
As in a sole proprietorship, this structure avoids double taxation–that is, the taxation of both the business income and the individual income.
The limited partnership offers more benefits to a passive investor than to someone who wants to be actively involved in the operation of the business.
Corporations are the safest, generally the most versatile, and, therefore, the most common form of business structure apart from the sole proprietorship. Of course, not all newly formed corporations are new businesses. Many are proprietorships and partnerships that have moved up to a more sophisticated structure.
Legally, a corporation is an entity totally separate from its investors. It is responsible for its own bills, files its own income tax returns, and pays its own taxes. It can sue and be sued. It lives on indefinitely, regardless of who its stockholders may be at a given time.
The main advantage of a corporate form of business structure comes from the fact that the owners (stockholders) are fully sheltered from the liabilities of the company. This can be particularly valuable to those who are attempting to build a fast-growth company that may involve considerable risk.
But, of course, the people running a corporation are not completely absolved of responsibility. Management can be sued by stockholders for malfeasance or nonperformance.
Advantages of a corporate business structure are:
The issue of stock, i.e., shares in the business. A company can sell off some of its shares when the price is high and buy back some of its shares when the price is low, thereby using its own stock as a medium for investment. Stock also can be used as security for loans, like cash in arranging a merger and as an inducement in the hiring and retention of key personnel.
Possible tax benefits. In some cases, corporations pay lower income taxes than individuals. On the other hand, corporate income is taxed twice–once at the corporate level and again when the profits are distributed as dividends to stockholders, who pay taxes on them as personal income.
Professional detachment. The people who run a corporation may not be the people who own it. The head of the firm may be an employee, hired by the stockholders to manage the company, in which case the manager may be free of personal and political issues.
Subchapter S Corporation
The closed, or Subchapter S, corporation can be a useful vehicle for getting a new business started. That is precisely why the provision was put into law in 1958.
Under Subchapter S regulations, the company passes all of its gains and losses to the stockholders, enabling the stockholders to use any initial losses the business may incur during startup to offset earnings from other sources–up to the amount that they have invested in the company.
Subchapter S corporations may have subsidiaries, providing they do not own more than 80 percent of the stock of a subsidiary. But they cannot have more than 35 stockholders.
Subchapter S corporations can be converted to open corporations; but, once that is done, owners are restricted as to when and how they can revert back to Subchapter S status
Limited Liability Company (LLC)
In the 1990s, the limited liability company (LLC), a new organizational form, gained legal status in many states. LLCs are similar to partnerships, except that the liability of partners is limited to their equity investment.
If you plan to have employees and a larger business, you might consider the LLC. In fact, many advisers now recommend that any new business be established as an LLC unless the peculiar facts and circumstances of that business indicate otherwise.
Typically, LLC members set forth a business purpose in their articles of organization or operating agreement. This agreement is ideal for incorporating a mission statement as part of the company purpose, as well. But its real purpose is to identify partners, the roles each plays, and how any disputes or buy-outs will be resolved.
An LLC’s operating agreement can provide for a dispute to be resolved by an appropriate mechanism. An agreement might include specified terms and circumstances for buying and selling ownership interests and can easily cover management decision-making processes.
Resources for Choosing a Business Structure
If you’re still not sure how you want to structure your business, you can use the many great resources on the Internet, including:
, a commercial site that provides incorporation services for a fee and has a good list of answers to commonly asked questions about incorporating and other business structures.
, where you can order a free handbook called “How to Incorporate Your Business Now” (the handbook is also available via 800/877-4224).
, which has great resources, many of them downloadable for free or a small fee–for example, a free encyclopedia article that includes extensive descriptions of all the types of business structures and what it takes to form your company under each of them (
; scroll down to the Small Business index entry, then click on Small Business Legal Structures).
, where you can download free e-books on incorporating in various states and access articles on incorporating for the lowest possible cost.
, a collection of links to essential information for starting your business.
, a Business Start Page offering a free minicourse with planning tools for deciding whether to start your business as a sole proprietorship, partnership, or corporation.
, a comprehensive and clear article about business structure options by Lee Madere, Jr., a lawyer.
, which also offers a comprehensive overview.
, the Small Business Association (SBA) site; it has a good collection of links to relevant sites for each state, and provides a starting point for finding information not only about the laws for incorporating in each state, but also about other legal requirements for business, such as registering your business name.
David Caplan, the author of a series of books on how consumers can get things for free, has started several businesses in California and other Western states. This article is adapted from his new book, How to Start a Business for Free, from Silver Lake Publishing, which is available via 888/663.3091, as well as in major bookstores and online.