Step 1: Choose an Entity TypeYou’ve decided to start a business. You’ve got a general idea and a general plan, but you aren’t sure what structure your business needs to have in place. This decision will impact your taxes, what filings are required, your ability to raise outside money and the potential personal liability you could have for the company’s actions and accounts. This series is meant to provide a very high level look at the different types of business you might form. There are several key considerations:
- Liability. Are owners liable for the business’s obligations? Certain types of liability (like professional malpractice, for example) can never be limited.
- Tax. Does the business pay tax on its profits, the founders on their income, or both?
- Costs. Does the state charge for formation? Is an attorney or accountant required?
- Administrative burdens. What governmental or other hoops do the owners need to jump through?
- Flexibility. How nimble is the organization? Can founders make big decisions and implement them quickly?
- Future plans. How does the structure work for growth? Outside investment?
Summary of Entity Types
|Liability||Remains with owner||Remains with owners (other than LPs)||Owners shielded||Owners shielded|
|Tax||Remains with owner||Remains with owners||Paid by corporation and paid by shareholders if distributions are made (unless S Corp. election is made). Potential for QSBS benefit on sale||Remains with owners like a partnership (unless an election is made to be taxed as a corporation)|
|Costs||Low||Low-Medium||Medium-High (depending on state)||Medium-High (depending on state and complexity)|
|Administrative Burdens||Low||Low-Medium, can be high if complex tax||High||Medium-High|
|Flexibility||Highly flexible for one person||Highly flexible||Medium (formalities must be observed), Low if S Corp election is made||Medium (formalities must be observed, flexibility can come with increased cost), Low if S Corp election is made.|
|Future Plans||Not great for outside investment, growth||Not great for outside investment, growth||C-Corps are preferred form for most investors|
Potential for QSBS benefit on sale
|C-Corps are preferred form for most investors, but some will invest in LLCs|
A little more detail on Entity Types
You open a business, by yourself, without taking any (or the right) affirmative steps to formalize it. This is a sole proprietorship.
Sole proprietorships are easy to administer because one owner controls everything.
The taxes are paid by the owner as self employment taxes for the individual. The owner reports profits and losses on a personal income tax return on a Schedule C. The bottom line profit or loss from the Schedule C is recorded on the tax return. If your business is profitable, you will also have to make quarterly estimated tax payments to the IRS.
The owner is also personally on the hook for all of the company’s liabilities. This means that if the company has debts, the creditors could come after the owner’s personal assets to pay those debts. If the company is sued, the individual owner is responsible for defending that lawsuit and paying any judgment.
Finally, if a business owner is looking for outside investment, traditional investors are unlikely to give a sole proprietorship any money.
Two or more people form a business without taking specific steps to formalize it. They have formed a partnership.
Partners manage the business and assume all responsibilities for it. By default, a partnership’s profits, losses and management authority are divided equally among the partners. Partners can change these defaults in a partnership agreement.
Like a sole proprietorship, taxes pass through and are paid by the individual owners. The allocation of taxes can be set out in the partnership agreement. At the end of the tax year, the partnership provides each owner with a Schedule K-1 that indicates the partner’s share of income, deductions, credits or losses. The partners then report the same on their individual tax forms.
Each partner is on the hook for all of the company’s liabilities. This is true even if the other partner is the one that made the decision. For example, a partner takes out a huge loan in the name of the partnership. The other partner is unaware. The partnership defaults on the loan. Both partners are liable for repaying the loan from their personal assets (the second partner may be able to make some claim against the first partner, but the financier will be repaid regardless).
Also, if two friends form a business together, the law might call it a partnership even if that is never specifically said by the founders.
Partnerships can have higher administrative costs because of the complex legal relationship between the partners. Generally, partners should hire an attorney and an accountant to properly form the partnership and do the taxes.
A note about limited partnerships: in another type of partnership, a Limited Partnership (LP), one or more general partners function as they would in an ordinary partnership. They are liable for the partnership and they manage it. One or more limited partners, by contrast, are able to enjoy a liability shield similar to that of a corporation, but they give up the ability to manage the partnership. Forming an LP generally requires a formal filing with the state in which the LP is formed. There are ways to combine LPs and other structures to create more complex structures that enjoy tax advantages for the LPs while still ensuring minimal liability. Private equity funds are often set up as LPs with funders as limited partners and fund managers are general partners.
A corporation is a legal entity separate and apart from the individual founders. The corporation is a separate person in the eyes of the law. The corporation is responsible for its own debts and liabilities and pays its own taxes. Corporations must observe all required formalities (like governance and banking rules) in order to shield shareholders and directors from company liabilities, but doing so creates a complete separation. For example, if a corporation takes on a large loan and is unable to repay it, the company could go bankrupt, liquidate and dissolve. If the creditor is still owed money, it cannot pursue the individual owners for any portion of it (assuming no wrongdoing). Because the corporation pays its own taxes, this means that the owners, when they are paid by the corporation, pay their own taxes as well. This is often called “double taxation.” Corporations can elect two different tax treatments, each named for the subchapter of the IRS code that describes them. The first, a C Corporation, is the traditional double tax model and the default if no election is made. The second treatment is an S Corporation, which allows pass through taxation similar to a partnership or sole proprietorship. Getting S Corp status requires filing an affirmative election with the IRS. Why wouldn’t every company elect S Corp status? There are many reasons. First, the types of shareholders an S Corp can have are limited to individuals and certain types of trust. No institutions can be shareholders, so major investment is often unavailable. Having different classes of ownership with preferential treatment for one over another is not permitted, and major investors would typically require it. The total number of shareholders in an S Corp is also limited. Owners of a corporation can also be paid as employees, allowing the business to deduct the expense from its taxable profits. Observing the corporate formalities also comes with some expenses. Forming the business requires a filing with the state and an annual filing every year after that. Those filings are accompanied by fees. Other formalities vary by state and may or may not be altered by the corporation's bylaws. At minimum, a corporation will likely need to have board and shareholder meetings at least annually and keep books and accounts that are entirely separated from the owners’. Failing to observe these formalities can result in a loss of the liability protection that makes corporations attractive.
A limited liability company is a (in the scope of the history of corporate law) new hybrid entity that combines features of a partnership and a corporation.
LLCs allow owners to receive pass through taxation like a partnership, but allow for liability protection like a corporation.
LLCs can also make S- or C- corporation elections for different tax treatment if it is desirable. LLCs are not limited in the number or type of shareholders they can have unless they make an S-Corp election. Tax treatment of an LLC can also vary by state. Deciding on the optimum tax structure depends on a number of factors which should be discussed with a qualified accountant. In fact, the calculation can be so nuanced that in a single LLC with multiple founders, each founder may have a different desired structure based on their own individual tax situation.
LLCs are liable for their own debts and obligations, providing the corporate liability shield to owners that was once only available to corporations. Like a corporation, this shield is only available so long as the LLC observes required formalities. These formalities may not be as strict as a corporation, but they will still create some expenses. Forming the business requires a filing with the state and an annual filing every year after that. Those filings are accompanied by fees. Other formalities vary by state and may or may not be altered by the company’s operating agreement.
Step 2: Get your existing intellectual assets (IP) into the Company
Some new businesses already have some intellectual property (which could be inventions, creative works like art or games, or simply proprietary information like recipes) at the time of formation. Assigning that intellectual property to the business can depend on the type of intellectual property and the type of business.
Generally speaking, transfer of a copyright interest, trademark interest or interest in an invention would require a written agreement. Transfer or assignment of governmental registrations may require additional paperwork filed with the governmental agency.
A formal agreement can take many forms. In an LLC, for example, an initial assignment of research or creative works might happen in the company’s operating agreement and be treated as a capital contribution. In a corporation, it might be used as consideration for an initial stock purchase.
In the context of workers, an employee’s work is sometimes considered owned by the employer by default. An independent contractor’s work, by contrast, is often not. In both cases, there are exceptions to the rules. In either case, specific language about the assignment of all creations and inventions is ideal. The language should specifically call out the type and scope of work being created and make sure it is assigned to the company without any further action by either party. Language that says “will assign” can be interpreted to mean “will, at some undetermined point in the future, assign but doesn’t yet.”
The language should also include a further assurances clause. This would basically provide that if, for some reason, the transfer or assignment of the rights or interest was not effective or required additional paperwork to be effective, both parties agree they would sign it.
For some types of works, especially if dealing with foreign workers, an assignment should also include a waiver of all claims arising from moral rights. Moral rights go beyond the exclusive rights of ownership to protect a creator’s inherent rights in a work (like attribution, for example). These rights are stronger in the European Union than in the United States, and often cannot be transferred.
Once the company has shored up all of its existing portfolio, it should be careful to include assignment or transfer provisions in future agreements.
Step 3: File Paperwork
Once an entrepreneur has settled on a form of business entity, he or she may need to file with the state to officially form it.
A general rule of thumb is that filing is required if there is any limitation on the owner’s liability. States typically require corporations, LLCs and LPs be officially formed through the Secretary of State, Division of Corporations or similar state office.
The requirements for what needs to be filed and where will vary by jurisdiction.
For example, to form a corporation in North Carolina, a founder would need to file Articles of Incorporation, designate a registered agent in the state and pay the filing fees. There a number of formalities that follow, but that is the first step. In Delaware, by contrast, there are no Articles of Incorporation and there is, instead, a Certificate of Incorporation.
The Secretary of State or other office responsible in each state will have information on what is required to be filed for each entity type. The SBA and other organizations can also be helpful.
That said, these charter documents represent the foundation upon which the rest of the business will be built. If the business was a country, this filing would be the constitution. It should not be taken lightly and, even if using a state-sanctioned or state-provided form, it is crucial to understand and consider the implications of these documents.
Step 4: Get an EIN
An EIN, or employer identification number, is a number assigned by the IRS to a business. The number can is used for tax filings and other reportings.
Despite the name, it isn’t only for businesses with employees. Corporations, LLCs and partnerships, even if they do not have employees, will need an EIN to report income to the IRS. Sole proprietorships and single member LLCs will need EINs to hire employees, set up certain retirement plans, file for bankruptcy, enter into certain transactions or to convert to another form.
In addition, a business’s credit can be tied to an EIN.
How does a company get an EIN? This is, almost verbatim, the email I send to clients who ask this question:
You can find information on how to apply for your company’s employer identification number (EIN) with the IRS here: https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online. The process is straightforward and should only take a few minutes.
Step 5: Get Licenses
Some business need to get additional licenses from the federal, state or local government.
The federal government only regulates certain industries. For example, television and radio broadcasters need to get licenses from the Federal Communications Commission. If an entrepreneur is unsure whether the business is going to be in a federally regulated field, he or she should ask an attorney.
At the state level, more industries are regulated. For example, in North Carolina, there are 700 different state-issued occupational licenses and permits. Licensing ranges from acupuncture and air traffic control to vet tech work and well contracting, and everything in between (not quite A to Z, but close!). Ideally, a member of a regulated profession knows they are in a regulated profession before opening a business without proper approvals and risking enforcement. But, that often isn’t the case.
Finally, some counties and cities will require a permit simply to open a business. Others will require certain types of businesses get additional licensure (often contractors for construction projects have to go through a local approval process, for example).
If a new business requires a permit or license to operate, it is wise to obtain that in advance. Often, the cost is minimal and the penalties for noncompliance are more significant.
Step 6: Consider Trademark Registration
After a founder has invested in the formation of the business, the founder should consider whether to file a trademark registration with the United States Patent and Trademark Office.
A trademark or service mark is a usually word, phrase, symbol or design that identifies and distinguishes the source of goods or services. For example, consider Coca-Cola, as well as the Coca-Cola calligraphy design. Or the Nike swoosh symbol.
For a business that will derive value from a unique brand, ensuring that others do not use the same or a similar mark can be key. A federal trademark registration provides constructive notice to the rest of the country that “hey, this name/logo is taken for this product/service.” Registration also provides for easy evidence of ownership if the owner ever has to sue someone for using the registered mark, and it provides additional remedies.
Registering the mark also provides a quantifiable asset that can be licensed, sold or leveraged going forward. While there is value in a name alone, a registered mark provides economic advantage in the form of confidence in ownership.
Trademark registration comes with some costs. First, there is the filing fee. This is relatively minimal when compared to the benefits of registration.
Second, the process is not as straightforward as the USPTO’s website makes it seem. The simple user interface has often led people to think they don’t need to prepare or research how to complete the registration. Hiring an attorney can provide some assurance that this process will be handled properly and the attorney can advise on strategy and likelihood the registration will be approved. Most trademark attorneys, including Odin Law and Media, will handle these applications on a relatively predictable, flat fee basis.
Step 7: Open Bank Account(s)
A new business owner doesn’t need a lawyer to open a bank account. She will need an EIN and the bank will likely want to see some governing documents. Otherwise, she can just book an appointment at a bank near her and be off to the races.
So, why do I mention it here? The importance of separating finances cannot be overstated. If a business ends up liable for some debt or damages down the line, any liability shield that may exist will be tossed out the window if the business and personal finances of the owner are co-mingled.
A new business should open the new account(s) as quickly as possible, separate out accounting from personal accounting of the founders and keep that separation in place for the life of the business.
Step 8: Get Insurance (or don’t)
One of the main questions attorneys are asked is “how can I limit my exposure for ______?”
The blank could be something specific, like an action the person is thinking about taking. More often, it is a concept like “how do I limit my personal exposure for my business?” or “how can I limit my exposure for the actions of an employee?”
While there are number of things that can be done on the legal side, something new businesses should consider is whether the business would benefit from one or more insurance policies.
For example, a business with a physical presence almost certainly should have general liability insurance. Most landlords will require this. A business with a lot of online content and frequent online activity may want a cyber liability policy. Businesses with vehicles need auto insurance just like individuals do. And so on.
Even if an attorney has done everything they can to put into place corporate structures, policies, procedures, contracts and waivers to protect from liability, there is still a chance of liability. At minimum, there is a chance a business may have to pay defense costs against a lawsuit – even one without merit.
Insurance can help mitigate that risk, albeit at a cost. Whether and what insurance to buy is often a matter of cost and risk tolerance.
Step 9: Consider Professional Help
No, I am not suggesting you may need a therapist (though you may!). I am suggesting you may need a lawyer and an accountant.
There is an old phrase: a man who represents himself has a fool for a client. I don’t always agree with that, but it can be true.
I like to think that lawyers and accountants are really just relatively smart people with a developed skill set. Anyone can develop the same skills. Really, anyone.
But, a good lawyer or accountant not only spent some time in school learning the building blocks of their profession, they’ve spent some time on the job learning and experiencing a variety of situations. An individual founder could learn some of the skills, but doing so would pull time away from building the business. The founder could try to replicate the experience of having practiced law or worked as a CPA for a number of years, but doing so would be difficult and would again pull time away from building the business.
A smart founder knows when to invest the time and resources into developing a skillset, and when to hire someone else who already has it.
Step 10: Know What You Don’t Know
This is a catch all. It is the single best piece of advice I can give, and it means nothing on its own: “know what you don’t know.”
This does not mean a new business owner should learn everything about everything (see hiring professionals). What it means is the new business owner should be able to recognize when a particular issue or a particular need is outside of what he or she can reasonably handle without help.
This likely means investing a little bit of time in a lot of different disciplines to be able to do a little issue spotting. Spotting an issue is just that: spotting it. It does not mean solving the problem. For that, a founder can rely on an expert: a programmer, marketer, accountant, lawyer, etc.
If a founder does not recognize gaps in their own knowledge or skillset, they are likely to create new problems in an attempt to solve old ones.