How to Form a Business
Updated: Jul 27, 2021
Let me set the scene - You decided to create your own company. You drew up your business plan. Decided what your company would create and/or what service it will provide. Dreamed up your dream office and crew. You have all your ideas in writing and you are ready to take the next step - the legal step.
The first legal step you will take in pursuit of your entrepreneurial dreams is deciding on a name for your company. I know it sounds silly, but you have to ensure whatever name you choose is not already taken by an existing company. You may want to brainstorm a handful of different ideas and then check them against the business search in your state to ensure the names are available. Once you know the name is available, you are ready to take your next step.
The second step is deciding on your business structure. In the United States there are four main business structures: sole proprietorship, partnership, limited liability company (LLC), and corporation. Each business structure has its own pros and cons. Today, we will briefly look at each business structure and in the coming weeks we will dive deeper into each type.
A sole proprietorship is a type of enterprise owned and run by one person in which there is no legal distinction between the owner and the business entity.
Pros: A sole proprietorship requires no state filing, you just simply start operating. Further, because you are not formally incorporated with a sole proprietorship, you are not subject to business tax. In order to pay your taxes, you will simply file your personal tax return and claim any additional income made through your sole proprietorship. Due to not being formally incorporated, there is no requirement to keep up on filing or reports like other business entities have to. The record keeping for a sole proprietorship is rather easy as sole proprietors are not required to keep business and personal funds separated, so they tend to commingle their funds. Lastly, since you are the only person in charge - you make all the decisions. You do not need shareholder, members, or the boards approval like you might in other business structures.
Cons: The largest con is that sole proprietorships are subject to unlimited liability. This means that you are liable for all business expenses and debts, if someone is hurt on your property, or is harmed by a product of your business or a mistake you made. This means there is no legal difference between you and your business. Because you have unlimited personal liability in a sole proprietorship, a vendor, customer, or lender can come after your personal assets to satisfy any obligations of the business.
A partnership is a formal arrangment by two or more parties to manage and operate a business and share its profits
Pros: You have an extra set of hands to help run the business. As a small business owner you will likely be wearing multiple hats in the beginning, but a partnership allows for you to share the workload with someone(s) else. In a partnership, you and your partner can decide how to share the debt. In most cases, partners opt to share the business debt equal to the profit shares. This helps ease the financial burden of having to do it alone.
Cons. You cannot act independently. In being part of a partnership, you are required to work with your partner in making decisions. There a is chance for disagreement. Anytime you work with someone else, there is potential for conflict. It is essential to address in writing how said conflicts will be handled at the outset to help keep peace amongst the partners. Most troublesome of all, just as with sole proprietorships, partnerships face unlimited liability.
Limited Liability Company (LLC)
A limited liability company is a business structure in which the owners are not personally liable for the company’s debts or liabilities. An LLC is a hybrid entity that combines the characteristics of a corporation with those of a partnership or sole proprietorship.
Pros. Pass through taxation, which refers to the fact that a pass-through business pays no taxes. Instead, some control person pays the business's taxes through that person's own personal tax return. Membership flexibility. An unlimited number of members can be added and at any time, upon agreement, members can be removed from ownership. Most importantly, limited personal liability. The owner/members personal assets are protected in case of business loss.
Cons. Profits subject to social security and medicare taxes. Salaries and profits of an LLC are subject to self-employment taxes, currently equal to a combined 15.3%. Further, some states require annual reports in order to keep an LLC in good standing. These sometimes correspond with fees, reports, and meticulous paperwork and filing processes. Additionally, because of pass-through taxation to the owner’s personal tax return, owners/members must keep separate financial records in order to avoid any personal liability, which also necessitates separate bank accounts.
A corporation, sometimes called a C corp, is a legal entity that's separate from its owners. Corporations can make a profit, be taxed, and can be held legally liable. Corporations offer the strongest protection to its owners from personal liability, but the cost to form a corporation is higher than other structures.
Pros. Owners are separate from legal liability so they’re not entirely responsible when faced with legal issues or debt. In general, it’s nice to have the business as a separate entity, so that owners are completely separate. Owners also have the ability to sell stock, which raises the likelihood of acquiring financial capital. A corporation has a well-established structure with clearly defined roles, accountabilities and agendas. Plus, employees have the option to buy stock at a fixed-in price, and receive stock benefits.
Cons. Corporations are much harder to form and maintain than other entities. They must also publish annual reports and other data. This allows creditors to assess their creditworthiness. To make sure you are actually functioning as a corporation, the government requires you to follow formalities. This includes shareholder meetings, maintaining financial independence, board of directors' meetings, and records of corporate activities. These are extra costs that don't add real value to the company. Federal, state, and local entities impose heavy regulations on corporations. This can cost a lot of money and prevent profits and growth.
Deciding your business formation is something that should be done with your long term business goals and current resources in mind. I highly suggest you speak with an attorney before deciding what type of business entity to form. Certain entities such as corporations and LLCs require specific documentation at the time of filing, these documents lay the ground work for your business and therefore should be customized to your specific needs. If you or someone you know is looking for guidance and/or help forming their company, please reach out to The Rose Law Firm. As a small business owner myself, it would be my honor to help you start (and sustain) your dream business.