Tax and Legal Questions for Starting a Business
Starting a business requires some knowledge of tax and legal requirements and potential issues that could arise during the course of business. The following questions are basic ones to think about as you're writing a business plan and deciding how you want to set up your organization from a legal and tax perspective. Note that this information isn't exhaustive and should be viewed as a starting point for your research.
Should I hire a lawyer and/or an accountant?
Lawyers and accountants can cost you hundreds or even a few thousand dollars during the start-up phase of your business. Consider the risk and return equation when deciding if you should spend the upfront capital on professional assistance. High risk business ventures and complicated entity structures are more likely to encounter legal problems or tax nightmares. Hire a lawyer if your business venture is high risk, such as selling alcohol or storing toxic chemicals. If you plan to issue stock to the public which can introduce numerous tax rules and regulations, hire an accountant.
Otherwise, take a do-it-yourself approach for low risk businesses and only consult a professional when you’re unable to figure something out. Use templates to create your legal documents – check out docstoc.com and search for what you need. You can also find legal templates on CD-ROM in reference books such as Nolo’s Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State. You’ll also want to brush up on tax information for small businesses to make sure you keep track of expenses and payroll properly.
What type of entity status should my business have?
There are four popular entity types for small businesses:
- Sole proprietorship – A business owned and operated by an individual who assumes all liability and debt.
- General partnership – A business owned by two or more individuals who assume all liability and debt. By default, the owners have equal ownership in the business, which translates to equal liability. A partnership agreement specifies if owners will have various degrees of ownership, control, or liability in the business.
- S-corporation – A business that is owned by at least one individual who doesn’t personally assume all liability and debt for the business. S-corporations are taxed like partnerships but generally have the most restrictions and regulations compared with the other entity types listed here.
- Limited liability corporation (LLC) – A business type that provides its owner(s) with the limited liability of a corporation and the taxation rules of a partnership. Fewer rules apply to LLC’s than S-corporations.
Although they aren’t listed here, a few other partnership options are available, including a limited partnership if one or more partners has a passive role. Another entity type is a C-corporation, which has the same liability protection as an S-corporation but is subject to very different taxation and employee benefit rules. Many large companies elect C-corporation status, but the tax and benefit differences don’t make as much sense for a small business. The following tables help you compare and contrast the four most popular entity types for small businesses:
What kind of effort is necessary to set up each entity type?
| Sole proprietorship | General partnership | LLC | S-corporation |
| Minimal effort | Some effort | Some effort | Most effort |
| File papers for a fictitious name (also called a DBA) with your Secretary of State | File papers for a fictitious name (also called a DBA) with your Secretary of State | File articles of incorporation with the Secretary of State, and file a certificate of authority in any other state in which you do business | File articles of incorporation with the Secretary of State, and file a certificate of authority in any other state in which you do business |
| Apply for an employee identification number (EIN) if you plan to pay employees | Apply for an EIN if you plan to pay employees | You must apply for an EIN after you incorporate, regardless of whether you plan to pay employees or not |
You must apply for an EIN after you incorporate, regardless of whether you plan to pay employees or not |
| The owners typically create a formal partnership agreement | Create a formal operating agreement if you have more than one owner | Create a corporate records book and learn what recordkeeping is required to retain corporate status (e.g., annual meetings, stock certificates, etc. |
What liability protection do I get with each entity type?
| Sole proprietorship | General partnership | LLC | S-corporation |
| No liability protection, but you can purchase insurance to protect you against lawsuits brought about by damages your business causes | No liability protection, but you can purchase insurance to protect you against lawsuits brought about by damages your business causes | Limited liability protection | Limited liability protection |
| You have no protection from business debt (e.g., you will be forced to pay off business debt with your personal assets) | You have no protection from business debt (e.g., you will be forced to pay off business debt with your personal assets) | Owners aren’t personally liable for corporate debts and other lawsuits brought against the corporation, unless the corporate veil can be pierced due to fraudulent behavior, irresponsible business practices, or failure to pay taxes | Owners aren’t personally liable for corporate debts and other lawsuits brought against the corporation, unless the corporate veil can be pierced due to fraudulent behavior, irresponsible business practices, or failure to pay taxes |
How is each entity taxed?
| Sole proprietorship | General partnership | LLC | S-corporation |
| Owners have pass-through taxation, which means that net business profits or losses flow through to the owners’ personal income | Owners have pass-through taxation, and multiple owners of a partnership pass-through only part of the profits or losses based on their percentage of ownership | Owners have pass-through taxation, and multiple owners of an LLC pass-through only part of the profits or losses based on their percentage of ownership | With an S-corporation, you also have the benefits of pass-through taxation based on your percentage of ownership |
| Salaries, bonuses, and profits are subject to 15.3% self-employment tax, which includes both Social Security plus Medicare tax. Paying self-employment tax on profits can be a huge disadvantage if you think you’ll have high net profits | Salaries, bonuses, and profits are subject to 15.3% self-employment tax, which includes both Social Security plus Medicare tax. Paying self-employment tax on profits can be a huge disadvantage if you think you’ll have high net profits | Salaries, bonuses, and profits are subject to 15.3% self-employment tax, which includes both Social Security plus Medicare tax. Note that non-managing members of a multiple-member LLC are not subject to this rule |
You may keep some profits in the business that the IRS will tax at a lower corporate rate. Profits that you take as distributions are taxed at your personal income rate |
| Profits are taxed at your personal income tax rate even if you leave the profits in the business to reinvest the following year |
Profits are taxed at your personal income tax rate even if you leave the profits in the business to reinvest the following year |
Profits are taxed at your personal income tax rate even if you leave the profits in the business to reinvest next year | Salaries and bonuses but not other profits are subject to 15.3% self-employment tax |
| If you prefer the tax status of a corporation, you can elect that the IRS tax your business as a corporation by filing federal form 8832 | If you prefer the tax status of a corporation, you can elect that the IRS tax your business as a corporation by filing federal form 8832 |
Are there any other positive attributes about each entity?
| Sole proprietorship | General partnership | LLC | S-corporation |
| Sale of ownership isn’t subject to federal or state securities laws, which can be very complex | Sale of ownership isn’t subject to federal or state securities laws, which can be very complex | Sale of ownership isn’t subject to federal or state securities laws for an LLC in which all members are active | If you plan to incorporate, you'll typically have lower fees with an S-corporation versus an LLC |
| You can deduct the health insurance premiums you pay for you or your family, up to your amount of net business profit | You can deduct the health insurance premiums you pay for you or your family, up to your amount of net business profit | You can deduct the health insurance premiums you pay for you or your family, up to your amount of net business profit | You can easily raise capital through a stock offering |
| Because you and your business are the same entity, it’s very easy to move money into and out of the business. You can take a distribution of profits or lend the business money without special rules or considerations | Because you and your business are the same entity, it’s very easy to move money into and out of the business. You can take a distribution of profits or lend the business money without special rules or considerations | If you’re the managing member, it’s very easy to move money into and out of the business. You can take a distribution of profits or lend the business money without special rules or considerations | The S-corporation is a formal entity, which can give customers a sense of credibility |
| The LLC is a formal entity, which can give customers a sense of credibility |
Are there any other negative attributes about each entity?
| Sole proprietorship | General partnership | LLC | S-corporation |
| If the owner or owners die or leave the business unexpectedly, the business automatically ceases to exist unless an agreement or trust is in place stating otherwise |
If the owner or owners die or leave the business unexpectedly, the business automatically ceases to exist unless an agreement or trust is in place stating otherwise |
You must pay state filing fees each year |
You must pay state filing fees each year |
| Because the LLC has recently become such a popular option, fees are sometimes quite a bit higher for LLCs than S-corporations | S-corporations have some extra requirements that must be met (e.g., less than 100 shareholders, only one class of stock, no foreign investors) | ||
| Some states assess a filing fee and a hefty annual tax, so make sure you check before deciding to incorporate as an LLC |
The IRS may audit you if you don’t pay yourself a reasonable salary |
I've decided to incorporate. Should I go with an LLC or S-corporation?
If your main goal in incorporating is to limit your liability, incorporate as an LLC. This will save you a lot of time and red tape. If you expect a hefty amount of profits and want to minimize your taxes, an S-corporation may be worth the more stringent requirements. This is a decision best left to the pros, as you’ll need to factor in the additional regulations and higher CPA costs your business will have as an S-corporation. Consult a tax professional to help you decide what’s best for your situation.
Should I incorporate in another state?
You may think that incorporating in Delaware or Nevada is advantageous because of favorable tax laws and lower incorporation fees compared to the state where your business is located. Don’t forget about the additional fees and taxes you’ll be required pay to the state where you do business. If you incorporate in a foreign state, you’ll need to file two sets of state tax forms, which can increase your CPA costs. The incorporation process is enough of a headache – keep it as simple as possible by incorporating in the state where you do business.
What tax forms will I need to file annually?
The IRS has great resources that help you figure out which tax forms to file.
By: Gale Bowman
2-06-2010
After graduating from Notre Dame over four years ago, Gale realized that young professionals need a source of reliable information as they face “real world” challenges. Gale manages WhatCollegeForgot.com and presents workshops to college students and recent grads.
