Incorporation: The Ins and Outs of Business Forms
It ain’t easy to start a business.
You’ll have to quit your job, raise capital, set up shop, get a Web site, find some clients and somehow—this is the hardest part—find enough time to sleep. You’ll also have to choose a business form, which is tricky. With corporations, partnerships and more, there’s a lot to choose from, and the arcana of each can have profound legal and tax results.
Below, you’ll get a taste of each form, enough to sound intelligent when you’re chatting with your lawyer or accountant, which, by the way, is the first place you should go when starting your business. When it comes to choosing a business form, an expert’s advice is simply crucial.
For Newbies: The Sole Proprietorship
This is Business 101, the simplest form your company can take. A sole proprietorship is a business owned by a single person (or two people if you’re married and file a joint tax return, hence count as one in the eyes of the IRS) in which the business is considered no different from its owners for legal and tax reasons. This means you’re personally liable for all the debts the business incurs, and if it gets sued, you’ll get sued too. As for taxes, the company’s profit and loss are declared on your personal tax return, using a simple form known as “Schedule C.” (This concept is known as “pass-through income”; you report the business profits on your own tax return, where they’re taxed at your personal tax rate.)
A “sole P,” as it’s called, is easy to start. Just get the right license for your business—often you’ll do this at city hall—and file a fictitious name statement, if the business name does not include your own name within it. (Otherwise put, “Joe Schmoe & Associates” does not need a fictitious name statement if Joe Schmoe is the owner; “AAA Consulting” does.) Some states also require a publish notice, in which you take out a small ad declaring the start of your business.
Net-net, you can start a sole P for less than $100. The accounting is easy, so you’ll save time and money on April 15, and you can put your energy into what matters, namely, writing code, building networks and finding clients. But the owners have no shield from lawsuits, and their personal assets can be attached or sold if the business goes under in debt.
If you’re working on the buddy system—with a partner—you’ll need to form a partnership, and there are two kinds.
In a general partnership, two or more people agree to operate a business together, using for rules a partnership agreement that states, in clear detail, who does what, who gets what and how. (For example, each partner gets 50 percent of the profit, or the first partner makes the sales while the second keeps the books, and so on.)
Each partner has the power to bind the business in contracts, even if the other partners don’t know about it and even if they disagree. Hence, you’ll need to have absolute trust in your partner. And as with a sole proprietorship, each partner is personally liable for the partnership’s debts. Taxes are “pass-through” as well, meaning you’ll state your profits and loss on your personal tax return and pay at personal, not corporate, rates.
In a limited partnership, a general partner runs the business on behalf of limited partners who front the money to start it, but have little or no role in its daily affairs. Limited partners merely share in the profits in return for their money. They’re not liable for business debts, and by and large, they can’t be sued if the business does something wrong (but not always; your attorney can explain the legalities). Not so for the general partner. Unlike his colleagues, the limited partners, he’s at personal risk for the company’s debts. And worse, he can be sued in a corporate lawsuit. But there’s a reward for all that risk: The GP often gets a larger share of the company’s profits, as well as the salary he draws for the day-to-day work of running the firm.
Bottom line: If you’re setting up shop with a friend, or you’ve got investors who won’t be part of the business, consider a partnership.
Next Up: The LLC
The LLC, or limited liability company, is a hybrid, a combination of a partnership and a corporation (which, as we’ll see below, leaves shareholders at little or no risk for corporate debts and lawsuits). In an LLC, “members,” akin to “partners,” own and manage the business. But unlike a partnership, the LLC is a separate legal entity. If it goes under or gets sued, the members are off the hook. (Again, there are exceptions, and your lawyer can explain them.) There’s also a second, important perk: Like a partnership, the LLC is a pass-through form, meaning you’ll declare its profits and losses on your personal tax returns and pay at personal rates, which are often lower than corporate rates.
In each state that permits them, LLCs have a slew of formalities, including paperwork requirements and other state filings. As with any business, you’ll need a good lawyer and accountant to guide you on your way. Why? With an LLC, a simple error in paperwork can mean hundreds or thousands of dollars at tax time.
At Last, the Corporation
At last: the granddaddy of business forms, the “corporation.”
No matter their type (and there are two), all corporations are seen as separate legal entities by the state and the IRS. They’re composed of shareholders who invest their money but often do little or nothing to run the business. And even if they do, as in small corporations of one or two people, the shareholders are protected from corporate debt and lawsuits by the “corporate shield.” The result? If the corporation is sued, your personal assets are safe. If it goes under in debt, you won’t have to sell your house to pay for it.
The first type of corporation, the C corporation, is a separate legal and tax entity subject to corporate tax rates, which can be quite high based on your line of business and corporate size. Gone is the pass-through effect: The corporation must file a separate and highly complex tax return, the 1120, with the IRS. In fact, it’s so complex that you’ll need a good accountant just to start it, and the penalties for errors are steep.
The second type of corporation, the S corporation, is a pass-through entity: Its profits and loss are reported on shareholders’ tax returns, and hence, they are taxed at personal rates. (The corporation still has to file the 1120.) The net effect? An S corp., as they’re called, gives you the pass-through advantage of smaller, simpler business forms, but keeps the advanced legal protection of the corporate shield.
No matter their type, all corporations must file a slew of documents with the state, including their Articles of Incorporation, and pay a mass of state fees and taxes as well. What’s more, there are legal requirements for holding meetings of shareholders and the board of directors, and if they’re unmet, the company can be declared an “alter ego” of its owners, nothing but a paperwork shell with no corporate shield.
The bottom line? A corporation is an advanced business form. It gives you special legal protection as an owner and shields you from corporate debt. But it’s complex and time-consuming. You’ll need a lawyer and an accountant just to file the papers, and lawyers and accountants, alas, don’t come cheap. If you’re starting a well-financed firm, if you’ve had some experience or if you’re in need of legal protection from litigious clients, this choice is for you. If not, stick with the basics and consider a sole proprietorship, a partnership or an LLC.
A Word of Advice
By now your head may be spinning. Separate entities? Pass-through accounting? Alter egos? And as if that weren’t enough, there are more business forms to consider. Take the “joint venture,” which is formed by two or more companies to do a specific task, such as research or launching