Thinking Of Starting A Business? Do Yourself A Favor…
Whether you are concerned about protecting your business, preventing business claims from affecting your personal assets, or planning for the distribution of your assets to your heirs, you need to know how to limit liability. And as I always say, you don’t have to decide alone. Use an attorney or other professional advisor, like an accountant, to decide which entity is best for you.
Every business is operated under the umbrella of one of the following entities: sole proprietorship, partnership, C or S corporation, or limited liability company (LLC).
Each entity has advantages and disadvantages in terms of taxes, liability, and owner control. The type of business you set up depends on your present income, your plans and goals, your tax status, and a variety of other circumstances. Which entity is right for you?
Don’t forget that the legal form of your business is one of the most important decisions you’ll make. The tax code is thousands of pages long and extremely difficult to wade through, yet you won’t be able to use that as an excuse if you choose the wrong entity for your business. If you’re thinking of setting up a business, do yourself a favor: Hire a good attorney and accountant to advise you in the process of selecting an entity.
Before you decide which entity to go with, there are a number of important housekeeping chores to take care of:
- Write a mission statement indicating what sort of product/service you’ll offer and start writing a business plan.
- Begin assembling your team of professional advisors.
- Take steps to legalize your business. Almost all jurisdictions require some kind of licensure. Check with local, state, and federal agencies to see that you comply, and expect to pay some fees.
- Register your business name with the state. This will establish you as a bona fide business and indicate whether your business name is already being used by some other company.
- Get a trademark or patent for any intellectual property. Be sure to check with a lawyer who specializes in patent law.
- Scout out a place of business and check local zoning laws. In addition to reviewing any leases with a lawyer before signing, make sure you have the proper permits for your enterprise—for example, health, fire, and sales tax permits. You are responsible for making sure your business complies with local and state laws.
In its purest form, the sole proprietorship is considered by most people as a no-fuss, no-muss enterprise. As a sole proprietor, all you need do is decide the nature of your product or service, advertise, and start plying your trade. You won’t have to deal with complicated legal documents or hire expensive legal advisors. Sometimes paperwork is still required for sole proprietorships, so make sure you check with the proper local, state, and federal agencies and obtain any necessary documents. For example, you may need a business license. If you choose a business name other than your own (called “doing business as,” or DBA for short), you’ll have to register the name. Relatively speaking, the legal matters associated with establishing a sole proprietorship are simple and straightforward, things you can do yourself. However, this is a very risky way to start a business.
Is A Sole Proprietorship For You?
Sole proprietorships offer people the opportunity to run their businesses as they see fit, with minimal intrusion from the government. You are the owner, and decisions and profits are all yours. The sole proprietorship requires little paperwork and is the simplest business entity to operate. Moreover, if you decide to discontinue your business, no one else needs to be consulted. Pay off your debts, liquidate your assets, and close up shop.
A sole proprietorship may work for people like freelancers and consultants who want to keep their businesses small and their staffs limited. If you intend to bring in partners or you need investors, the sole proprietorship won’t work because it precludes anyone else from owning equity. Nor is the sole proprietorship ideal if you have reason to be concerned about liability. As a sole proprietor, you are personally liable for all the debts your business incurs. All of your personal assets are also at risk. Liability can be a big drawback.
Like a sole proprietorship, a partnership requires no special paperwork. It is simple and relatively cheap to start. You and your partner(s) will probably want to operate under a business name, so be sure to register it with the appropriate state agency. There will be a small fee associated with this step.
In addition, you should set up an agreement so that each partner’s rights and liability are clearly outlined. Partnership agreement forms can be purchased at stationery stores or provided by lawyers but should be reviewed very carefully to make sure they apply to your specific situation.
Is A Partnership For You?
Let’s say you don’t want to run the show by yourself. Perhaps you lack the experience to make your business successful, or you simply prefer sharing responsibility with others. Then you may consider a partnership. It is often said that two heads are better than one, and for some people, the additional ideas and enthusiasm generated by a partnership can bring comfort to what would otherwise be a daunting task. Partnerships can also increase the amount of available capital, and new businesses need plenty of that.
On the downside, in a partnership you give up a certain measure of freedom and control. People being people, disputes are bound to occur, causing many a sleepless night. It is also important to remember that business decisions and actions were taken by your partner are legally your business decisions and actions, even if you do not know about them in advance. You are obligated by your partnership to live up to all agreements entered into by the partnership. In a general partnership, as in a sole proprietorship, liability rests entirely on the shoulders of the owner(s). Not only are you fully liable for your decisions, but you’re also fully liable for the decisions of your partner. Once again, your personal assets are completely at risk, but now they’re at risk for decisions your partner may make.
A third and very different choice of business form is the corporation. Unlike the sole proprietorship and the partnership, the corporation is an entity completely separate from you, the person incorporating it. Your company is now an “Inc.” and with that designation comes some additional paperwork and compliance issues based on the laws of incorporation unique to the state in which you choose to incorporate. However, the corporation provides a level of protection for you. Because it is a separate entity, it should protect your personal assets from creditors of the corporation. Although you may want to do some of the legwork yourself, you should use a lawyer for much of it.
Though the rules for creating a corporation vary from state to state, there are two basic steps:
- You file articles of incorporation with the secretary of state’s office or the corporation commission, and
- You establish an operating agreement or shareholders agreement.
The basic document for incorporation can be obtained from the office of the secretary of state. Different states have different names for this document, for example
- Articles of incorporation
- Certificate of incorporation
- Articles of association
Once you incorporate, there are certain rules and formalities that must be observed. For instance, most states require corporations to hold shareholders’ meetings and keep updated business records, and some states have special forms for filing this information. Such regulations may seem silly when you are the sole owner of and the only shareholder in your corporation, but it is critical that you comply with the requirements. If not, your corporation could be dissolved and you might end up paying a fine.
There are consultants who specialize in assisting companies with compliance requirements. A consultant will make sure all necessary meetings are held and documented, and that all incorporation paperwork is filed with the state. Check with your legal counsel, who may provide this service or direct you to a consultant in your area.
On the bright side, remember that the corporation owns its own assets and pays its own debts. This is the secret of the rich. If on paper at least, you don’t own anything, then you can’t lose it. If a party claims injury from your business and sues, your personal assets should be protected.
Before you incorporate, you must decide which type of corporation best suits your needs.
You’ll recall that the limited-liability company (LLC) is a relatively new business entity that may offer the tax advantages of a partnership along with the limited liability of a corporation. In some states, you must choose how your LLC will be taxed. The process of launching an LLC, which is similar to incorporation, requires more paperwork and is costlier than launching a partnership.
LLCs are legal in all states, but the laws governing them differ from state to state. In general, to form an LLC, you must file articles of organization with the office of the secretary of state, as you would for a corporation. In some states though, you are required to produce an operating agreement, as with a partnership. This agreement can be oral, but you should put it in writing nonetheless to protect your future interests.
Is A Limited-liability Company For You?
Take a moment to consider exactly what an LLC can and cannot do before forging ahead. Do you intend to be the sole owner of your LLC? Then check with your state to see if single-owner LLCs are legal. And don’t assume that the label “limited liability” will eliminate your risk should your company default on loans. Although an LLC generally limits the liability of its members, it may require them to guarantee loans personally. You should also know that transactions outside the state where the LLC was formed may be treated differently by the law than transactions instituted within the state.
Remember, an LLC is a business entity that can combine the tax benefits of a partnership with the limited liability of a corporation. This marriage can be used to your advantage. However, consolidating two sets of regulations can lead to confusion. Make sure you do your homework, learn the rules, and above all, seek professional advice.
Editor, Rich Dad Poor Dad Daily