Welcome to the second installment of a six-article series on starting your first business (SY1B). In this series, we cover a range of important topics that will help you get your first business up and running:
- How To Choose Your Business Name
- How To Handle Legal Business Formation [You are here.]
- How To Set Up Your Business Finances
- How To Develop Your Business Operations
- How To Build Your Workforce
- How To Market Your Business
Starting a business requires more than coming up with a name and deciding what products and services you’ll sell. To be on the up and up, you’ll have to take a few legal steps. Enter business formation—the formal filing of your business with appropriate government agencies that determine personal liability and how taxes are paid, among other key business aspects.
If the thought of handling legal matters for your business concerns you, don’t worry. We walk through the business formation process below, so you can better understand what all is involved. If you’re still apprehensive after reviewing this article, keep in mind there are solutions available to guide you through the process step by step and submit the appropriate business filings for you.
Company Formation: 6 Steps To Success
1. Select an appropriate business structure.
Choosing a business structure is a critical step in the business formation process. Your business structure determines two key factors: How you’ll be taxed each year and how much your personal assets will be at risk. The latter aspect often surprises many first-time business owners, as they don’t realize they could be personally liable for what goes on in their business in certain cases.
That’s why it’s important to know about the various business structure types. While there are several types, the IRS notes the following as the five most common ones:
- Sole proprietorship
- S corporation
- Limited liability company (LLC)
If you own an unincorporated business that isn’t a corporation-treated LLC, then you have a sole proprietorship. The IRS details the appropriate forms you would file in this case.
A sole proprietorship is the easiest business structure type to get as it requires no formal registration. The good part: You can still claim your business name with your state. The bad part: You won’t have a separate business entity.
This lack of separation comes with several downsides. For one, there is no distinction between the business’ assets and your own, so you can be held personally liable for the debts and obligations of your business. In addition, if you plan to raise money for your business, you’ll face an uphill battle. Banks tend to avoid lending to sole proprietorships because of the added risk; plus, you can’t sell stock.
So who uses a sole proprietorship? The Small Business Administration (SBA) indicates that this business structure type is mostly used by owners trying to test a business idea before selecting a more formal option or owners who operate a very low-risk business.
If you and one or more people want to go into business together, this business structure might work for you. In a partnership, each partner contributes some combination of labor, skill, property, and money in return for a share of the profits and losses of the business. Check out this IRS page for tax information related to partnerships.
Like the sole proprietorship, a partnership is the simplest business structure to form, except for two or more people instead of one. Unlike a sole proprietorship, a partnership has varying levels of personal liability because there are two different kinds: limited partnership (LP) and limited liability partnership (LLP).
There is only one general partner in an LP, and they have unlimited liability; all other partners have limited liability. In most cases, this difference in liability is because the other partners also have limited control over the company. These differences should be documented in a partnership agreement (which we cover later in this article). There are also some distinctions in how taxes are handled for the general partner versus other partners.
Unlike LPs, LLPs provide limited liability protection to all partners. Partners are protected from debts against the business entity and the actions of other partners. Typical users of partnerships include people in the same profession, such as lawyers, architects, and accountants.
From a federal tax standpoint, a corporation (sometimes called a C corp) is treated as a separate taxpaying entity. It conducts business, has net income or loss, and distributes profits to shareholders. Notably, corporations are subject to a double tax—profits are taxed both when the corporation earns them and when distributed to shareholders. The IRS details several other tax distinctions and relevant tax forms you’ll need after forming a C corp.
While a double tax may not sound appealing—not to mention the high formation cost and additional record-keeping and reporting requirements—corporations do offer the strongest protection from personal liability. They are also able to raise money by selling stock.
A corporation may be right for you if you plan on operating a medium- or higher-risk business, would like to raise money more easily, or plan to sell your company in the future and want an easier ownership transition.
An S corporation (or S corp) is a special type of corporation with different tax aspects than the standard C corp, and it’s a tax status that must be filed with the IRS. Shareholders of S corps report income and losses on their personal tax returns, thus avoiding the double tax dilemma. However, there are several criteria for S corp status, including having a maximum of 100 shareholders and only one class of stock. This IRS page provides a full list of requirements.
Keep in mind that S corps are treated differently by each state when it comes to taxes. For example, some states simply treat S corps as C corps, while other states tax S corps on profits above a specific limit.
Other than the above distinctions, S corps are C corps by another name. As long as you meet the criteria of the IRS, you can file as an S corp.
Limited Liability Company (LLC)
An LLC is a flexible business structure that can be taxed differently depending on how you choose to set it up. You can start an LLC by yourself or with other members—what owners of this business structure are called.
By default, LLCs are not considered taxable business entities. If you are the sole member, you would typically pay taxes in the same manner as a sole proprietor. If there are multiple members, the LLC is taxed like a partnership. Please note that you can also choose to have your LLC taxed as a corporation if you have a scenario where electing to do so would save more on taxes.
As the name suggests, an LLC protects you from personal liability in case your LLC, for instance, files for bankruptcy or faces a lawsuit. Your personal assets are considered separate from the business and won’t be at risk. In this respect, an LLC is similar to a corporation or LLP. Just note that certain types of companies, such as banks and insurance companies, cannot be LLCs depending on state requirements and federal tax regulations.
An LLC could be the right choice for any number of businesses, large and small. They work well for medium- or higher-risk businesses and owners who want to pay a lower tax rate than they might with a corporation.
2. Choose a registered agent for your business.
A registered agent is needed to formalize your company, whether you want to register your business as a corporation, partnership, or LLC. In simple terms, a registered agent—also referred to as a statutory agent or agent of process—is an individual or entity who you assign to receive essential legal documents on behalf of your business.
A registered agent:
- Must be designated to form your business as a legal entity within your state.
- Must have a physical address located in the state where you form your business. P.O. boxes are not accepted. This applies to every state in which your business is registered.
- Must be open for business during standard business hours from Monday through Friday (except holidays).
- Can be you or a third party that provides a registered agent service.
Without a registered agent, you can’t legally form an LLC or other business entity. All states have this requirement, so there’s no way around it. Your only choices are to designate yourself as your own agent, assign a third party as your agent, or operate your business informally. The latter option means you’d forego the protections and benefits of operating under a legal entity, which could leave you in a risk position.
While you have the option of being your own registered agent, choosing a third party as your registered agent provides several benefits:
- You can have legal mail sent to your registered agent if your business doesn’t have a physical location (beyond a P.O. box).
- You can avoid being served embarrassing legal documents in front of employees or customers.
- You don’t have to worry about missing critical documents or deadlines while away on business or personal travel.
3. Obtain federal and state tax ID numbers.
You’re familiar with your social security number; it enables the federal government to identify you as a taxable individual. You also have to obtain similar numbers for your business—these are called federal and state tax ID numbers.
Federal tax ID number. Commonly referred to as an employer identification number (EIN), this number is required for you to pay federal taxes, hire employees, open a business bank account, and apply for business licenses and permits (which we cover later in this article).
You can easily apply for an EIN for free using the IRS’s EIN Assistant tool. Note, however, that you may need to replace your EIN if any of the below changes happen. (The IRS lays out exactly what circumstances require applying for a new EIN, depending on your business structure.)
- Name change
- Address change
- Change in tax status
- Change in ownership
State tax ID number. A state tax ID number is only required if your business must pay state taxes. While the process of getting this number is similar to an EIN, you’ll need to check with your state government for exact steps on obtaining your state tax ID number.
4. Create an ownership agreement.
Regardless of the business structure you choose, you’ll need to document how the business is organized and how it operates in an ownership agreement. This agreement goes by different names depending on your business structure—partnerships have partnership agreements, corporations have bylaws or shareholders’ agreements, and LLCs have operating agreements.
Your ownership agreement should cover a few key areas:
- Ownership rights and responsibilities. Assuming there is more than one owner, how will rights and responsibilities differ between them? Do they have different roles within the business? Can new owners be added and, if so, how will that be handled?
- Management structure. Will all owners help run the business, or will one person manage while the other owners contribute money or advice? Will you hire one or more managers who are not owners?
- Decision-making. Is there a distinction between day-to-day decisions and long-term or major decisions? Which decisions can be made by which owners? Which decisions require a unanimous vote?
An ownership agreement can cover many more areas, but you should at least address the above to minimize any confusion or misunderstandings during the course of operation.
5. Apply for relevant licenses and permits.
Suppose a federal agency or your state regulates your business activities. In that case, you’ll need to apply for an appropriate business license—a government-issued document that permits you to operate your business within a specified geography.
Federal level. Numerous federal agencies regulate business activities. For example, the Bureau of Safety and Environmental Enforcement regulates mining and drilling of natural gas, oil, or other mineral resources on federal lands. You’ll need to research your specific business activities to determine which agency you should reach out to for licensure. For a brief list of activities and their respective regulating agencies, check out this SBA article.
State level. Compared to the federal government, state regulations for business activities tend to be broader—for example, construction, farming, restaurants, and retail. State business licensure can include standard and business-specific state business licenses and professional or occupational licenses.
6. Obtain business insurance.
As you know from other areas of life (e.g., home ownership), insurance can help stave off unexpected costs. Business insurance is no different—it can help protect you from expenses related to accidents, natural disasters, and lawsuits that might otherwise cause you to lose your business.
If your business has employees, federal law requires that you have workers’ compensation, unemployment, and disability insurance. Beyond this, some states require additional insurance.
Here are a few examples of business insurance:
- General liability insurance. Applicable to any business, this insurance grants protection against financial loss resulting from bodily injury, property damage, slander, defending lawsuits, and much more.
- Product liability insurance. If your business manufactures, wholesales, distributes, or retails a product, this insurance guards against financial loss due to a defective product causing harm.
- Professional liability insurance. If your business provides a professional service, such as financial or medical advice, this insurance financially protects you from malpractice, errors, or negligence.
The business formation process is more complicated than choosing a business name. But it’s a hurdle you can more easily overcome with help from Yahoo Business Maker Legal Package, which helps you select a business entity that’s right for you. Once you’ve made your choice, Legal Package completes and files all the paperwork, obtains an EIN, provides one year of registered agent service, and generates a full business license report. Make business formation a more manageable task with Legal Package. Get started today.