By: Brian J. Meli
This is Part 1 of a two-part article on the legal basics of starting a business. Part 2 can be read here.
It starts with a great idea and ends with a thriving, profitable business. Every entrepreneur’s vision is the same: take a conceptually promising idea and with a lot of hard work and a healthy dose of ingenuity, turn it into a successful commercial enterprise. But as any entrepreneur worth his seed money knows, it’s always easier on paper than it is in execution. The reality is that, more often than not, the business goals of a start-up go unmet; the lofty dream of seven figure revenues, unfulfilled.
Ask any serial entrepreneur and they’ll tell you the same thing; don’t be afraid to fail, because failure is just a part of the game. But accepting failure and expecting it are two very different things. You have to operate like your venture is going to make the cut by laying the groundwork for eventual success. Otherwise, what’s the point? Failing to generate enough sales to become profitable isn’t what any entrepreneur envisions when he opens for business, but as long he gives himself every opportunity to succeed, there’s no shame in throwing in the towel and calling it a learning experience. The same can’t be said, though, for shuttering ones doors due to poor planning. And the time for that planning is before the receipts come in, not after.
Step one of starting any business is deciding on the form it’s going to take. Selecting a business form is like laying the foundation upon which it will rise and take shape. Lay the foundation incorrectly and your fledgling venture could top out before you intended, or worse yet, topple over.
In the U.S. there are five primary types of business forms to choose from, each with its own sets of subcategories. So while the following list is by no means exhaustive, it provides a good starting point for the aspiring new business owner. The form you choose will ultimately depend on your own unique circumstances, and should be discussed thoroughly with a qualified professional.
The Sole Proprietership:
It’s the simplest, quickest and cheapest business form there is. The simplest because, in most cases, there’s no official documentation needed, no forms to file, no agreements to write. It’s the cheapest because all those forms and agreements you don’t need won’t incur filing charges and legal fees. And it’s the quickest because if you go into business for yourself (and you don’t have any partners) then you’ve essentially formed one. That’s because sole proprietorships are the default form for a single-owner business when no election is made to organize as anything else.
Sole proprietorships are best suited for the part-time entrepreneur; the individual who may not be ready to quit her day job just yet. They receive pass-through taxation status, so any income received by the business is taxed to the owner as an individual. But what you gain in simplicity and cost-savings, you lose in protection. Because there’s no legal distinction between you and your company, your personal assets can be looked to for satisfaction of business debts or other liabilities such as legal judgements. So starting off as a sole proprietor may be fine if you’re just wading into the start-up pool, but as your business begins to grow, it’s almost always preferable to convert your sole prop into one of the other forms on the list.
An easy way to think of a partnership is a group of two or more sole proprietors—because if you’re a sole proprieter and you share profits with anyone else, that’s exactly how the law will see it. A partnership can be formed easily. So easily in fact that you can do it without even knowing it. All it takes is two or more individuals (or company’s) sharing profits. Like sole props there’s no formal filing requirement (although a partnership agreement between the partners is highly advisable), and like sole props any income from the partnership passes through to the individual partners for tax purposes.
Unfortunately, the laws governing partnerships tend to be inflexible, and because partnerships can be formed without the intent of the parties, they’re often ill-defined and can be a source of dispute. Also, like sole proprietors, general partners are personally liable for all the debts of the partnership, with each partner being 100% liable for the whole. Furthermore, a partnership is generally only in existence for as long as the partners remain active. If a parter passes away or withdraws, the partnership is usually terminated. This can make for a bumpy ride if a partnership has multiple parters who aren’t fully committed to the cause. So while the more partners there are, the more money the partnership can raise, but there’s also more potential for conflict between them. For these reasons, partnerships may not be the best long-term business form, and are often more suitable for short-term, strategic endeavors of a defined duration.
The Limited Liability Company:
The most popular business form in recent years, because it combines many of the best qualities of the others, is the limited liability company. The LLC is a relatively new creation, conceived to address the shortcomings of the sole prop and partnership. It carries the limited liability protection of a corporation (LLCs are legal entities separate from their owners), and the simplicity and pass-through taxation of a partnership. Plus, it gives its owners, known as “members,” the flexibility to write many of their own rules governing the control of the company. They do cost some money to form, and require Articles of Organization to be filed with the state in which they’re formed, but for many start-ups the costs of forming an LLC are outweighed by the benefits to their Members.
The most well known business form is also the one requiring the most structure and complexity. Corporations require formal registration, corporate bylaws and Articles of Incorporation, and the issuing of stock certificates to all owners, making them cumbersome to implement and manage. But no business form is better suited for accommodating sustained growth. Corporations are separate legal entities owned by their stockholders, who appoint a board of directors to oversee the corporate mission and to elect managers to run the day-to-day operations. This structure insulates stockholders from personal liability while enabling them to grow rapidly through restructurings, mergers and acquisitions. Usually corporations elect to be taxed separately from their shareholders, but not always. Either way, corporate tax returns can be mutli-faceted and complex. While corporations can be costly to start and time-consuming to manage, they’re exceptionally well-suited for growing businesses that are looking for flexibility and access to capital.
Non-profts are tax-exempt organizations that must qualify for such status under the Income Revenue Code. In order to be eligible for tax exempt status the company must first be formed under state law, and then file an application with the Internal Revenue Service, who serves as ultimate arbiter of tax-exempt eligibility. Similar to for-profit corporations, non-profits are headed by a board of directors that manage the non-profits’ affairs. With non-profits however any surplus revenue realized by the organization must be retained and cannot be distributed back to the owners. Any start-up considering non-profit status should be aware that non-profit organizations have many more requirements than for-profit businesses.
The content of this blog is intended for informational purposes only. The information provided in this blog is not intended to and does not constitute legal advice, and your use of this blog does not create an attorney-client relationship between you and Brian J. Meli. Under the rules of certain jurisdictions, the material included in this blog may constitute attorney advertising. Prior results do not guarantee a similar outcome. Every case is different and the results obtained in your case may be different.