The ABCs of LLCs, Taxes and Small Business Regulations
Starting a business? Don't ignore tax, finance and banking fundamentals. From the ABCs of LLCs to tax-time necessities, this startup guide covers all the essentials.
If you're starting a business, making your product or providing your service will be only part of the job. There's also the paperwork: forming the business, paying its taxes and finding the money to run it.
The good news is plenty of help is out there to get your business started on the right foot — and most of it doesn't cost a dime. In this article, we lay out the basics of business formation, taxation and financing, along with useful resources to help you make the right decisions.
Before we begin, it’s important to note that you should speak to a certified legal advisor before making any legal or regulatory decisions. The following article does not constitute legal advice.
Table of Contents
- Business Formation: What Will Your Business Look Like?
- Taxes: Everyone Pays, But in Different Ways
- Financing: The Lifeblood of a Business
- Other Information and Resources
Business Formation: What Will Your Business Look Like?
Once you've decided to become "official," the first choice you'll face is where to incorporate your business. If you plan to do most of your business in one state and do not plan to sell your products online, the easiest course of action may be to incorporate in your own state. If, however, you plan to operate mainly as an ecommerce or web-based business, or pursue venture capital investment or an IPO in the future, it might make sense to incorporate in a state with different regulatory structures. Speak to a legal advisor before choosing where you incorporate.
You next decision is the form your business will take. You may have heard terms like "LLC" and "S corporation" but remain foggy on the details. How do you decide which one best suits your needs? Below, we lay out pros and cons of each.
Sole Proprietorship
This is simplest business entity to get up and running. Basically, the company is you and only you. There's little in the way of startup paperwork or fees, and you can run things any way you like. If your work requires licensing or permits, you'll need to comply with local regulations as well.
On the downside, you and your personal property may be liable for any losses or debts your business incurs. For instance, if your sole proprietorship is sued, your personal assets (such as your house) may be at risk.
You and your business are also identical for tax purposes. That is, your business' profits become part of your personal income, whether you use them for a spending spree or leave them sitting in a segregated bank account. It may be hard to get financing for this kind of business, and, as mentioned, you're personally responsible for its debts and any legal liability.
Find out the requirements for forming a sole proprietorship in your state.
Partnership
What if your business is so successful that it grows beyond your ability to manage it by yourself? By setting up a partnership, you could enlist some partners and share the responsibilities and profits. In most respects, a partnership is as simple to form and run as a sole proprietorship.
Like sole proprietorship, partners and their personal assets are not necessarily protected from the business' debts and legal liability.
A helpful advantage is that a partnership does not pay corporate taxes on profits; instead, partners pay individual taxes only on any compensation they may extract from the partnership.
Limited Partnership
This is a sub-species of partnership that carries the advantage of shielding most of the partners (called limited partners) from the legal liability of the business. At least one general partner must remain personally liable, however.
Corporation
Creating a corporation increases the separation between you, the owner, and the business, which is now considered its own legal entity. If your business gets sued, chased by creditors or otherwise runs into trouble, your own personal assets are generally safe. Types of corporations include C corporations, S corporations and LLCs.
Corporations require that you follow a host of rules and regulations, which differ from state to state. Plan to set aside time for some paperwork along with money for fees.
In addition, forming and running a corporation involves more formalities than a partnership. For example, you and any co-owners must appoint a board of directors (often yourselves), choose officers and draft bylaws (rules for running the corporation). Fortunately, a wealth of guidance is available online. But remember: Every state has its own procedures.
Find out the requirements of forming a corporation in your state.
C Corporation
A C corporation is taxed separately from its owners or shareholders. Unfortunately, that creates a situation that some call "double-taxation." That is, your business is taxed on its profits, and you, the owner, are taxed on any salary you draw from the business.
S Corporation
This type of corporation does not pay a corporate tax on profits generated by the business. Instead, owners or shareholders are taxed as individuals for any compensation they take from the company. As a result, you're legally separated from your business while solving the double-taxation problem.
Limited Liability Company (LLC)
LLCs are a popular choice for small businesses. The main reason is that LLCs combine some advantages of a corporation with those of a partnership. You and your business are still separate entities for legal purposes, and you can have co-owners (though you don't need to).
As with an S corp, any profits pass through an LLC untaxed and are only taxed once to you, the owner. There are some papers to file and fees to pay to the state. Also, you should have a document called an operating agreement, which sets out rights and responsibilities of the LLC members. In general, however, an LLC is much easier to form and run than a corporation.
LLCs do, however, have some disadvantages. For example, some investors may be reluctant to invest or take equity in LLCs.
Taxes: Everyone Pays, But in Different Ways
If you have a trusted accountant who will assist you with business tax issues, make him earn his money. Your accountant is your best resource for specific tax information. Generally speaking, however, these business tax basics and resources may be helpful.
Employer Identification Number (EIN)
Almost all businesses need an EIN, which lets the IRS track wages and other payments made to employees and owners. Sometimes banks use EINs to set up accounts for businesses. Getting one is fairly straightforward and takes just a few minutes — do it online here.
Deductions
"Writing off" business expenses isn't just a time-honored tradition; it's a business necessity. For tax purposes, "business expense" is pretty broadly defined: If you can make a case that a product or service is used in connection with your business in some way, you may be able to deduct that expense from your business' taxable income. Speak to your accountant about the specific deductions you plan to take.
If you do deduct expenses from your business income, you'll do yourself a favor by keeping a solid set of records. Save receipts for everything you plan to deduct. Then enter these figures in a ledger so that when tax time rolls around, you won't have a quarter's (or year's) worth of receipts to sift through
Tax Breaks
Part of handling your business taxes well isn't just knowing how much to pay, but also how much not to pay. A host of tax breaks are available for small businesses. Do you make and sell products in your home? There's a credit for that. Do you provide health insurance for fewer than 25 employees? There's a credit for that. Even something as basic as a net operating loss can help you at tax time.
For the biggest trove of free tax advice, you can go straight to the experts: the IRS. They seem to appreciate how dreadful it is to read about tax law, so their website features video tutorials on dozens of topics, including business income and expense, recordkeeping, retirement plans and more.
Financing: The Lifeblood of a Business
Money may or may not make the world go 'round, but it's definitely crucial to running a business. Many young companies don't yet generate the profits or have the customer base to stay afloat, so they rely on financing from outside sources. Below are two common sources of financing for small businesses: loans and equity investment.
Loans
A sole proprietorship is only as creditworthy as its proprietor, so it can be very difficult to get financing for this simple type of business. A family member might make a gift or loan, but there are tax limits on gifts, and loan agreements between family members can get sticky if things go wrong. In general, it's easier to get outside funding if there's more separation between business and owner, as with a corporation or LLC.
Even during good economic times, getting a small business loan from a bank can be challenging. Lenders are often skittish about making loans to businesses whose owners couldn't pay back the whole thing on demand. This may seem silly, but banks know the failure rate for small businesses is high, and make lending decisions accordingly.
Enter the Small Business Administration (SBA), a federal agency that's responsible for increasing lending to small businesses. The SBA does not write loans itself; instead, it guarantees portions of loans made by the lenders it works with. This lessens the risk to the lenders and makes them more willing to take chances on new businesses.
If you're lucky enough to run a business that meets particular criteria, you may qualify for a federal grant. While highly competitive and difficult to qualify for, federal grants have the significant advantage of not requiring repayment. Learn more on this topic from the SBA here.
Equity Investment
Equity investment, which includes venture capital (VC) and “angel” investment, is a type of financing well suited to companies that can't easily qualify for loans. It's usually a cash investment made in exchange for shares of ownership in and a degree of control over the company.
Control over your business is another important issue to consider. A corporation can be divided into shares; a partnership, not so much. Most venture investors will require documented shares in exchange for their money, which often equates to a say in how the business is run. Ask yourself if you're ready to share decision-making authority in exchange for cash.
Keep in mind that a VC or angel investor is going to want an exit strategy in place even before committing funds to you. Investors want their return at some point, although they're usually willing to wait longer for a business to become profitable than a bank is willing to wait for a loan payback. When it comes time for repayment, however, they may expect a higher ROI than interest on a loan. Exits are usually made when a business is sold outright to another corporation or investor, or becomes publicly traded via an initial public offering (IPO).
Other Information and Resources
You may still feel overwhelmed by all the different financial and legal aspects of running a business, and chances are you still have a lot of questions. We recommend hiring an attorney, but some online resources can help as well.
- Lawpivot is a legal information website that provides customized answers from licensed attorneys. After entering your question and supplying a few basic facts about your business, you can get answers from multiple lawyers and ask follow-up questions — all for free. This is a great way to get feedback from people who focus on your unique issues.
- Nolo is a long-established publisher of legal manuals and documents. The business has moved into the 21st century with a robust website filled with free information, most of it authored by well-qualified attorneys.
Remember: Legal information is not the same thing as legal counsel. No online resource will provide the same level of personal legal service, or legal rights, that a licensed attorney can. If you feel you require the advice of a lawyer, both of the above sites offer directories that can connect you with one who makes sense for your issues and your budget.
Stick to the Fundamentals
When it comes to your small business, sticking to the fundamentals — formation, taxes and finance — can really set you up to succeed. Make sure you understand what's at stake, and run your business accordingly. When in doubt, seek legal and financial counsel from licensed professionals you can trust.