Readers, I’m happy to introduce you to Nellie Akalp, a serial entrepreneur and small business expert. She currently serves as the CEO of CorpNet.com, an online legal document filing service, where she helps entrepreneurs start a business, incorporate or form an LLC and offers free business compliance tools. In the first of two blog posts, she answers questions we posed about what legal format your small business should take. In Part II tomorrow, she answers questions about common mistakes made by small business owners and other topics. Connect with Nellie on Google+ and contact her at info@CorpNet.com.
What are the key legal issues that someone starting a small business needs to consider?
Akalp: When someone is starting a small business, there are many things they need to take care of from finding a location to hiring an accountant. When it comes to legally starting a business, here are the main tasks that need to be done:
– Pick a business name; before diving too far with a name and branding, you need to make sure that the name isn’t infringing on the rights of someone else’s business. This isn’t a complex process – you don’t need an attorney. In seconds, you can perform a free trademark search to see if the name you’re considering is available to use in the U.S.
– Choose a business structure; if you don’t create a formal business structure, by default you’re operating as a sole proprietor (assuming you’re the sole owner). As a sole proprietorship, there’s no separation between the business and business owner. That means that if your business is sued or can’t pay its debts, you can be personally on the line. Formal business structures, such as the LLC, C Corporation, and S Corporation, help to separate your personal assets from the business. Each structure has its own set of advantages or disadvantages depending on your specific situation.
– Register your business name; if you form an LLC or corporation, your business name gets registered at this point. However, if you decide you’re not ready to incorporate, then you need to register your business name with your state. To do this, you’ll need to file a DBA (Doing Business As). This step makes sure you’re legally able to use the business name in your state. It also makes sure that no one else can use the name in your state either.
– Get a federal tax ID number; A U.S. Federal Tax Identification Number (which is also called an Employer Identification Number) lets the IRS track your company’s transactions. Think of it as a social security number for businesses. If you’re operating as an LLC or corporation, your business is required to have a Tax ID number. If you are a sole proprietor, you’re not obligated legally to get a Tax ID number, but it’s smart practice. With a Tax ID number for your business, you won’t have to give out your personal security number to every client or vendor who asks for it.
For a small business, what are the benefits of forming an LLC?
Akalp: In an LLC, the owner’s personal assets are shielded from business liabilities just as they would be in a corporation. In addition, the IRS views the LLC as a “disregarded entity.” Thus, an LLC does not file separate taxes; company profits and losses flow through to the owners and are subject to each owner’s individual tax rates. The LLC is great for a business that wants liability protection, but seeks minimal formality. It’s also the perfect structure for a business with foreign owners since anyone (C Corp, S Corp, another LLC, a trust, or an estate) can be an owner of an LLC.
What about incorporation?
Akalp: Many small businesses consider themselves ‘too small’ to worry about incorporation. However, incorporating a business can be a very smart idea. Here’s why:
- Liability protection: First and foremost, similar to the LLC, the corporation (C corporation or S corporation) protects the owner’s personal assets from any liability of the company. That is, if your company happens to be sued, your personal assets (i.e. property, savings accounts) are shielded from any judgment. Of course, lawsuits are worst-case scenarios and there’s a slim chance you’ll ever run into legal problems. However, if you’re sued as a sole proprietor, you’ll be sued personally. And that means everything – from your children’s college fund to your retirement savings – is at risk. Also keep in mind that creditor judgments can last up to 22 years, so you need to worry not only about protecting the assets you have today, but the assets you’ll have tomorrow.
- Taxes: Federal income tax rates can be lower for corporations than for individuals. And as a corporation, you may be entitled to additional deductions.
- Credibility: Adding ‘Inc.’ after your company name boosts your credibility in the eyes of some customers and partners.
- Business credit/capital: As a corporation, it can be easier for you to access a line of business credit. And forming a C corporation will be essential if you plan to seek venture capital funding.
- Added layer of privacy: With a corporation, the company’s ‘registered agent’ goes on public record, and not your home or business address (in most cases).
Under what conditions should a small business founder consider incorporating vs. forming an LLC?
Akalp: There are two main types of corporations, the C corporation and the S corporation. Here is a bit about both structures that may help someone determine if they should form an LLC or incorporate:
The Corporation (C Corp)
A corporation is considered a separate entity from its owners. This means that the corporation (and not the owners) is responsible for any of its debts and liabilities. This is often called the “corporate shield” as it protects the owner’s personal assets from the business.
A corporation has a formal structure consisting of shareholders, directors, officers and employees. Every corporation must select at least one person to serve on its board of directors and officers are required to manage the day-to-day activities of the company.
Corporations need to vote on important company issues. For this reason, the corporation is often seen as administrative overkill for the average small business, and is a better option for bigger companies who plan to go public, seek VC (venture capital) funding, or invest profits back into the company.
As a separate business entity, a corporation files its own tax returns. As a C corporation owner, you’ll need to file both a personal tax return and a business tax return. In some cases, this can result in a “double taxation” burden for small businesses where first the business must pay taxes on its profits, and then the owners/shareholders must pay taxes on an individual level when those profits are distributed to them.
An S corporation is a corporation that’s been designed to address this double taxation issue. An S corporation does not file its own taxes. Rather, company profits are “passed through” and reported on the personal income tax return of the shareholders. S corporation owners are taxed on their respective shares of the company’s profits (and these profits are not subject to self-employment tax). If an S corporation owner works in the business, they must be paid a reasonable wage for their activities and the S Corporation must pay payroll taxes on these wages.
An S corporation starts out like a C corporation; then the owners elect ‘S corporation Status’ by filing Form 2553 with the IRS in a timely manner. However, be aware that not every business can qualify to be an S corporation. For example, an S corporation cannot have more than 100 shareholders and shareholders must be U.S. citizens or residents.
Here is Part 2 of our interview with more helpful advice from Nellie Akalp.