Ask a small-business person why they're forming a corporation, and you're likely to get a vague answer like "for tax purposes." Wrong answer. If you're an entrepreneur, here's what you need to know when it comes to setting up your next business.
In addition to Money Talks News, I’ve owned a few businesses – from a restaurant to a real estate investment company. In some, I was the sole owner. In others, I had partners. But while the companies were different, they all had one thing in common: During the start-up stage, the owners spent entirely too much time on things that didn’t matter.
One example? Naming the business. Since it was 20 years ago, I don’t remember how long it took me to come up with Money Talks, but I don’t think it took much thought. I was a fan of the expression, “Money Talks, BS walks.” Simple. But when I went into the restaurant business with two of my friends? I think it took us at least a month of often heated discussion to finally arrive at a name we could all agree on.
Another example of something entrepreneurs often waste valuable time and money on? Deciding what form their business should take: sole proprietorship, corporation, subchapter S corporation, LLC, yada, yada, yada.
That’s not to say things like names and business formation aren’t important at all – just not at first. What’s more important? Thinking about how you’re going to make money.
Check out the following news story I recently shot called “Should You Incorporate?” Then meet me on the other side for more…
Now, here’s a little more information on the different ways you can organize a business.
A sole proprietorship is a fancy name for a simple form of ownership: It’s just you and maybe your spouse. Sole proprietorships aren’t separate legal entities, so there’s no legal paperwork required. Just open a checking account and go. Exception: If the business has a different name than yours, you might have to file a fictitious name form with your state.
Pros: Fastest, easiest, and cheapest. If you want to change it later to some other form of business, like a corporation, no problem.
Cons: Since you and your business are the same thing, if your business loses a lawsuit, so do you. There’s also no way to shift taxes from you to the company.
If you’ve got more than one person in your business, you’ve automatically created a partnership. But there’s still paperwork, because you should always have a legal partnership agreement that lists everyone’s rights and responsibilities. Most partnerships are general partnerships, meaning all partners operate and are responsible for the business. There are also limited partnerships, where one general partner is in charge while the others are “silent,” with no say-so and limited liability.
Pros: Other than sole proprietorships, partnerships are the easiest and cheapest form of business to set up and maintain.
Cons: As with sole proprietorships, partnerships offer no protection against judgements, lawsuits, or other liabilities incurred by the business, unless they’re limited partners.
Limited liability company (LLC)
LLCs are relatively new, having only been around since the 1980s. These are basically a mix of a partnership and a corporation. Like a corporation, an LLC is a separate legal entity, so owners are shielded from personal liability. And like a partnership, they’re simpler than a corporation.
Pros: Cheaper and easier to set up and maintain than a corporation, and limited liability.
Cons: More hassle and expense to set up and maintain than a partnership or sole proprietorship.
A corporation is the most formal type of business ownership. It’s a separate legal entity that can outlive its owners, who are called shareholders. A corporation can be as big as General Motors, with millions of shareholders, or as small as Money Talks News, with one. Some types of corporations (known as C corporations) file and pay their own taxes. Others (S corporations) file a tax return, but their profits and losses flow through to the shareholders.
Pros: As with LLCs, corporate shareholders are not liable for losses, debts, or lawsuits of the company. Since corporations can issue stock, they can also be useful for raising money.
Cons: Corporations are the most complex and expensive forms of business to establish and maintain.
Which should you choose?
I’ve talked to lots of new business owners who – like the one in the video above – incorporate for the wrong reason: income taxes. While forming a corporation can sometimes alter your tax situation, it’s relatively rare. Also rare is the small-business person who won’t be required to personally sign for the debts of their company.
So the primary reason to form a corporation or other separate business entity is to shield your personal assets from liability – that is, lawsuits. How important that is depends on the person and the business. If you have substantial assets, it’s important. If you own a business subject to lawsuits – say, a restaurant or a news service that sometimes says negative things about other companies – it’s important.
Best advice? There’s no point going through the hassle or expense of setting up an LLC or corporation until you know you’ve got a viable business. If you’re working with others, definitely put a partnership agreement together before you do anything. But if you’re working alone, focus first on getting your business off the ground. Then pay for an hour with a good CPA or lawyer and get some good advice on where to go next.
How should you do it?
As with many legal chores, there are several ways to approach a partnership, LLC, or corporation. Traditional, and most expensive, is simply to hire a lawyer: Expect to spend $1,000 or more. The least expensive approach is to find the necessary forms and do it all yourself. In between are sites like Legal Zoom and services like We The People that offer a little hand-holding along with the forms for about half the price of a lawyer.
There’s plenty of more detailed advice and information online: My favorite site for all things legal is Nolo.