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Legal Aspects of Starting a Small Business

After the planning process has been completed, a prospective business owner should move from the conceptual stage towards the actual legal formation of the business.  The legal aspects of starting a business are complicated and are not intended to be fully discussed in this primer course.  Oftentimes it is prudent to seek appropriate counsel on matters of this nature. 

However, there are three important legal related areas that prospective entrepreneurs should consider.  They are legal forms of business ownership, required licenses and permits and federal requirements.  We will take a preliminary look at all three.

 

Forms of Ownership

One of the first decisions that you will have to make as a business owner is how the company should be structured. This decision will have long-term implications, so consult with an accountant and attorney to help you select the form of ownership that is right for you. In making a choice, you will want to take into account the following:

  • Your vision regarding the size and nature of your business.
  • The level of control you wish to have.
  • The level of structure you are willing to deal with.
  • The business' vulnerability to lawsuits.
  • Tax implications of the different ownership structures.
  • Expected profit (or loss) of the business.
  • Whether or not you need to reinvest earnings into the business.
  • Your need for access to cash out of the business for yourself.

 

Basic Ownership Structures

There are five basic ownership forms.  However, most new small businesses starting out are initially formed as sole proprietorships. 

Sole Proprietorship
The sole proprietorship is a simple, informal structure that is inexpensive to form.  It is usually owned by a single individual.  The owner who operates the business is personally liable for all business debts, can freely transfer all or part of the business and can report profit or loss on personal income tax returns.

General Partnership
Partnerships are inexpensive to form; they require an agreement between two or more individuals or entities to jointly own and operate a business. Profit, loss, and managerial duties are shared among the partners and each partner is personally liable for partnership debts. Partnerships do not pay taxes, but must file an informational return.  Individual partners report their share of profits and losses on their personal return. Short-term partnerships are also known as joint ventures.

C Corporation (Inc. or Ltd.)
This is a complex business structure with more startup costs than many other forms. A corporation is a legal entity separate from its owners, who own shares of stock in the company. Corporations can be created for profit or nonprofit purposes and may be subject to increased licensing fees and government regulation than other structures. Profits are taxed both at the corporate level and again when distributed to shareholders.
Shareholders are not personally liable for corporate obligations unless corporate formalities have not been observed; such formalities provide evidence that the corporation is a separate legal entity from its shareholders. Failure to do so may open the shareholders to liability of the corporation's debts. Corporate formalities include:

  • issuing stock certificates
  • holding annual meetings
  • recording the minutes of the meetings
  • electing directors or ratifying the status of existing directors 

Corporations should always be assisted by a qualified attorney.

Sub Chapter S Corporation (Inc. or Ltd.)
This structure is identical to the C Corporation in many ways, but offers avoidance of double taxation. If a corporation qualifies for S status with the IRS, it is taxed like a partnership; the corporation is not taxed, but the income flows through to shareholders who report the income on their individual returns.
 
Limited Liability Corporation (LLC)
The LLC is generally considered advantageous for small businesses because it combines the limited personal liability feature of a corporation with the tax advantages of a partnership and sole proprietorship. Profits and losses can be passed through the company to its members or the LLC can elect to be taxed like a corporation. LLCs do not have stock and are not required to observe corporate formalities. Owners are called members, and the LLC is managed by these members or by appointed managers.

(Learn more about each of these forms, including the advantages and disadvantages of each…….)

 

Federal Requirements

Most small businesses do not require a federal license or permit. However, if you are engaged in one of the following activities, a federal license is required.   

  • Investment Advising
  • Drug Manufacturing
  • Preparation of Meat Products
  • Broadcasting
  • Ground Transportation
  • Selling Alcohol, Tobacco, or Firearms

Employer Identification Number (EIN)

With the exception of sole proprietors, most businesses must apply for an EIN regardless of whether they have employees.

(learn more about EIN numbers from the IRS  IRS site )

(apply for an EIN from IRS IRS' online application)