Chapter 2: Making it Legal
Whether you're moonlighting as a consultant a few weekends a month or working 80-hour weeks for yourself, you'll eventually come to the question of how to organize your business for legal purposes. It's an important one to consider. The legal structure you choose for your business can affect a lot of important business variables, including…
- Your liability for business-related events.
- Your ability to go public.
- Your taxes.
We'll discuss the basics in this chapter, but keep in mind that every business is different and there's a lot more complexity to these structures than we'll cover here. While it makes a lot of sense to start working as a sole proprietor, it's also a good idea to meet with a business attorney at some point to discuss which structure makes the most sense for your short- and long-term goals.
Galia Aharoni , an attorney with HG Business Law, LLP , highlights a few important considerations for tech business owners thinking about legal structure:
- Liability: Sole proprietorships and partnerships are "pass-through" entities, meaning that any liability the business has passes directly to the owners. This scares some people, but
Skylar Bader , of YourStartupLawyer.Com , likes to remind IT pros that business insurance can solve the problem of unlimited liability. "You'll have buy that insurance for your business if you become a LLC or a corporation [and] you don't want your business to go bankrupt," she points out. "So why not skip incorporating and just buy the insurance alone?" Another key point: most clients require that their IT contractors have Errors and Omissions and General Liability Insurance before they'll sign a contract.
- Business structure: While sole proprietorships are the easiest and least expensive type of business to form and maintain, they are limiting in some ways. Sole proprietors can't be partners, for one thing. So if you're dead set on launching a business with a partner, sole proprietorship isn't an option.
- Going public: If you have plans to go public one day (i.e., sell stock in your company), you have to organize as a corporation. But, warns Aharoni, because corporations are complex to form and maintain, it's important to be really clear about why you want to go public. If you're having trouble articulating your reasons, she recommends considering a simpler structure.
- Tax consequences: At the federal level, sole proprietorships, LLCs, and partnerships are not taxed separately. That means all business revenue is reported as income for the owners. But some states tax LLC revenue, and partnerships may have to pay employment and excise taxes. Bader notes that sole proprietorships are by far the easiest structure to file taxes for, which is why they're so attractive to new business owners.
To get a better idea of how the various business structures compare to each other, take a look at this table.
||Cost to Set Up
||Earnings / Losses
||Can You Go Public?
||None, besides costs for licensing or permitting.
||Owner is liable for all business liabilities.
||All earnings and losses pass through to owner.
||The business is not taxed separately, so taxes are simple. Owners must pay self-employment taxes.
||This is the default structure you'll have if you take no action.
|Limited Liability Company (LLC)
||Minimal (less than those of a corporation).
||Limited. Owners' assets are protected from losses / liabilities incurred by the business.
||All earnings and losses pass through to owner(s).
||The business is not taxed separately at the federal level. All profits or losses are reported as income by owners. Some states tax LLC income, so check your state's laws. Owners must pay self-employment taxes.
||You can have multiple owners, including individuals and other businesses.
||Minimal (less than those of a corporation).
||Full. Owners split liability equally among them, as in a sole proprietorship.
||All earnings and losses pass through to owners.
||The business is not taxed separately at the federal level. Partnerships are responsible for self-employment taxes, estimated tax, income tax, employment taxes, annual return of income, and excise taxes.
||Partnerships allow you to work with someone whose skills complement your own. If you plan to hire employees, you can incentivize them by offering eventual partnership.
||Expensive, relative to other structures. This structure also takes longer to set up and is more complex to maintain, possibly requiring outside help.
||Limited. Shareholders can usually only be held liable for the amount of their investment.
||Owners are paid out of corporate earnings; earnings not paid to owners are taxed separately.
||In some cases, corporations are taxed twice: first when the business earns money and again when it pays dividends to shareholders.
||Most venture capitalists require corporation structure.
Next: Sole Proprietorships: The Structure of the 21st Century