Business Formation Basics

Business Formation Basics

What is your favorite part about the idea of starting your own business? Is it the mountain of legal paperwork necessary to get it set up correctly? I thought not. Unfortunately, it is a critical step in any new venture and often overlooked. Rather than go into all the horror stories I’ve witnessed when people skip this step, let’s focus our energies on arming you with the information you need to be successful.

Corporate Formation

The first step in the process is forming a legal entity separate from yourself to encapsulate your business. For some people, you won’t need not do this step. You can actually just start servicing clients and the government will consider you a sole proprietor. However, if the answer to any of the following questions is yes, I suggest forming an actual entity.

  • Am I going into business with another person?
  • Will I have a high volume of expenses associated with my business income?
  • Do I want to raise money for this company or plan on selling it one day?
  • Is there a large potential liability associated with operating this business?

If you’ve now decided you need a separate entity for your business, here are a couple more items you’ll need to consider

Structure - what is the proper structure for your business? The main choices are S-Corp, Partnership, Limited Liability Company (LLC), and C-Corp.

  • Partnership - simple form for companies with more than one owner. There are different types of partnerships, but generally you want a Limited Liability Partnership (LLP). This protects the partners from personal liability for the actions of other partners or debts the partnership incurs (unless they are personally guaranteed). The profit and loss of the partnership is allocated to each partner at the end of the year.
  • Limited Liability Company - you can form one if you are solo or with as many other partners as required. An LLC with more than one person is often considered a de facto partnership from a tax standpoint, but you have the option of electing to be taxed as a corporation. Also, as in a partnership, you are personally protected from liability in case of business lawsuits or bankruptcy.
  • S-Corp - this can be a good option for new owners and can benefit from the same “pass-through” tax treatment of partnerships and LLCs based on the state you are in. However, to obtain status as an S-Corp, you must contact the IRS, which adds another layer to the formation process. You can also have other shareholders in this structure, but it is capped at 100 and they have to all be U.S. citizens.
  • C-Corp - if you want all the legal protections afforded to the other structures, and plan on raising money from investors, this is the best structure. There is a higher overhead associated with annual filings, and technically a “double taxation” on profits in the business, but it is still the preferred structure of most investors I have ever met. This is because it is the easiest structure for selling stock to outside parties without complicated tax effects, and also lets you easily incentivize employees with stock and option grants. If you think your company is going to be the next Amazon, go ahead and choose this structure.

Location - most of the time it is going to make the most sense to incorporate in the state in which your business conducts the majority of its operations. This is probably where you live as well. This gets you out of having to pay for a Registered Agent, which is a fancy term for someone who collects your mail in the state where you are incorporated. If you live in that state, you can just list the business address. Also, if you incorporate in a state that is different from where you conduct business, you will also have to file in that state as well. That just adds to the paperwork of keeping your business in good standing, and distracts you from making money, which is why you started your business anyway. The main exception is for C-Corps that want to raise outside money, in which case I suggest Delaware. If you want more info on why, email me and I will be happy to elaborate.

Ownership - if you are a solo founder and have no plans on bringing in partners, you can skip this step. For everyone else, this might be the most important step. Before you go into business with another person, you need to completely discuss the ownership breakdown of the entity. Here are some questions you should answer before forming an entity:

  • What are our roles, responsibilities and time commitments?
  • What is the starting breakdown of ownership?
  • How and why might that change over time?
  • Are either of you putting money or assets into the company?
  • Will either of you take a salary or regular distributions?
  • Are profits and losses allocated (if it is a partnership or LLC) based on ownership or some other formula?
  • Are you both or individually going to personally guarantee any of the business’s debts?
  • Who will be responsible for putting in money if the company needs funds?
  • What is the end-game for the company (i.e. going public, hold forever, sell to someone else)?

Any hours you spend up front answering these questions will be time well spent. You do not want to get into a situation five years from now where something you sped through or overlooked is stopping a deal from closing, and I’ve unfortunately seen that happen many times. It might be (probably is) worth investing in a consultation with a lawyer and/or CPA when it comes time to make these decisions and document the understanding between the partners.

Federal Employer Identification Number

The Federal Employer Identification Number aka Employer Identification Number aka Federal Tax Identification Number is a number that the government uses to identify your business and track your filings and holdings. You can think of it like the Social Security Number for your business. From the name, you might think you only need one if you plan on having employees, but that actually doesn't matter. The point is you need one to conduct most any kind of business, including getting to the next steps in this process. Go here to the IRS website and apply for one. It is surprisingly easy to navigate the process, especially considering it is a government website. Once you have your number emailed to you, proceed to the next step.

Business Accounts

The hardest part is over. Now you just need to decide where to keep all of the money you’re going to make, and who to use to help finance the short term cash needs of the business.

  • Banking - there are a metric ton of choices of who to bank with, but I suggest starting with an institution where you already have accounts and, ideally, a relationship with one of the bankers. I see people get drawn in by some of the newer banks that are supposedly set up to better service business customers, but their fees are rarely justified early on. I suggest finding a bank with low and transparent fees, national reach, and a robust online banking portal.
  • Credit Card - there are lots of good reasons to open a credit card line for your new business. Primarily, you get the fraud protection of an entire lending institution standing between you and fraudsters. If you go around using your business debit card everywhere, and the information or card gets stolen, fraudsters have direct access to your funds. Even if you eventually get them back, you have to deal with the fact that your money is gone for that time period. Conversely, credit cards use other businesses' money. If something happens, you are not liable and all of your funds are still in your bank account to use as needed. Watch this video where Frank Abagnale discusses it in greater detail why it is wise to use a credit card. You can choose whichever card works best for you (i.e. cash back, travel, other perks), but leave the business debit card locked away somewhere far from the light of day.

You are now all set to start making your business a success. This upfront paper-heavy process can seem onerous, and it is, but it is a necessary step that must be taken to set your business off on the right foot.

For answers to questions you have about this or related topics, schedule your free consultation today.