Legal and Tax Considerations for Your New Business
Setting up an LLC, creating contracts and more
As soon as you decide to start a business, you should begin looking into the things that will protect your personal assets: namely, legal entities, insurance and contracts. Small business lawyer Nicole Pavlik joined our webinar series to help our community of founders understand what are some of the first steps a new business owner should take.
What legal entity is best for my business?
Actually, that’s a question best answered by a tax professional, Pavlik explained. Even before a founder has substantial revenue, they should establish a relationship with a CPA, accountant or enrolled agent, who will guide them toward establishing a company as either sole proprietorship or partnership, an LLC or a corporation. Each of these entities are distinguished by how much they protect your personal assets in the case of lawsuits or other intervention, how income is reported to the IRS and how they’re taxed.
Sole proprietorship or partnership
Sole proprietorships or partnerships function the same way; the only difference is the number of people in the business.Typically informal, these cost little to no money to register with your state and don’t usually require a lot of paperwork to establish. The income from a business set up as a sole proprietorship is reported on the entrepreneur’s personal tax return. Sole proprietorships or partnerships do not protect your personal assets on their own.
LLC (limited liability company)
Establishing your company as an LLC helps protect your personal assets from claims or business debts. A business registered as an LLC can’t be publicly traded. However, it can be run by several members or managers. A member-managed LLC is operated daily by all members, or owners. A manager-managed LLC is run by an appointed manager or group of managers, meaning every owner isn’t involved in the day-to-day operations of the business.
To establish your company as an LLC, you’ll have to file articles of organization with your state’s secretary of state or corporation commission. The articles contain the company’s name, the names and addresses of the owners and the registered agent, or the person who can accept things like legal documents on the company’s behalf. “I find that most people are able to establish the initial articles online themselves,” explained Pavlik. “But if anybody ever feels uncomfortable doing it, I always advise seeking an attorney to advise and help as much as needed.” It should be noted that if your business operates in multiple states, you will need to file LLC paperwork with each of those states.
Every LLC should also have operating agreements. This is an internal document that outlines how the company is governed. It answers questions like how will voting happen and what’s considered a majority? How will disputes be settled? Pavlik also thinks it’s worth companies taking their operating agreements a bit further. “What I say should be included in operating agreements…are a roadmap for when unexpected things happen, such as death, incapacitation, or divorce” of a member. That language is typically in a separate document called a buy-sell agreement, but it’s worth bringing it to the forefront along with the other management details.
A corporation is run by directors who are chosen by shareholders; corporations protect the directors’ and shareholders’ personal assets.These companies are required to keep minutes of shareholder and director meetings. To have your business taxed as a corporation, you’ll have to file articles of incorporation with your state. Corporations are governed by internal bylaws, which outline the same information as an LLC’s operating agreements.
A C-corp is the default classification for corporations. Companies with that tax classification are taxed twice; the corporation’s revenue is taxed and then the shareholders are taxed on the money they receive as well. Business owners may choose to have their company taxed as an S-Corp instead. The government doesn’t tax businesses with an S-Corp tax classification at the corporation level; instead, they tax shareholders based on the company’s revenue. If you’d rather your company be taxed as an S-Corp, you would need to indicate that with a specific form (Pavlik recommends getting help from a tax professional to prepare the form). Additionally, the company must have fewer than 100 shareholders, all of whom must be United States citizens.
Pavlik stressed to our audience that tax considerations are the differences entrepreneurs should focus on when registering their business with the state. “Understand that there is no such thing as being taxed as an LLC,” she explained. When you file an LLC’s articles of organization, your business will be taxed as a sole proprietorship or partnership unless you explicitly choose to be taxed as a C-Corp or an S-Corp. It’s not uncommon for a business’ entity to change over time. “A lot of times, it’s the growth of [a client’s] business that allows them to then adjust their tax classifications. So, they could start off in one way, and as they grow, it could make sense to be taxed at a different classification.”
What puts my personal assets at risk?
Even if your business is classified as an LLC or corporation, there are instances when your personal assets may still be at risk. Courts can set aside a company’s limited liability when addressing debt or misconduct claims when there’s no clear separation between a business’ assets and a founder’s; this is called piercing the corporate veil.
An entrepreneur’s personal assets can also be at risk in the case of malpractice or negligence. Still, nobody’s perfect. Insurance policies can support entrepreneurs who make honest mistakes with their customers.
What kind of insurance does my small business need?
Even if your business is a single-person LLC, you will need to have insurance. Doctors, lawyers and anyone in the business of giving counsel should take out malpractice insurance for their businesses. Service professionals should have errors and omissions policies, which cover you and your employees should a client seek damages for things like incorrect advice or failing to deliver services on time. “It’s covering you for, ‘oops, I messed up’, but not that you were intentionally doing something wrong,” Pavlik went on. Getting outside help with your workload? “I always say that if you are contracting work out to an independent contract, it is smart to make sure that they have their own insurance.
Business owners who have a lease for a physical location will likely be required to have a certain level of third-party bodily injury and third-party property damage insurance. Owners of online-only and brick-and-mortar businesses are protecting themselves and their customers with data breach and cyber attack insurance.
How else can I protect myself?
Get it in writing. “A contract is a visual representation of the relationship, saying ‘these are the services we’re agreeing to, this is how you’re going to pay me, this is what you’re going to pay me, this is what’s going to happen if you don’t pay me on time.’ So, it is protecting both parties,” Pavlik said.
Dispute resolution and termination clauses should be in all your contracts, as well as the boilerplate commonly at the end of contracts that includes rules using contractors, acts of God (also known as force majeure) and what breaches are allowed. Pavlik shared an example that a building owner may create a contract that indicates that even in the event of an act of God, your rent is still due. Though often a separate document, a nondisclosure agreement can be folded into a contract in order to protect your company’s intellectual property. She also cautioned business owners against focusing on brevity when it comes to contracts.
Another way to establish the boundaries for a partnership or assignment is to give a client or vendor a scope of work. Though not technically a contract, a scope of work is a written document that makes responsibilities, what kind of work isn’t covered and timelines clear. Avoid using the word “reasonable” to explain how long a project will take, Pavlik cautioned, since the word leaves too much room for disagreement. Your scope of work should also outline how and under what conditions changes can be made. It’s common in many industries for two entities to update scopes of work or contracts via email. That’s not necessarily a bad thing, Pavlik explained. “But if you can foresee yourself doing that, then again, in your original contract, I suggest that you just say, ‘any future changes that we do will be done via email’.”
Does this mean I need a lawyer?
There are some things you can figure out, like filing your articles of organization, but ultimately, you should establish a relationship with a lawyer, said Pavlik. You will need help reviewing your contracts. Look for someone who has experience with businesses in your industry and about the same size as yours. Interested in getting a patent or trademark? You’ll need a lawyer with those specialities; do not attempt to do that work yourself. Whether you need help setting up standard contracts or protecting your innovation, you’ll need a lawyer who translates legalese to plain English.
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