Congratulations! You’ve identified or experienced gaps in the market, and so you developed a business idea that you think will explode. You’ve burned the late-night oil at the end of your day job putting together a business plan. You’re ready to follow your calling as an entrepreneur.
That’s amazing! It takes an enormous amount of courage and planning. As a business owner, you’re the expert on the product or service you’re providing.
But…unless you were a lawyer in a past life, or have a whole bunch of them in your family you can call, you might not be as familiar with the legal aspects of running your business. And that’s OK. You don’t need to be a lawyer to start a business. But, if you’ll allow it and want to keep reading, I’ll make a plug for hiring one. Lawyers, particularly corporate lawyers, can help you navigate the complexities of starting and growing your business. This post will help you think about some of the key legal basics you should keep in mind as you build your business, and what questions you should ask when looking for an attorney.
First Things First – Hire an Accountant
Before you pick a name, before you order business cards, before you troll Instagram to make sure the handle you want is still available, even before you call a lawyer – call an accountant. Starting and operating a business comes with tax consequences, some expected and some sneaky, and getting an expert involved early is one of the best gifts you can give your future self.
Corporate Formalities – Not Just For Show
Next, start thinking about the type of entity you’d like to have. Forming a legal entity is how you protect yourself from being personally liable for the obligations of your business. It’s the thing that separates you from the work your business does (and the debts and obligations it will incur).
I like to think of entity formation as building a bridge between you and your business. The entity is the structure that carries the weight and keeps the two sides separate. Like any other bridge, it needs maintenance. You preserve the separation between you and your company by doing things like:
- Keeping personal and business finances separate (open up a business bank account).
- Signing contracts in the company’s name (and not yours).
- Adequately capitalizing your business (no $5 contributions, please).
Respect the structure, and it does its job. One of the benefits of forming an entity is limited liability protection—meaning your personal assets (your house, your car, your personal checking account) are generally shielded from business debts and lawsuits. Generally, your liability is limited to the amount of the cash you put into the business (often referred to as your capital contribution). Keep in mind that lenders and landlords often ask business owners to sign personal guarantees when taking out a business loan or signing a lease, which can put your personal assets back on the line for those specific obligations. For the most part, the bridge keeps the business on one side and you (and your most important stuff) on the other.
This protection isn’t guaranteed. If the company’s structure is ignored and corporate formalities aren’t observed—if personal and business funds are mixed, if corporate records are never maintained, or if the entity is used to commit fraud or otherwise evade legal obligations, as a few examples—a court can decide to pierce the corporate veil. That’s exactly what it sounds like: shattering the divide between you and the business so personal assets become reachable by creditors. If you let the bridge crumble or actively pull out the beams, that protection disappears.
Choosing the Right Entity for You
Next, let’s talk about the type of legal entity that’s right for your business. You’ve probably heard of limited liability companies (LLCs) and corporations. People sometimes ask why partnerships don’t get more attention, or if they should form a partnership. The short answer is most small business owners don’t actually need them. Partnerships are like the fax machines of legal entities. You might still have one in the office that gets used from time to time, but you’re not going out to buy a new one. I usually see partnerships in the context of family businesses that are older than me (I’m a millennial, for what that’s worth). That said, partnerships do still have their place.
Limited liability and other partnerships are popular in private equity and real estate investing because they offer pass‑through taxation, flexibility in allocating profits and losses, liability protection for passive investors, and a clear separation between management and investor roles. They’re useful tools—just not usually the tool most new business owners need.
The Swiss Army Knife of Companies – Meet the LLC
Let’s start with LLCs. For most people starting a business, an LLC works just fine. Here’s the low-down on LLCs:
- LLCs aren’t taxed at the business level, unless they elect to be taxed as c-corporations.
- Profits and losses generally “flow through” to the owners (called members).
- Taxes may be owed whether cash was actually distributed or not, because tax follows allocated income, not cash distributed to the owners.
- Generally, state law doesn’t require you to adhere to the same level of corporate governance formalities as with a corporation.
Here’s a lesson I didn’t learn in law school: If you are a business owner contributing blood, sweat, and tears to the business and not cash in exchange for your membership interests in the LLC, your contribution of services is generally considered taxable income to you. If you plan on contributing services to an LLC in exchange for an ownership interest in the LLC, I recommend speaking to your accountant and your lawyer before making the contribution. They can help you structure the contribution in a way that works for the business and is tax advantaged to you.
As I mentioned above, LLCs can also be taxed as corporations, but the election isn’t automatic. The owners must file a Form 8832 to elect for the company to be taxed as a corporation, and if the goal is to be taxed as an s-corporation, a Form 2553 is also required. If you’re considering forming an LLC to be taxed as a corporation, please do reach out to an accountant to help you think through the implications of that choice. When you (or preferably, your lawyer) draft your company’s operating agreement, the provisions in that agreement will need to reflect the company’s tax status.
More Rules, More Tools – The Corporation
Now, onto corporations! Corporations come in two basic flavors: c-corporations and s-corporations. C‑corporations pay tax at the entity level. Then, shareholders pay tax again on distributions—the classic double‑taxation structure. C‑corporations can be a great fit if you want multiple classes of stock, plan to take on outside investment in multiple rounds, or need other flexibility in how the company grows. Some business owners are put off by the concept of double taxation, but here’s the thing: that second layer of tax at the shareholder level only kicks in when the corporation actually makes distributions. If the company reinvests its earnings rather than distributing them, shareholders aren’t taxed on income they haven’t received. The corporation still pays tax on its profits at the entity level, but you avoid the second hit until cash comes out of the company.
Keep in mind, state laws usually impose stricter governance requirements on corporations than on LLCs, meaning you should have annual shareholder meetings and regular meetings of your board. That’s not a bad thing, and you should probably be doing that anyway, even if you have an LLC.
Earlier I described some of the tax characteristics of s-corporations, but there are some other s-corporation traits you should know. S‑corporations come with restrictions on the number of shareholders you can have (100), who those shareholders can be (U.S. citizens or residents, estates, certain tax-exempt organizations, and some kinds of trusts—but not other corporations, partnerships, or nonresident aliens) and the classes of stock of the company (all shares must have identical rights to distributions and liquidation proceeds, though different voting rights are allowed). Your s-corporation can own a subsidiary corporation and elect to have it treated as a qualified subchapter S subsidiary, also known as a QSub. A QSub is disregarding for federal income tax purposes, meaning its assets, liabilities, income, deductions, and credits are all treated for tax purposes as if they are owned by the parent s-corporation.
Incentivizing Employees – Your Entity Choice Matters
If you want to incentivize employees by providing equity, the entity you create will influence the type of equity incentives you can offer. Corporations have a somewhat lengthy menu of equity incentives to choose from: stock options, stock appreciation rights (SARs), restricted stock, restricted stock units (RSUs), and other performance awards, like phantom stock. Phantom stock isn’t as spooky as it sounds. At its core, phantom stock is a contractual right to receive cash payments tied to the value of actual company stock or the financial performance of the company, without granting real equity. LLCs usually turn to granting profits interests and phantom units as equity incentives. What is a profits interest, you ask? To put it simply, a profits interest gives the owner of that interest the right to receive a percentage of the company’s future profits, but not its existing value. This sounds swell to most business owners, but here’s the rub: for LLCs taxed as partnerships, granting a profits interest makes the owner of that profits interest part of the partnership. The owner of the profits interest will be taxed as an owner of the business, and may lose access to certain employee-only tax benefits. Business owners love the idea of granting their employees a profits interest, but don’t always think about the potential tax impact of granting that interest. Cash is king, my friends, as are four-day work weeks, healthy PTO policies, and the occasional (and I mean occasional!) pizza party. Giving employees equity isn’t the only way to incentivize them to work hard and align their interests with yours.
Most business owners choose corporations when they plan to issue equity because the tools are more familiar. Everyone has heard of stock options; profits interests? Not so much. Equity incentives can be complicated to draft and administer. For the love of your business, talk to a lawyer before you issue any.
Once you’ve picked the type of entity you want, the next questions are where to form it and how to keep your corporate records organized. Your bylaws or operating agreement deserve better than being folded into a shoebox for the next five years. You may also need local, state, or federal permits to operate your business, and you will probably need multiple forms of insurance, especially if you hire any employees. An attorney and an insurance broker can help you figure out what permits and insurance you might need for your business.
Important Caveat:
I’m not your lawyer. This is not legal advice. This post is an over-simplified summary of complex topics. It is intended for general informational purposes only. Reading this post does not create an attorney-client relationship. If you want advice tailored to your unique circumstances, reach out and we can talk.