Legal issues in starting up – a primer

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In the last blog, malikyte asked a couple of questions about starting up. One was about legal issues.

Here’s a quick primer, based on US law as I understand it:

In starting a new business, step one is to choose your legal structure. You basically have a couple of options. Typically legal structure has two considerations: taxation, and legal liability.

1. Sole proprietorship. In this simplest case, all income generated flows to you personally, and is taxed at ordinary income rates, including self-employment tax. Income is taxed ONE TIME, not twice, as with C-Corporations, which is a major advantage. The other advantage of this form of ownership is that it is almost mindlessly simple to set up, and is the default setting if you start a business without incorporating. The disadvantage is that you assume 100% legal liability (e.g. you can’t hide behind a corporate veil). I recommend you start out as a sole proprietorship. That way, you save legal fees of setting up a corproation, and can spend more money on marketing while you confirm you have a real business. Once you have a real business, convert to a corporation.

As a sole proprietorship you still need to register your business with your local government. In the US, this typically means paying money for a license, and advertising in 1-2 business publications that you have started up a sole proprietorship. Your local city clerk can tell you what you need to do. Cost: Maybe a couple hundred dollars if you follow this required step.

2. Corporation. The are C-Corps and S-Corps, and now the increasingly popular LLCs (Limited Liability Corporations). In all corporations you get the advantage of limited legal liability, as the corporation is considered the entity, and so it is more difficult for someone to sue you for your personal holdings (unlike in a sole proprietorship); however, anyone can sue you anytime, so this kind of protection may not be as strong as you hope.

With a C-Corporation, you have the advantage of all sorts of creative shareholder classes and categories. However, you pay taxes twice: a corporate tax, and then a tax on dividends.

An S-Corporation solves the double taxation problem. All income flows directly to you, and you still get liability protection. You can only have one class of stock, and 20 shareholders with an S-Corp.

An LLC has all the advantages of an S-Corporation. However, if you go into business with a partner, you get added flexibility. That’s because you can specify which partner gets which deductions and which income — regardless of relative ownership. You can’t do that with an S-Corp (e.g. equal partners get taxed equally).

Most new business are incorporating as LLCs these days.

3. Partnerships. I’d avoid partnerships because partners still incur 100% legal liability for the business. So if one partner does something really stupid, you can be 100% liable, down to your personal assets.

So, my advice is: Start as a sole proprietorship to keep it simple early on. Incorporate later, once you are sure you have a sound business. Incorporate as an LLC or S-Corp to avoid double taxation. Switch to the more complex C-Corp if you ever get to the point of wanting to go public.

And consult a lawyer and accountant as I am neither and don’t know your unique situation. But you have to talk to both, to cover both taxation and legal liability issues.

Finally, if you go into business with someone else, hash out a ton of issues about ownership, responsibilities, how much money each puts up, etc. I’ve covered those somewhere else.

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  • malikyte

    Andrew,

    This was exactly what I was looking to read about, and unfortunately didn’t really know exactly where to start looking to find it (other than the reply by other readers from the last blog). I’m also certain that former IT classmates of mine will find this very useful – I plan on linking both them, and my former professors to this article.

    I realized I would eventually have to consult true legal advice on the matter, and the fact that you didn’t go into depth about that is applauding, it’s like you knew exactly what I was asking for. It’s very much appreciated. The timeliness is also a testament to your desire to inspire through example. Thank you.

  • aneitlich

    Malikyte,

    Thanks for the kind words. The pleasure’s all mine, and best of success.

  • ColdRolledSteel

    Although consulting an attorney is a requirement is an absolute must before forming anything other than a sole proprietorship (and even then I highly recommend it), you should take advantage of as many source of information as possible.

    I strongly recommend Nolo Press (at http://www.nolo.com) for their many, many books and self-help legal tools. I referred to their “How to Form Your Own California Corporation” and “The Small Business Start-Up Kit for California” before starting my sole proprietorship. (I took the path Andrew recommended – now that my business is a going concern, I’ll be incorporating in August or September.) But there are plenty of other Nolo titles regarding business structures (including those for other localities.)

    I also recommend two other Nolo titles “Web & Software Development, a legal guide” and “Non-disclosure Agreements.” Both of these provided alot of information and background regarding the legal issues that we run across on a day-to-day basis.

    (BTW, I’m not affiliated with Nolo. I’m just an independent developer in the SF Bay Area who likes to eat at Juan’s in Berkeley, which is just 2 blocks from the Nolo corporate store. Great deals there!)

  • http://boyohazard.net Octal

    For those of us in the UK, similar advice is available at the site becauseyoucan.com