Starting a new business venture is exciting, but dealing with all the nuances of setting up the legal structure for your business can seem daunting. For most entrepreneurs, avoiding the process altogether is typical, or casually asking a friend for advice on legal matters is another approach that’s taken.
As a business owner, you can’t afford to avoid the legal structures and the basics of business entities for your business. You have to make sure that you’re informed and well-versed in the legality of choosing your business entity.
Here are some of the things to avoid when choosing your business entity.
- Not fully understanding tax consequences. Some business owners are under the impression that they’ll pay less in taxes if they create a certain type of business entity, but this isn’t necessarily true. Rule of thumb is to make sure that you get advice from a business lawyer or accountant before deciding on a particular tax structure.
- A sole proprietorship or a general partnership is known as a “disregarded entity,” which means that the owners of the business reports business income and expenses on their personal tax returns, and pay tax on any profit.
- Corporations can be taxed in two ways. A (C) corporation pays taxes on all its income and profits, and if the (C) corporations pay dividends to the owners, it has to be reported on their personal tax returns and they have to pay taxes on all dividends.
- Some entrepreneurs will pay more taxes under the “double taxation” system: (S) corporations can avoid double taxation by being an (S) corporation, and they don’t pay corporate income tax. The profits for an (S) corporation pass through to the shareholders’ personal tax returns, which means that the shareholders pay personal income tax on them.
- A limited liability company is taxed the same way as a sole proprietor or partnership. Moreover, an LLC can also choose to be taxed as a (C) corporation or an (S) corporation. The corporate tax status allows an LLC’s owners to minimize self-employment taxes or to deduct expenses that wouldn’t be deductible.
- An LLC will save money on taxes. This isn’t true. The Limited Liability Company (LLC) was designed to protect the asset of a business owner, it doesn’t serve as a tax deduction at the end of the year. LLC is perfect holding assets for partnership relationships between individuals or other corporations. You as the business can actually have an LLC taxed as an (S) Corporation or (C) Corporation for tax purposes, but you don’t need an LLC to make write-offs because they won’t save you on taxes.
- Assuming that you should incorporate in Delaware (or Nevada or Wyoming). A lot of entrepreneurs think that by incorporating in Delaware or Nevada or Wyoming, they will save tons of money on taxes. Actually, incorporating out-of-state may cost you more than you think, and create more paperwork than incorporating in your home state. If you incorporate out-of-state, you’ll need to maintain both of your corporations one in your home state and the state that you have incorporated. You’ll also be responsible for annual reporting and fees in both states. But if you incorporate in your home state, you’ll only have one state to deal with.
- Not having an agreement between you and your business partners. In the beginning, business partners tend to get along with each other, never thinking that they won’t be able to work things out. It’s a mistake to think that things will always remain the same and no one will change. Business evolves along with business goals, visions, and relationships with each other. Eventually, there will be conflict, and without an agreement between the owners, conflict can be very expensive.
Before you start doing business with your business partners, set up a business legal structure that includes an agreement among the owners. The agreement that you develop can discuss how to deal with conflicts and how to resolve issues with departing owners, and how to take on new owners, and how profits and losses will be divided.
It solely depends on the type of business entity, you might have a partnership agreement, an operating agreement, to a buy-sell agreement.