Starting a Business
There are three primary questions faced by everyone who starts a new business: how am I going to make money? How am I going to manage my risk? How am I going to handle my finances?
1. How am I going to make money?
The first question is more practical than legal. In order to make money, you need to have a business plan, and your business plan should be more than just a couple of good ideas bouncing around. There is a value to writing down your “couple of good ideas.” On paper, what may have appeared good in concept may not be as good as you thought.
You can find lots of free advice on starting a business and creating a business plan on the Internet. One of the best sites is the federal Small Business Administration, www.sba.gov. Another good site is SCORE®, www.score.org.
2. How am I going to manage my risk?
The second question requires you to analyze both what types of risk your business will create and how you can manage that risk. Each business faces separate risks. A manufacturer faces the risk that his or her product may cause physical harm to something or someone. A service provider faces the risk that his or her service may be negligent.
You can manage your risk by (a) deciding how to structure your business, (b) chosing language in your contracts with your customers, and (c) by insuring against your known and unknown risks. Business risk can only be managed, it cannot be eradicated entirely.
In structuring your business, the simplest business structure is a sole proprietorship. This is when an individual is in business for himself or herself under his or her name or a fictitious business name. In a sole proprietorship, the individual remains personally liable for all business risks.
A partnership is a business organization between two or more people for a common purpose. Partnerships are governed in California by the Revised Uniform Partnership Act or RUPA. A partnership assumes an agreement between the business owners, called “partners,” to share in the business expenses and the business profits or losses. In the absence of a written agreement, RUPA sets out default provisions to govern the partners’ relationship. In a general partnership, each partner remains personally liable for all of the business risks. In a limited partnership, the general partner remains personally liable for all business risks, and the limited partners remain liable only to the extent of their contribution to the partnership.
A corporation is a business organization that can insulate its owners, called “shareholders,” from being personally liable for business risks. This is sometimes called the “corporate limitation of liability.” Generally, a shareholder is only liable for a corporation’s actions to the extent the shareholder invested in the corporation. Corporations are treated by law as persons, and can sue and be sued in their own name. The California Corporations Code recognizes two forms of for profit corporations: general corporations (including professional corporations) and closely held corporations. The federal Internal Revenue Service recognizes two categories of corporations: C Corporations and Sub-Chapter S Corporations.
Limited liability companies or LLCs are a hybrid of partnerships and corporations. Like partnerships, the owners of an LLC, called “members,” can separate each member’s right to manage the LLC from his or her economic rights in the LLC. Like a corporation, each member is only liable for the LLC’s actions to the extent of his or her investment in the LLC.
As an aside, in California, the term “joint venture” is only descriptive. A joint venture must be structured as a partnership, limited partnership, corporation or LLC.
3. How am I going to handle my finances?
The third question concerns both legal and accounting concepts. If your business is successful, you will pay taxes. How you pay taxes will depend in part upon the structure of your business.
A sole proprietor generally pays taxes quarterly under Schedule C as a self-employed individual and at the end of the year in the 1040 personal filing. Partners receive a K-1 showing their profit or loss from the partnership, which they file at the end of the year with their personal return. Corporations and LLCs are more complicated.
Under the Internal Revenue Code, or IRC, a corporation can elect to be taxed as a C corporation or a Sub-Chapter S corporation. A C corporation, which includes any publicly traded corporation, is taxed on its income and its shareholders are then taxed on any distributions paid to them by the corporation. In contrast, a Sub-Chapter S corporation is treated for income tax purposes as a “pass through entity.” In other words, the company is not taxed on its income, only the shareholders are. The shareholders of a Sub-Chapter S corporation are treated similarly to partners in a partnership.
LLCs are also pass-through entities for corporate income tax purposes. However, the IRC treats payments made to members differently than payments made to shareholders. For corporations, wages paid to shareholder can be treated as business expenses but distributions paid to shareholders cannot. The IRC treats any payment to a member as a non-expense distribution, unless it is a guaranteed payment.
As you can see from the summary of issues set out above, starting a business takes practical skills, legal advice, accounting input and insurance advice. As the business owner, you provide the practical skills. However, you also want to set up a team of professional advisors – an attorney, an accountant and an insurance agent – to assist you in making your new business a success.