Small Business FAQ Part One

by | Feb 25, 2022 | Small Business

As a small and medium business-focused attorney, I get a lot of questions about whether and how to incorporate a business from my clients. Below is a shortlist of some of the most frequent questions I get and general information. However, please don’ take these responses as gospel for your specific business. Every business is unique, and you should consult with.

1. What are the benefits of incorporating?

Incorporating a business entity is the first step in reducing your personal liability for business risks. For example, if you operate a sole proprietorship (i.e., a business but no LLC or corporation) and a customer or business partner sues you, you lose. Then your personal assets (such as your car or house) could be subject to liens or other collection actions.  However, if you run your business through an LLC or corporation, it is possible to protect your personal assets from liability.

2. What are the different types of entities?

The two entities relevant to most businesses are limited liability companies (LLCs) and corporations (CORPs).

One or more individuals or entities can start LLCs. They are pass-through tax entities – meaning tax liability flow through the LLC to the individual Members (i.e., partners). LLCs are the most straightforward business entities to incorporate. LLCs are also very customizable. You can set up your governance and management rules in almost any way that you want.

One or more individuals or entities can also start corporations. Unlike LLCs, corporations pay tax at the corporate level (i.e., a corporate income tax) and at the shareholder level (via dividends). However, corporations enjoy certain benefits over LLCs. For example, they are easier to scale if you plan on soliciting investment from many different sources. Corporations are also very customizable. You can create as many classes of stock (i.e., equity holders) as you want and subject them to as many different restrictions and rules as you want.

3. What are the tax implications?

Taxes are levied on three levels: federal, state, and local. The federal government recognizes two types of tax entities: pass-through and corporate. If you pay a corporate income tax, you are subject to the double-taxation issue described above. If you don’t, then you are a pass-through tax entity.

Pass-through tax entities are either (a) disregarded entities or (b) partnerships. A disregarded entity is a business that is wholly owned by a single entity (a person or company), and all of the business’s tax liability passes directly to the owner. A partnership splits the tax liability among the partners pursuant to their equity arrangement.

Your business could also be subject to additional specialized federal taxes depending on its business operations (e.g., investment, tariffs, gasoline, etc.).

The state imposes several different taxes: (1) income [in some states], (2) franchise, (3) property, (4) sale, and (5) specialized taxes. The state income tax, like for federal tax, is either pass-through or corporate. The franchise tax is paid by the entity and is usually imposed annually. Property taxes are owed if your business owns real property. Sales taxes are generally imposed on the sale of goods. Finally, specialized taxes are levied on particular goods such as alcohol, tobacco, and cannabis.

Finally, local taxes typically piggyback on state taxes and may impose an additional surcharge on top of the state tax. For example, the state sales tax might be 6.0%, but the county in which your store is situated adds 1.5%. Usually, you don’t need to separate local and state taxes. However, you may also have to pay a registration fee or tax in the county or city where your business operates.

4. Where should I incorporate?

Most guides will tell you that Delaware is the best state to incorporate. However, while that is true for publicly traded companies and large private companies with a national or global footprint, that likely isn’t true for most small and medium businesses. For your business (or really, any business) to transact business in a state, it needs to be incorporated in that state or registered as a foreign business. Once your business is registered, it is subject to similar filing fees and franchise tax obligations.  For example, if your business primarily sells to customers in California, Nevada, and Arizona but it is incorporated in Delaware, all you did was add Delaware as another state to which you have to pay filing fees and a franchise tax. Therefore, you would be better served to incorporate in CA, NV, or AZ.

5. Should I incorporate?

Whether you should incorporate a business or not depends on many different factors – only a fraction of which are covered in this FAQ. Ultimately, whether you should start a company depends on your goals and time. What are your goals? Are your goals achievable with the time you can devote to them?