The term "small business" gets thrown around a lot, but what exactly does it mean? Sometimes, it seems like more of a vague concept than something concrete you can wrap your head around. Further, what does the term mean to you as an entrepreneur?
A small business is one that's independently owned and operated and also isn't dominant in its specific industry, according to Merriam-Webster's legal definition for the term. It also must meet the standards put in place by the U.S. Small Business Administration (SBA) or local state laws. These guidelines, which vary by industry, will largely be determined by how many employees you've overseen throughout the previous 12 months, as well as your company's annual income.
The federal government further defines a small business as one that is for profit and operates primarily in the United States.
Small businesses can also take on any number of legal forms, including sole proprietorships, partnerships, S corporations, and limited liability companies (LLCs). Each type of business structure has its own benefits and affects every aspect of your company, including how you're taxed, how much personal financial liability you want to take on, how you plan to raise capital, and how you register your business.
How to Legally Form a Small Business
Every small business will have a unique path to formation. The process will largely depend on your legal business structure, your industry, and your company's specific business needs.
There are key legal steps that just about every startup will have to take along the way. Here are some of the critical parts of the process and legal considerations you'll need to make as you launch your small business.
Choose a Business Legal Structure
Before anything else, decide which legal business structure makes the most sense for your new business. This legal structure will define how your business operates, from obtaining capital and funding to the personal liability of its owners to the amount of control you have over your business.
Here are the most common types of business and some of their pros and cons:
Sole Proprietorship
As a sole proprietor, you're the only owner of your company, which means you have complete control of the business. You don't need to take on a separate business identity, although you can adopt a trade name or a "doing business as" (DBA) name. You also have the option of operating a sole proprietorship using your Social Security number.
However, you're personally liable for any debts or other financial or legal obligations your business takes on. Sometimes, it's more difficult to raise capital for a sole proprietorship since there are no stocks to sell and banks are slow to lend money to solo business owners.
Sole proprietorships are common among professionals who take on a lot of work as independent contractors.
Partnership
This is a fairly simple arrangement for two or more people who own a business. In this case, the financial liabilities and business and legal responsibilities are equally divided among all parties.
Under this umbrella, you might opt to form a limited partnership or a limited liability partnership. In a limited partnership, just one partner has unlimited liability and all others have limited liability — and usually limited operational control. In limited liability partnerships, all owners have limited liability, protecting all partners involved.
Corporation
A corporation forms a completely new legal entity separate from all owners involved. Through incorporation, entities are allowed to earn profits, are taxed by the government, and are financially and legally liable on their own. This business structure offers the greatest number of protections to those involved. Corporations are also able to amass capital by selling stocks to investors.
There are two main types of corporations: C corporations and S corporations. The primary difference between the two is how they're taxed.
A C corp can be taxed twice on its profits. The first taxation comes when the money is earned by the corporation. Then, it's taxed again when dividends are given to the company's shareholders. An S corp avoids double taxation by allowing the business's profits, as well as some losses, to be considered personal income of the owners, meaning it bypasses that extra tax.
Limited Liability Company (LLC)
Think of an LLC as a blend of a partnership and a corporation. As an owner, you shoulder less personal liability should you be sued or go bankrupt, which means your personal assets are protected. Your profits are also considered personal income, which means they won't be subjected to corporate taxes. LLC owners are considered self-employed, though, so don't forget to pay your Social Security, Medicare, income tax, and other employment taxes.
Nonprofit
These tax-exempt businesses focus on work that benefits the greater good of the public and aren't responsible for paying state or federal taxes. You'll need to file with the Internal Revenue Service (IRS) to receive this special tax-exempt status, though, and you'll have special rules to follow about how your finances are handled.
Select a Business Name
Choosing the right name for your business is an important step for any business owner. Every state has its own legal requirements when naming a company, so be sure to check your local laws.
Usually, you'll need to select a name that is completely unique from already existing businesses. Most states offer a database of all existing companies for you to check your possible business names against. Some states also have rules barring specific words from use in a business name.
Register Your Business With State and Local Governments
You can't just wake up one day and decide that you're operating your own business. Before you can conduct any business or professional activities, you need to actually register with your state and local governments.
Once you've determined which type of legal business entity you want to be, you'll need to register your business. How your business is registered will largely rely on where you live. Every state, county, and even some larger cities have their own rules and applications for registering a business. Check your local laws through a business bureau, economic development department, or the secretary of state to find out where and how to register your startup.
At the very least, you'll be required to obtain a general business license in your state or county — or any state or county where you're conducting business. Most states allow you to register online, although some still prefer the old-fashioned way — pen and paper.
Get Federal and State Tax ID Numbers
Most businesses, no matter the size and scope, need a federal tax ID — otherwise known as an Employer Identification Number (EIN) — and a state tax ID to file federal and state business taxes. You can get the EIN through the IRS website and a state tax ID through your state government.
These ID numbers are necessary for running your business, from opening a bank account to hiring employees to filing your annual tax returns, so don't skip over this step. Also, be sure to read up on your local tax laws to make sure you're paying everything you owe.
Apply for All Relevant Licenses and Permits
You'll need to obtain all necessary licenses and permits before you can start operating your business. These important documents will come from either federal or state agencies — and sometimes both — depending on the legal requirements where you live.
It's important that you do exhaustive research. The licenses you need to run your company will depend on your location, your industry, your business activities, and your size. Do your groundwork at the local, state, and federal levels to make sure you have every document you need in hand. You don't want to be caught without the right permits and inadvertently break state or federal laws.
Manage Your Small Business Finances Like a Pro With Skynova
As a small business owner, use Skynova's easy-to-use accounting software to create financial records of all your income and expenses and streamline your bookkeeping. Our invoicing system also makes it easy to bill your customers and track payments for accurate record-keeping.
Monitor sales tax, customizing it depending on wherever you happen to be. List all expenses, whether you're purchasing office supplies or submitting payment to a vendor, by journaling all transactions. Store receipts from every purchase and keep them handy if any questions arise.
Our all-in-one platform creates a convenient and centralized hub for all of your bookkeeping and accounting needs.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant, a business consultant, business law and employment law experts, and a tax professional to ensure you're meeting all state and federal requirements when forming your business.