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Legal Guide for Starting & Running a Small Business

The all-in-one business law book

This bestseller has all the legal and practical information you need to get your business up and running. Learn how to:

  • raise start-up money
  • choose between a sole proprietorship, corporation, or LLC
  • save on business taxes and insurance.

Handle the key legal issues facing small businesses -- from getting permits to negotiating a lease and hiring employees.

Available as part of the Nolo's Start & Run a Business Bundle

  • Product Details
  • Whether you’re just starting a small business, or your business is already up and running, legal questions come up on an almost daily basis. Ignoring them can threaten your enterprise—but hiring a lawyer to help with routine issues can devastate the bottom line.

    The Legal Guide for Starting & Running a Small Business has helped more than a quarter million entrepreneurs and business owners master the basics, including how to:

    • raise start-up money
    • decide between an LLC or other business structure
    • save on business taxes
    • get licenses and permits
    • choose the right insurance
    • negotiate contracts and leases
    • avoid problems if you’re buying a franchise
    • hire and manage employees and independent contractors
    • attract and keep customers (and get paid on time), and
    • limit your liability and protect your personal assets.

    Whether you’re a sole proprietor or an LLC or corporation, a one-person business operating out of your home, or a larger company with staff, this book will help you start and run a successful business.

    “[An] excellent resource …”—Wall Street Journal

    “One of the top six business books.”—INC.


    Number of Pages
    Included Forms
    • Checklist for Starting a Small Business
  • Table of Contents
  • Your Legal Companion for Starting and Running a Small Business

    1. Which Legal Form Is Best for Your Business?

    • Sole Proprietorships
    • Partnerships
    • Corporations
    • Limited Liability Companies
    • Choosing Between a Corporation and an LLC
    • Special Structures for Special Situations
    • The Benefit Corporation

    2. Structuring a Partnership Agreement

    • Why You Need a Written Agreement
    • An Overview of Your Partnership Agreement
    • Changes in Your Partnership

    3. Creating a Corporation

    • The Structure of a Corporation
    • Financing Your Corporation
    • Compensating Yourself
    • Do You Need a Lawyer to Incorporate?
    • Overview of Incorporation Procedures
    • Eleven Basic Steps to Incorporate
    • After You Incorporate
    • Safe Business Practices for Your Corporation

    4. Creating a Limited Liability Company

    • Number of Members Required
    • Management of an LLC
    • Financing an LLC
    • Compensating Members
    • Choosing a Name
    • Paperwork for Setting Up an LLC
    • After You Form Your LLC
    • Safe Business Practices for Your LLC

    5. Preparing for Ownership Changes With a Buyout Agreement

    • Major Benefits of Adopting a Buyout Agreement
    • Where to Put Your Buyout Provisions
    • When to Create a Buyout Agreement

    6. Naming Your Business and Products

    • Business Names: An Overview
    • Mandatory Name Procedures
    • Trademarks and Service Marks
    • Strong and Weak Trademarks
    • Before the Trademark: Name Searches
    • How to Use and Protect Your Trademark

    7. Licenses and Permits

    • Federal Registrations and Licenses
    • State Requirements
    • Regional Requirements
    • Local Requirements
    • How to Deal With Local Building and Zoning Officials

    8. Tax Basics for the Small Business

    • Employer Identification Number
    • Becoming an S Corporation
    • Business Taxes in General
    • Business Deductions
    • Tax Audits

    9. Raising Money for Your Business

    • Consider Writing a Business Plan
    • Two Types of Outside Financing
    • Fourteen Common Sources of Money
    • Document All of the Money You Receive

    10. Buying a Business

    • Finding a Business to Buy
    • What’s the Structure of the Business You Want to Buy?
    • Gathering Information About a Business
    • Valuing the Business
    • Other Items to Investigate
    • Letter of Intent to Purchase
    • The Sales Agreement
    • The Closing
    • Selling a Business

    11. Franchises: How Not to Get Burned

    • What Is a Franchise?
    • The Downsides of Franchise Ownership
    • Investigating a Franchise
    • The Franchise Disclosure Document
    • The Franchise Agreement
    • Resolving Disputes With Your Franchisor

    12. Insuring Your Business

    • Working With an Insurance Agent
    • Property Coverage
    • Liability Insurance
    • Other Insurance to Consider
    • Saving Money on Insurance
    • Making a Claim

    13. Negotiating a Favorable Lease

    • Finding a Place
    • Leases and Rental Agreements: An Overview
    • Short-Term Leases (Month-to-Month Rentals)
    • Written Long-Term Leases
    • Additional Clauses to Consider
    • Shopping Center Leases
    • How to Modify a Lease
    • Landlord-Tenant Disputes
    • Getting Out of a Lease
    • When You Need Professional Help

    14. Home-Based Business

    • Zoning Laws
    • Private Land Use Restrictions
    • Insurance
    • Deducting Expenses for the Business Use of Your Home

    15. Employees and Independent Contractors

    • Hiring Employees
    • Job Descriptions
    • Job Advertisements
    • Job Applications
    • Interviews
    • Testing
    • Background Checks
    • Immigration Law Requirements
    • Personnel Practices
    • Illegal Discrimination
    • Wages and Hours
    • Occupational Safety and Health
    • Workers’ Compensation
    • Termination of Employment
    • Unemployment Compensation
    • Independent Contractors
    • Employers’ Health Care Insurance Requirements Under Obamacare

    16. The Importance of Excellent Customer Relations

    • Developing Your Customer-Satisfaction Policy
    • Telling Customers About Your Policies

    17. Legal Requirements for Dealing With Customers

    • Advertising
    • Retail Pricing and Return Practices
    • Warranties
    • Consumer Protection Statutes
    • Dealing With Customers Online

    18. Cash, P2P Payments, Credit Cards, Checks, and Cryptocurrency

    • Cash
    • P2P Payments
    • Credit and Debit Cards
    • Checks
    • Cryptocurrency

    19. Extending Credit and Getting Paid

    • The Practical Side of Extending Credit
    • Laws That Regulate Consumer Credit
    • Becoming a Secured Creditor
    • Collection Problems
    • Collection Options

    20. Put It in Writing: Small Business Contracts

    • What Makes a Valid Contract
    • Unfair or Illegal Contracts
    • Misrepresentation, Duress, or Mistake
    • Must a Contract Be in Writing?
    • Writing Business-to-Business Contracts
    • Signing Your Contracts
    • Electronic Business-to-Business Contracts
    • Electronic Contracts for Online Sales
    • Enforcing Contracts in Court
    • What Can You Sue For?

    21. The Financially Troubled Business

    • Thinking Ahead to Protect Your Personal Assets
    • Managing the Financially Troubled Business
    • Seeking an Objective Analysis
    • Workouts
    • Selling the Business
    • Closing the Business
    • Understanding Bankruptcy


    • Checklist for Starting a Small Business


  • Sample Chapter
  • Chapter 1:
    Which Legal Form Is Best for Your Business?

    When you start a business, you must decide on a legal structure for it. Usually, you’ll choose a sole proprietorship, a partnership, a limited liability company (LLC), or a corporation. Not every structure fits everyone. Your job is to understand how each legal structure works and then pick the one that best meets your needs.

    The best choice isn’t always obvious. After reading this chapter, you might decide to seek some guidance from a lawyer or an accountant.

    For many small businesses, the best initial choice is either a sole proprietorship or—if more than one owner is involved—a partnership. Either of these structures makes especially good sense in a business where personal liability isn’t a big worry— for example, a small service business in which you are unlikely to be sued and for which you won’t be borrowing much money. Sole proprietorships and partnerships are relatively simple and inexpensive to establish and maintain.

    Forming an LLC or a corporation is more complicated and costly, but it’s worth it for some small businesses. The main feature of LLCs and corporations that is attractive to small businesses is the limit they provide on their owners’ personal liability for business debts and court judgments against a business. Another factor might be income taxes: You can set up an LLC or a corporation in a way that lets you enjoy more favorable tax rates. In certain circumstances, your business might be able to stash away earnings at a relatively low tax rate. In addition, an LLC or a corporation might be able to provide a range of fringe benefits to employees (including the owners) and deduct the cost as a business expense.

    Given the choice between creating an LLC or a corporation, many small business owners will be better off going the LLC route. For one thing, if your business will have several owners, the LLC can be more flexible than a corporation in the way you can parcel out profits and management duties. Also, setting up and maintaining an LLC can be a bit less complicated and expensive than a corporation. But sometimes a corporation will be more beneficial. For example, because a corporation—unlike other types of business entities—issues stock certificates to its owners, a corporation can be an ideal vehicle if you want to bring in outside investors or reward loyal employees with stock options.

    Keep in mind that your initial choice of a business form doesn’t have to be permanent. You can start out as sole proprietorship or partnership and, later, if your business grows or the risks of personal liability increase, you can convert your business to an LLC or a corporation.

    For some small business owners, a less common type of business structure might be appropriate. While most small businesses will find at least one good choice among the four basic business formats described above, a handful will have special situations in which a different format is required or at least desirable. For example, a pair of dentists looking to limit their personal liability might need to set up a professional corporation or a professional limited liability company. A group of real estate investors could find that a limited partnership is the best vehicle for them. These and other special types of business organizations, including benefit corporations, are summarized at the end of this chapter.

    You might need professional advice in choosing the best entity for your business. This chapter gives you a great deal of information to assist you in deciding how to best organize your business. Obviously, however, it’s impossible to cover every relevant nuance of tax and business law—especially if your business has several owners with different and complex tax situations. And for businesses owned by several people who have different personal tax situations, sorting out the effects of “pass‑through” taxation (where partners and most LLC members are taxed on their personal tax returns for their share of business profits and losses) is no picnic, even for seasoned tax pros. The bottom line is that unless your business will start small and have a very simple ownership structure, before you make your final decision on a business entity, check with a tax adviser after learning about the basic attributes of each type of business structure (from this chapter and Chapters 2, 3, and 4).

    Ways to Organize Your Business
    Type of Entity Main Advantages Main Drawbacks
    Sole Proprietor Simple and inexpensive to create and operate

    Owner reports profit or loss on personal tax return

    Owner personally liable for business debts
    General Partnership Simple and inexpensive to create and operate Owners (partners) report their share of profit or loss on their personal tax returns

    Owners (partners) personally liable for business debts

    Limited Partnership Limited partners have limited personal liability for business debts as long as they don’t participate in management

    General partners can raise cash without involving outside investors in management of business

    General partners personally liable for business debts

    More expensive to create than general partnership

    Suitable mainly for companies that invest in real estate

    C Corporation Owners have limited personal liability for business debts

    Fringe benefits can be deducted as business expense

    Corporate profit can be split among owners and corporation, resulting in lower overall tax rate

    More expensive to create than partnership or sole proprietorship

    Paperwork can seem burdensome to some owners

    Separate taxable entity

    S Corporation Owners have limited personal liability for business debts

    Owners report their share of corporate profit or loss on their personal tax returns

    Owners can use corporate loss to offset income from other sources

    More expensive to create than partnership or sole proprietorship

    More paperwork than for a limited liability company, which offers similar advantages

    Income must be allocated to owners according to their ownership interests

    Fringe benefits limited for owners who own more than 2% of shares

    Professional Corporation Owners have no personal liability for malpractice of other owners More expensive to create than partnership or sole proprietorship

    Paperwork can seem burdensome to some owners

    All owners must belong to the same profession

    Nonprofit Corporation Corporation might not have to pay income taxes

    Contributions to certain charitable corporations are tax deductible

    Fringe benefits can be deducted as business expense

    Full tax advantages available only to groups organized for the following purposes: charitable, scientific, educational, literary, religious, testing for public safety, fostering national or international sports competition, and preventing cruelty to children or animals

    Property transferred to corporation stays there; if corporation ends, property must go to another nonprofit

    Limited Liability Company Owners have limited personal liability for business debts even if they participate in management

    Profit and loss can be allocated differently than ownership interests

    IRS rules allow LLCs to choose between being taxed as partnership or corporation

    More expensive to create than partnership or sole proprietorship

    A member’s entire share of LLC profits might be subject to self‑employment tax

    Professional Limited Liability Company Same advantages as a regular limited liability company

    Owners have no personal liability for malpractice of other owners

    Gives state‑licensed professionals a way to enjoy those advantages

    Same as for a regular limited liability company

    Members generally must all belong to the same profession or related professions

    Limited Liability Partnership Mostly of interest to partners in old‑line professions, such as law, medicine, and accounting

    Owners (partners) aren’t personally liable for the malpractice of other partners

    Owners report their share of profit or loss on their personal tax returns

    Unlike a limited liability company or a professional limited liability company, owners (partners) remain personally liable for many types of obligations owed to business creditors, lenders, and landlords

    Not available in all states

    Often limited to a short list of professions


    Sole Proprietorships

    The simplest form of business entity is the “sole proprietorship.” If you choose this legal structure, then legally speaking, you and the business are the same. You can continue operating as a sole proprietor as long as you’re the only owner of the business.

    Establishing a sole proprietorship is cheap and relatively uncomplicated. While you don’t have to file articles of incorporation or organization (as you would with a corporation or an LLC), you might have to get a business license to do business under state laws or local ordinances. States differ on the amount of licensing required. In California, for example, almost all businesses need a business license, which is available to anyone for a small fee. In other states, business licenses are the exception rather than the rule. But most states do require a sales tax license or permit for all retail businesses. Dealing with these routine licensing requirements generally involves little time or expense. However, many specialized businesses—such as an asbestos removal service or a restaurant that serves liquor—require additional licenses, which might be harder to qualify for. (See Chapter 7 for more on this subject.)

    In addition, if you’re going to conduct your business under a trade name such as Smith Furniture Store rather than John Smith, you’ll have to file an assumed name or fictitious name certificate at a local or state public office. This is so people who deal with your business will know who the real owner is. (See Chapter 6 for more on business names.)

    From an income tax standpoint, a sole proprietorship and its owner are treated as a single entity. Business income and business losses are reported on your own federal tax return (Form 1040, Schedule C). If you have a business loss, you might be able to use it to offset income that you receive from other sources. (For more tax basics, see Chapter 8.)

    Personal Liability

    A potential disadvantage of doing business as a sole proprietor is that you have unlimited personal liability on all business debts and court judgments related to your business.

    Example: Liam is the sole proprietor of a small manufacturing business. Believing that his business’s prospects look good, he orders $50,000 worth of supplies and uses them up. Unfortunately, there’s a sudden drop in demand for his products, and Liam can’t sell the items he’s produced. When the company that sold Liam the supplies demands payment, he can’t pay the bill.
     As sole proprietor, Liam is personally liable for this business obligation. So the creditor can sue him and go after not only Liam’s business assets, but his other property as well. This can include his house, his car, and his personal bank account.

    Example: Sara is the sole proprietor of a flower shop. One day Rex, one of Sara’s employees, is delivering flowers using a truck owned by the business. Rex strikes and seriously injures a pedestrian. The injured pedestrian sues Rex, claiming that he drove carelessly and caused the accident. The lawsuit names Sara as a codefendant. After a trial, the jury returns a large verdict against Rex—and Sara as the owner of the business. Sara is personally liable to the injured pedestrian, which means the pedestrian can go after all of Sara’s assets, business and personal.
     One of the major reasons to form a corporation or an LLC is that, in theory at least, you’ll avoid most personal liability. (But see Chapter 12 for a discussion of how a good liability insurance policy could be enough to protect a sole proprietor from personal liability if someone is accidentally injured.)

    Income Taxes

    As a sole proprietor, you and your business are one entity for income tax purposes. The profits of your business are taxed to you in the year that the business makes them, whether or not you remove the money from the business. This kind of taxation is called “flow-through” taxation, because the profits “flow through” to the owner. You report business profits on Schedule C of Form 1040.

    If you form an LLC or a corporation, you have a choice of two different types of tax treatment:

    • Flow-through taxation. One choice is to have the IRS tax your LLC or corporation like a sole proprietorship or partnership. The owners report their share of LLC or corporate profits on their own tax returns, whether or not the money has been distributed to them.
    • Entity taxation. The other choice is to make the business a separate entity for income tax purposes. If you form an LLC and make that choice, the LLC will pay its own taxes on the profits of the LLC. And as a member of the LLC, you won’t pay tax on the money earned by the LLC until you receive payments as compensation for services or as dividends. Similarly, if you form a corporation and choose this option, you as a shareholder won’t pay tax on the money earned by the corporation until you receive payments as compensation for services or as dividends. The corporation will pay its own taxes on the corporate profits.

    This chapter later explains the mechanics of choosing between these two methods. For now, just be aware that this tax flexibility of LLCs and corporations offers some tax advantages over a sole proprietorship if you’re able to leave some income in the business as “retained earnings.” For example, suppose you want to build up a reserve to buy new equipment, or your small label-manufacturing company accumulates valuable inventory as it expands. In either case, you might want to leave $50,000 of profits or assets in the business at the end of the year. If you operated as a sole proprietor, those “retained” profits would be taxed on your personal income tax return at your marginal tax rate. But with an LLC or corporation that’s taxed as a separate entity, the tax rate will almost certainly be lower.

    Fringe Benefits

    If you operate your business as a sole proprietorship, tax-sheltered retirement programs are available. A Keogh plan, for example, allows a sole proprietor to salt away a substantial amount of income free of current taxes. So does a one-person 401(k). You can’t really do any better by setting up an LLC or a corporation.

    When it comes to medical expenses for you and your family, however, there can be a tax advantage to setting up a corporation or an LLC. As a sole proprietor, you can take a tax deduction for the entire amount of your health insurance premiums, but you can deduct only part of your medical expenses not covered by insurance. Moreover, the personal deduction for uninsured medical expenses is severely limited because you can deduct such expenses only to the extent they exceed 7.5% of your income.

    The situation is different if you form a corporation or an LLC and choose to have the corporation or LLC taxed as a separate entity. Your corporation or LLC could hire you as an employee and—if you’re the only employee—the business could set up a medical reimbursement plan that pays for your health insurance premiums and 100% of other health costs incurred by you, your spouse, and your dependents. However, if you prefer to be a sole proprietor and you’re married, you can reach a similar result by hiring your spouse as an employee. See “Hiring Your Spouse Can Have Tax Benefits,” below, for details.

    Hiring Your Spouse Can Have Tax Benefits

    If you choose to do business as a sole proprietor, there’s a way you can deduct more of your family’s medical expenses. First, hire your spouse at a reasonable wage. Then, set up a written health benefit plan covering your employees and their families. Your business can then deduct 100% of the medical expenses it pays for you, your spouse, and your dependents. (Caution: Don’t do this if you plan to hire additional employees. It only works if your spouse is your sole employee.)

    But balance whether such a plan can save you enough money to justify the effort. There may be some expense for setting up the plan and handling the associated paperwork. Moreover, depending on your state, you might also have to provide your spouse workers’ compensation insurance and/or unemployment insurance.

    And remember that your business will be obligated for payroll taxes on your spouse’s earnings. (See Chapter 8 for information on payroll taxes.) But this isn’t all bad, because your spouse will become eligible for Social Security benefits, which can be of some value—especially if your spouse hasn’t already worked long enough to qualify.

    If you’re audited, the IRS will look closely to make sure your spouse is really an employee and performing needed services for the business.


    Routine Business Expenses

    As a sole proprietor, you can deduct day-to-day business expenses the same way an LLC, corporation, or partnership can. Whether it’s car expenses, meals, or travel, the same rules apply to all of these types of business entities.

    You’ll need to keep accurate books for your business that are clearly separate from your records of personal expenditures. The IRS has strict rules for tax-deductible business expenses (covered in Chapter 8), and you need to be able to document those expenses if challenged. One good approach is to keep separate checkbooks for your business and personal expenses—and pay for all of your business expenses out of the business or a separate credit card you use only for business expenses and pay for from a business checking account.

    It’s simple to keep track of business income and expenses if you keep them separate from the start— and challenging if you don’t.


    If two or more people are going to own and operate your business, you must choose between establishing a partnership, a corporation, or an LLC. This section looks at the “general partnership,” which is the type of partnership that most small businesses will be considering. The limited partnership is described toward the end of this chapter.

    The best way to form a partnership is to draw up and sign a partnership agreement (discussed fully in Chapter 2). Legally, you can have a partnership without a written agreement, in which case you’d be governed entirely by either the Uniform Partnership Act or the Revised Uniform Partnership Act (explained in Chapter 2).

    Beyond a written agreement, the paperwork for setting up a partnership is minimal—about on a par with a sole proprietorship. You might have to file a partnership certificate with a public office to register your partnership name and you might have to obtain a business license or two. However, the income tax paperwork for a partnership is more complex than that for a sole proprietorship. Partnerships must file separate information returns with the IRS. If you hire a tax professional to prepare your return, this will cost more than filing as a sole proprietor.

    Personal Liability

    As a partner in a general partnership, you face personal liability similar to that of the owner of a sole proprietorship. Your personal assets are at risk, in addition to all assets of the partnership. In other words, you have unlimited personal liability on all business debts and court judgments related to your business.

    In a partnership, any partner can take actions that legally bind the partnership entity. That means, for example, that if one partner signs a contract on behalf of the partnership, it will be fully enforceable against the partnership and each individual partner, even if the other partners weren’t consulted in advance and didn’t approve the contract. Also, the partnership is liable, as is each individual partner, for injuries caused by any partner while on partnership business.

    Example 1: Ted, a partner in Argon Associates, signs a contract on behalf of the partnership that obligates the partnership to pay $50,000 for certain goods and services. Esther and Helen, the other partners, think Ted made a terrible deal. Nevertheless, Argon Associates is bound by Ted’s contract even though Esther and Helen didn’t sign it.

    Example 2: Juan is a partner in Universal Contractors. Elroy, one of his partners, causes an accident while using a partnership vehicle. Juan and all the other partners will be financially liable to people injured in the accident if the car isn’t covered by adequate insurance. The same would be true if Elroy used his own car while on partnership business.

    In both of these situations, the personal assets (home, car, and bank accounts) of each partner will be at stake, in addition to partnership assets. But remember that a partnership can protect against many risks by carrying adequate liability insurance.

    Law From the Real World

    First Things First

    Ellen, Molly, and Brianna—all superb cooks—planned to open a catering business. They would hold on to their day jobs until they could determine whether the new business could support all three of them.

    At a planning meeting to discuss the equipment they would need for a commercial kitchen, Ellen said she wanted the business to be run as professionally as possible. To her, that meant promptly incorporating or forming an LLC. The discussion about equipment was put off while the three women tried to decide how to organize the legal structure of their business. After several frustrating hours, they agreed to continue the discussion later and to do some research about the organizational options in the meantime.

    Before the next meeting, Ellen conferred with a small business adviser, who suggested that the women refocus their energy on the kitchen equipment they needed and getting their business operating, keeping its legal structure as simple as possible. One good way to do this, she suggested, was to form a partnership, using a written partnership agreement. Each partner would contribute $10,000 to buy equipment and contribute roughly equal amounts of labor. Profits would be divided equally.

    Later, if the business succeeded and grew, it might make sense to incorporate or form an LLC and consider other issues, like a health plan, retirement plan, and other benefits. But for now, real professionalism meant getting on with the job—not consuming time and dollars forming an unneeded corporate or LLC entity.


    Partners’ Rights and Responsibilities

    Each partner is entitled to full information— financial and otherwise—about the affairs of the partnership. Also, the partners have a “fiduciary” relationship to one another. This means that each partner owes the others the highest legal duty of good faith, loyalty, and fairness in everything having to do with the partnership.

    Example: Wheels & Deals, a partnership, is in the business of selling used cars. No partner is free to open a competing used-car business without the consent of the other partners. This move would be an obvious conflict of interest and, as such, would violate the fiduciary duty the partners legally owe to one another.

    Unless agreed otherwise, a person can’t become a new partner without the consent of all the other partners. However, in larger partnerships, it’s common for partners to provide in the partnership agreement that new partners can be admitted with the consent of a certain percentage of the existing partners—75%, for example.

    State laws regulating partnerships dictate what occurs if one partner leaves your partnership and you don’t have a partnership agreement that provides for what happens. In about half the states, the partnership is automatically dissolved when a partner withdraws or dies; the business is then liquidated. In such a state, it’s an excellent idea to put a provision in your partnership agreement that allows the business to continue without interruption, despite the technical dissolution of the partnership. A partnership agreement, for instance, may contain a provision that calls for a buyout if one of the partners dies or wants to leave the partnership, avoiding a forced liquidation of the business. (Traditionally, these have been known as “buy-sell” agreements, but now we generally refer to them as “buyout agreements.”)

    Example: Tom, Dylan, and Maya are equal partners. They agree in writing that if one of them dies, the other two will buy the deceased partner’s interest in the partnership for $50,000 so that the business will continue. (Be aware that often a partnership agreement doesn’t fix a precise amount as the buyout price but uses a more complicated formula based on such data as yearly sales, profits, or book value.) To fund this arrangement, the partnership buys life insurance covering each partner in an amount large enough to cover the buyout. If Tom dies first, under the terms of the agreement, his wife and children will receive $50,000 from the partnership to compensate them for the value of Tom’s ownership interest in the business. Technically, the remaining partners would operate as a new partnership, but the important point is that the business would keep functioning.

    Other states—generally those that have adopted the revised version of the Uniform Partnership Act—follow a slightly different rule. In those states, if your partnership was created to last for a fixed length of time or was created for a specific project, and a partner leaves before the fixed time expires or the project is done, the partnership isn’t automatically dissolved. Instead, the remaining partners have the opportunity to continue the existing partnership rather than having to form a new one. But even if your state follows this more flexible approach, you’ll still want to use buyout provisions to specify how the departing partner—or the family of a partner who’s died—gets compensated for that person’s partnership interest.

    Income Taxes

    In terms of income and losses, the tax picture for a partnership is basically the same as that of a sole proprietorship. A partnership doesn’t pay income taxes. It must, however, file an informational return that tells the government how much money the partnership earned or lost during the tax year and how much profit (or loss) belongs to each partner. Each partner uses Schedule E of Form 1040 to report the business profits (or losses) allocated to each and then pays income tax on this share, whether or not this income was actually distributed during the tax year. If the partnership loses money, each partner can deduct the proportional share of losses for that year from income earned from other sources (subject to some fairly complicated tax basis rules—see “Investment Partnerships,” below).

    Investment Partnerships
    A partner’s share of the partnership’s losses from income earned through other sources can be deducted only if that partner actively participates in the business of the partnership. If, instead, a partner is a passive investor (as is often the case in partnerships designed to invest in real estate) or receives income from passive sources (such as royalties, rents, or dividends), any loss from the partnership business is treated as a passive loss for that partner. So, for federal income tax purposes the loss can be deducted only from other passive income—not from ordinary income.


    Fringe Benefits and Business Expenses

    When it comes to fringe benefits (such as retirement plans and medical coverage) and business expenses, the IRS treats partnerships like sole proprietorships. The discussion about “Fringe Benefits” and “Routine Business Expenses” for sole proprietorships, above, applies to partnerships as well.

    Special Tax Status Available for Spouses

    Ordinarily, if you and your spouse jointly own an unincorporated business, your business is classified as a partnership for federal tax purposes. So, you need to file an annual partnership tax return—IRS Form 1065—as well as IRS Form 1040. But better options might be available:

    • You and your spouse co‑own the business.
    • You and your spouse are the only owners of the business, and you file a joint tax return.
    • You both materially participate in running the business—joint ownership of business property isn’t enough.
    • You both elect for your business not to be treated as a partnership.
    • Your business isn’t held in the name of a partnership or an LLC.

    Being classified as a qualified joint venture also helps ensure that each of you gets proper Social Security credit.

    To get these benefits, you and your spouse should each file a Schedule C with your joint Form 1040.

    In your separate Schedule C forms, you’ll list your respective shares of profit or loss based on your ownership interests in the business. Most husband‑ and‑wife businesses are owned 50‑50.

    Spouses in any of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) may elect qualified joint venture status just like those in the other 41 states. However, couples in these states also have another option: They may choose to classify their jointly owned community property business as a sole proprietorship by filing a single Schedule C listing one spouse as the sole proprietor.

    The advantage of filing one Schedule C instead of two is that only the spouse listed as the business owner on the single Schedule C has to pay Social Security and Medicare taxes. This tactic will save on these taxes if the business earns more in profit than the Social Security tax ceiling ($160,200 in 2023). For example, if the business earns $200,000 in profit and each spouse files one Schedule C, they’ll owe a total Social Security and Medicare tax of (15.3% × $100,000) + (15.3% × $100,000) = $30,600. If they file one Schedule C, they’ll owe (15.3% × $160,200) + (2.9% × $39,800) = $25,664. The nonfiling spouse won’t earn any Social Security credits, but this might not affect the couple’s Social Security benefits much when they retire. But it likely will affect them if they divorce.

    You’ll find more information on qualified joint ventures and spousal businesses in community property states in IRS Publication 541, Partnerships.


    Put it in writing. If you go the partnership route, it’s best for the partners to sign a written partnership agreement, even though an oral partnership agreement is legal. The human memory is far too fallible to rely on for the details of important business decisions. Chapter 2 contains basic information on how to write a partnership agreement.


    If you’re concerned about limiting your personal liability for business debts, you’ll want to consider organizing your business as either an LLC or a corporation. (Of course, you might have other reasons in addition to limited liability for considering these two business structures.) Because the corporation has a longer legal history, I’ll deal with it first, but the LLC—covered next—might well be preferable for your particular business, despite its relative newness.

    This book deals primarily with the small, privately owned corporation. I’ll assume that all of the corporate stock is owned by one person or a few people and that all shareholders are actively involved in the management of the business—with the possible exception of friends and relatives who have provided seed money in exchange for stock. Because so many complexities are involved in selling stock to the public, this book doesn’t discuss public corporations.

    The most important feature of a corporation is that, legally, it’s a separate entity from the individuals who own or operate it. You may own all the stock of your corporation and be its only employee but—if you follow sensible organizational and operating procedures—you and your corporation are separate legal entities.

    All states have adopted legislation that permits a corporation to be formed by a single incorporator. All states permit a corporate board that has a single director, although the ability to set up a one-person board may depend on the number of shareholders. (See Chapter 3 for more details.) In addition, many states have streamlined the procedures for operating a small corporation to permit decisions to be made quickly and without needless formalities. For example, in most states, shareholders and directors can take action by unanimous written consent rather than by holding formal meetings, and directors’ meetings can be held online or by telephone.

    Limited Personal Liability

    One of the main advantages of incorporating is that, in most circumstances, it limits your personal liability. If a court judgment is entered against the corporation, you stand to lose only the money that you’ve invested. Generally, as long as you’ve acted in your corporate capacity (as an employee, officer, or director) and without the intent to defraud creditors, your home, personal bank accounts, and other valuable property can’t be touched by a creditor who has won a lawsuit against the corporation.

    Example: Andrea is the sole shareholder, director, and officer of Market Basket Corporation, which runs a food store. Ronald, a Market Basket employee, drops a case of canned food on a customer’s foot. The customer sues and wins a judgment against the business. Only corporate assets are available to pay the damages. Andrea is not personally liable.

    Liability for your own acts. If Andrea herself had dropped the case of cans, the fact that she is a shareholder, officer, and director of the corporation wouldn’t protect her from personal liability. She would still be personally liable for the wrongs (called “torts,” in legal lingo) that she commits.

    So much for theory. In practice, incorporating might not actually give you broad legal protection. In the real world, banks and some major corporate creditors often require the personal guarantee of individuals within the corporation. So the limited liability gained from incorporating isn’t always as valuable a legal shield as it first seems.

    Example: Market Basket Corporation borrows $75,000 from a bank. Andrea signs the promissory note as president of the corporation, but the bank also requires her to guarantee the note personally. The corporation runs into financial difficulties and can’t repay the debt. The bank sues and wins a judgment against the business for the unpaid principal plus interest. In collecting on the judgment, the bank can go after Andrea’s assets as well as the corporation’s property. Incorporation offers no advantage over a sole proprietorship when an owner personally guarantees a loan.

    As mentioned above, liability insurance can protect against many of the risks of doing business. Because of this, many businesses can structure themselves as sole proprietorships or partnerships without worrying about unlimited personal liability. But if you operate a high-risk business—childcare center, chemical supply house, asbestos removal service, or college town bar—and you can’t get (or can’t afford) liability insurance for some risks that you’re concerned about, incorporation might be the wisest choice.

    Example: Loren is afraid that a clerk at his After Hours beverage store might inadvertently sell liquor to an underaged customer or one who has had too much to drink. If that customer got drunk and hurt someone in a car accident, the injured person might file a lawsuit against the business.
     Loren contacts his insurance agent to arrange for coverage but learns that his liquor store can afford only $50,000 worth of liability insurance. Loren buys the $50,000 worth of insurance but also forms a corporation—After Hours, Inc.— to run the business. Now if an injured person wins a large verdict, at least Loren won’t be personally liable for the portion not covered by his insurance.

    The lesson of these examples is clear: Before you decide to incorporate your business primarily to limit your personal liability, analyze what your exposure will be if you simply do business as a sole proprietor (or a partner in a partnership).

    The limited liability feature of corporations can be valuable, protecting you from personal liability for:

    • debts that you haven’t personally guaranteed, including most routine bills for supplies and small items of equipment, and
    • injuries suffered by people who are injured by business activities not covered adequately by insurance.

    Also, for a business with more than one owner, incorporating can offer a great deal of protection from the misdeeds or bad judgment of your co-owners. In contrast, in a partnership, as noted above, each partner is personally liable for the business-related activities of the other partners.

    Example: Ted, Mona, and Maureen are partners in Mercury Enterprises. Mona writes a nasty letter about Harold, a former employee, which causes Harold to lose the chance of a good new job. Harold sues for defamation and wins a $60,000 judgment against the partnership. Ted and Maureen are each personally liable to pay the judgment even though Mona wrote the letter.
     If Mercury Enterprises had been a corporation, Mona and the corporation would have been liable for the judgment, but Ted and Maureen would not. Ted and Maureen would lose money if the assets of the corporation were seized to pay the judgment, but their own personal assets would be safe.

    Payroll taxes. Limited liability doesn’t protect you if you fail to deposit taxes withheld from employees’ wages—especially if you have anything to do with making decisions about what bills the corporation pays first. Also, because unpaid withheld taxes aren’t dischargeable in bankruptcy, you want to pay these before you pay other debts (most of which can be wiped out in bankruptcy) in case your business goes downhill.

    Income Taxes

    Federal taxation of corporations is a very complicated topic. This book deals only with basic concepts. The federal tax laws distinguish between two types of corporations. A “C corporation” is treated as a taxpaying entity separate from its investors and it must pay corporate federal income tax. By contrast, a corporation that chooses “S corporation” status doesn’t pay federal income tax; instead, income taxes are paid by the corporation’s owners.

    Law From the Real World
    Going With Your Gut

    Several years ago, John took over his dad’s rug cleaning business as a sole proprietor. He didn’t expect the business to ever grow beyond its status as a small local facility with six employees and $400,000 in annual sales. But grow it did—first to 10, then to 25 employees, operating in four suburban cities and taking in $3.5 million a year.

    About this time, John and his wife bought a nice house, put a few dollars in the bank, and finished paying off the promissory note to his dad for the purchase of the business. Things were going so well that John began to worry about what would happen to his personal assets if the business were sued for big bucks. He reviewed his insurance coverage and sensibly increased some of it. He reviewed his operations and improved several systems, including the one for storing, handling, and disposing of toxic materials. Still, he felt vaguely disquieted.

    Finally, even though he couldn’t identify any other risks likely to result in a successful lawsuit against his company, John decided to incorporate, to limit his personal liability for the business’s debts. He tried to explain his gut feelings of worry to his father but felt he wasn’t quite making sense. The older man interrupted and said, “I think you’re trying to say that things have been going so well lately that something is bound to mess up soon. And if they do, you want as much of a legal shield between your personal assets and those of the business as possible.”

    “Precisely,” John said. “But I’ve already protected myself against all obvious risks, so I can’t logically justify a decision to incorporate.”

    His father replied, “John, business decisions are like any other—if your gut tells you to be a little extra careful, go with it. Running a small business means being ready to trust your own intuition.”


    S Corporations

    Electing to do business as an “S corporation” lets you have the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner. Among other things, this means that as long as you actively participate in the business of the S corporation, business losses can be used as an offset against your other income—reducing, maybe even eliminating, your tax burden. But be aware that a cap applies to the amount of business losses you can claim. The corporation itself doesn’t pay taxes, but files an informational tax return telling what each shareholder’s portion of the corporate income is.

    Example: Paul decides to start an environmental cleanup business. Because insurance isn’t available to cover all of the risks of this business, he forms a corporation called Ecology Action, Inc. This limits Paul’s personal liability if there’s a lawsuit against the corporation for an act not covered by insurance.

    Paul is also concerned about taxes. He expects his company to lose money during its first few years; he’d like to claim those losses on his personal tax return to offset income he’ll be receiving from consulting and teaching work. He registers with the IRS as an S corporation. Unless he changes that tax status later, his corporation won’t pay any federal income tax. Paul will report the corporation’s income loss on his own Form 1040 and will be able to use it as an offset against income from other sources.

    For many years, if you wanted to limit the personal liability of all owners of your business and have the income and losses reported only on the owners’ income tax returns, you would have no choice but to create an S corporation. Today, you can accomplish the same goal by creating an LLC. Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, it’s generally better to structure your business as an LLC than as an S corporation. (But see “Choosing Between a Corporation and an LLC,” below, for a discussion of when it might be better to create an S corporation.)

    Limits on deductions. You can deduct S corporation losses on your personal return only to the extent of the money you put into the corporation (to buy stock) and any money you personally loaned to the corporation. Also, if you don’t work actively in the S corporation, there are potential problems with claiming losses, because they might be considered losses from passive activities. For the most part, you can use losses from passive activities only to offset income from passive activities. See your tax adviser for technical details.

    Shareholders pay income tax on their share of the corporation’s profits regardless of whether they actually receive the money or not. If the corporation suffers a loss, shareholders can claim their share of that loss.

    Example: Assume the same facts as in the previous example, except that there are two other shareholders in Ecology Action, Inc. Paul owns 50% of the stock, and Ellen and Ted each own 25%. Paul would report 50% of the corporation’s profit or loss on his personal tax return, and Ellen and Ted would each report 25% on theirs.

    Most states follow the federal pattern in taxing S corporations: They don’t impose a corporate tax, choosing instead to tax the shareholders for corporate profits. About half a dozen states, however, do tax an S corporation the same as a C corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

    Should Your Corporation Elect S Corporation Status?

    For federal tax purposes, it’s often best for a start‑up company to elect to be an S corporation rather than a C corporation. To make sure an S corporation is best for you, speak to a knowledgeable accountant or other tax adviser. Also keep in mind that an LLC might be an even better choice than either type of corporation. Starting as an S corporation rather than a C corporation could be wise for several reasons:

    • Because income from an S corporation is taxed at only one level rather than two, your total tax bill will likely be less. (But be aware that the two‑tier tax structure for C corporations can sometimes be an advantage. See the discussion below on how a C corporation can achieve tax savings through income splitting.)
    • Your business might have an operating loss the first year. With an S corporation, you generally can pass that loss on to your personal income tax return, using it to offset income that you (and your spouse, if you’re married) might have from other sources. Of course, if you’re expecting a profit rather than a loss—because, for example, you’re converting a profitable sole proprietorship or partnership to a corporation—this pass‑through for losses won’t be an advantage to you.
    • Interest you incur to buy S corporation stock is potentially deductible as an investment interest expense.
    • When you sell the assets of your S corporation, you might be taxed less on your gain than if you operated the business as a C corporation (because of the dual taxation structure of corporations).
    • Owners of S corporations can qualify for the pass‑through deduction—an income tax deduction equal to up to 20% of their share of the corporation’s net business income (see Chapter 8). This deduction is not available to C corporation shareholders.

    Your decision to elect to be an S corporation isn’t permanent. If you later find there are tax advantages to being a C corporation, you can easily drop your S corporation status, but timing is important.


    To be treated as an S corporation, all shareholders must sign and file IRS Form 2553, Election by a Small Business Corporation. For more information on this and other requirements for electing S corporation status, see Chapter 8.

    C Corporations

    Under federal income tax laws, a “C corporation” is a separate entity from its shareholders. So, the corporation pays taxes on any income that’s left after business expenses have been paid.

    As you saw earlier in this chapter, a sole proprietorship doesn’t pay federal income tax as a separate entity; the owner simply reports the business’s income or loss on Schedule C of Form 1040 and adds it to (or, in the case of a loss, subtracts it from) the owner’s other income. Similarly, a partnership doesn’t pay federal income tax; rather, the partnership annually files a form with the IRS to report each partner’s share of yearly profit or loss from the partnership business. Each partner then adds their share of partnership income to other income reported on their personal tax return (the familiar Form 1040) or deducts their share of loss. And an S corporation is treated as a sole proprietorship or partnership for federal income tax purposes, depending on the number of owners.

    A C corporation is different. It reports its profits on Form 1120 and pays corporate tax on that income. In addition, if the profits are distributed to shareholders in the form of dividends, the shareholders pay tax on the dividends they receive (creating the much-feared “double-taxation” scenario).

    In practice, however, a C corporation might not have to pay any corporate income tax even though it is a separate taxable entity. Here’s how: In most incorporated small businesses, the owners are also employees. They receive salaries and bonuses as compensation for the services they perform for the corporation. The corporation then deducts this “reasonable” compensation as a business expense. In many small corporations, compensation to owner employees eats up all the potential corporate profits, so there’s no taxable income left for the corporation to pay taxes on.

    Example: Zoey forms a one-person catering corporation, Zoey Enterprises Ltd. She owns all the stock and is the main person running the business. The corporation hires her as an employee with the title of president. The corporation pays her a salary plus bonuses that consume all of the corporation’s profits. Zoey’s salary and bonuses are tax deductible to the corporation as a corporate business expense. There are no corporate profits to tax. Zoey simply pays tax on the income that she receives from the corporation, the same as any other corporate employee.

    Tax Savings Through Income Splitting

    C corporation profits kept in the business are taxed at a flat rate of 21%. In some cases, small incorporated businesses may benefit from splitting income between the corporation and its owners, retaining money in the corporation for expenses, and lowering the corporation’s tax liability to an amount that’s actually less than what would have to be paid by the principals of the same business if it were not incorporated.

    Example 1: Sally and Randy run their own incorporated lumber supply company, S & R Wood, Inc. In 2022, their sales increased to $1.2 million. After the close of the third quarter, Sally and Randy learned that S & R Wood was likely to make $110,000 net profit (net taxable corporate income) for the year. They decided to reward themselves and other key employees with moderate raises in pay, give a small year-end bonus to other workers, and buy some needed equipment.
     This reduced the company’s net taxable income to $40,000—an amount that Sally and Randy felt was prudent to retain in the corporation for expansion or in case next year’s operations were less profitable. Taxes on these retained earnings were paid at the lowest corporate rate, 21%. If Sally and Randy had wanted to take home more money instead of leaving it in the business, they could have increased their salaries and paid individual income taxes at a rate of 22% or 24% or higher, depending on their tax brackets.

    Watch out for a double-tax trap. C corporation shareholders (like Sally and Randy) can also consider taking some income in the form of dividends rather than salary. Both the corporation and the shareholders have to pay income tax on the distributed funds. The corporation first pays a 21% corporate tax, and the shareholders then pay income tax on their corporate dividends at long‑term capital gains rates, which are 15% for most taxpayers, but 20% for high‑ income shareholders. The combined tax is often greater than taking a corporate salary. Still, in some situations, taking some dividends in place of salary might make sense—for example, if the corporation pays the flat 21% tax and the shareholder is in the 35% (or higher) bracket. In that case, the money saved on income and Social Security taxes can offset the fact that the corporation can’t deduct the dividend payment for tax purposes. But this gets complicated. Let a tax pro help you figure it out.

    Example 2: Assume S & R Wood is not incorporated but instead is operated as a partnership. Now the entire net profits of the business ($110,000 minus the bonuses to workers and deductible expenditures for equipment) are taxed to Sally and Randy. The result is that the $40,000 (which was retained by the corporation in the above example) is taxed at their individual rate of 22%, 24%, or higher rather than the flat 21% corporate rate.

    For a more detailed explanation of how income splitting can be an advantage to owners of small corporations, see How to Form Your Own California Corporation or Incorporate Your Business: A Step-by- Step Guide to Forming a Corporation in Any State, both by Anthony Mancuso (Nolo).

    The main point to remember is that once your business becomes profitable, doing business as a C corporation allows a degree of flexibility in planning and controlling your federal income taxes that is unavailable to partnerships and sole proprietorships. To determine whether or not favorable corporate tax rates are a compelling reason for your business to incorporate, you’ll need to study IRS regulations or go through an analysis with your accountant or other tax adviser.

    Tax savings might be a largely theoretical advantage for the person just starting out. If your business is like many start-ups, your main concern will be generating enough income from the business to pay yourself a reasonable wage. Retaining profits in the business will come later. In this situation, the tax advantages of incorporating are illusory.

    Example: In its first year of operation, Maria’s store, The Bookworm, has a profit of $25,000. As the sole proprietor, Maria withdraws the entire $25,000 as her personal salary, which means part of her income is taxed at 10% and part at 12% after she subtracts her deductions and personal exemption. It doesn’t make sense for Maria to incorporate to take advantage of income-splitting techniques—even if she could get by on, say, $20,000 a year, if she left the remaining $5,000 in the corporation, it would be taxed at the flat 21% corporate tax rate, so her total tax bill would be higher.

    21% Flat Rate Doesn’t Apply to S Corporations

    The 21% flat rate for retained earnings doesn’t apply to S corporations because, as discussed above, an S corporation does not pay taxes on earnings. Individual shareholders in an S corporation pay taxes on their portion of corporate earnings at their personal income tax rates (as if they were partners in a partnership). This is true whether or not those earnings are distributed to them, meaning that even if the shareholders do leave some earnings in the corporation, the shareholders will be taxed on those earnings at their regular tax rates.

    However, because an S corporation is a pass‑ through entity, in most cases, shareholders will be entitled to an income tax deduction equal to 20% of their S corporation income.


    Fringe Benefits

    The tax rules governing fringe benefits are complicated. Generally, however, if your business will be offering fringe benefits to its employees, you can enjoy a tax advantage if you organize as a C corporation. The business can pay for employee benefits and then take these amounts as business expense deductions. You and the other shareholders who work as employees of your corporation can have the corporation pay for employee benefits such as:

    • deferred compensation plans
    • group term life insurance
    • reimbursement of employee medical expenses that are not covered by insurance, and
    • health and disability insurance.

    But the real advantage is how these fringe benefits are treated on your personal tax return. As a shareholder, you won’t be personally taxed for the value of these employment benefits. That’s because employees of a C corporation—even if they’re owners—do not have to pay income tax on the value of the fringe benefits they receive. So, for example, your corporation may decide to provide medical insurance for employees and to reimburse employees for uninsured medical payments. The corporation can deduct these payments as a business expense—including the portion paid for the corporation’s owner-employees—and you and the other owner-employees are not taxed on these benefits.

    Other types of business entities can also deduct the cost of many fringe benefits as business expenses, but owners who receive these benefits will ordinarily be taxed on their value. That’s because the tax laws distinguish between an employee and a self-employed person. The tax laws say that you’re a self-employed person—and therefore are taxed on your fringe benefits—if you’re a sole proprietor, a partner in a partnership, a member of an LLC that’s taxed as a partnership, or an owner of more than 2% of the shares of an S corporation. An owner-employee of a C corporation, however, isn’t classified as a self-employed person. So when it comes to the taxation of fringe benefits, owner-employees of a corporation enjoy a unique advantage.

    This favorable tax treatment might seem like a powerful reason to organize your business as a C corporation. Not so fast. Obviously, there’s no advantage unless your business provides these benefits to employees in the first place. And that might be too expensive for some new businesses—especially because many types of employee benefits must be provided on a nondiscriminatory basis to a wide range of employees or to none, and must not be designed to primarily aid the business owner. If you put together a fringe benefit package that favors you and the other owner-employees, the IRS will require you and the other owners to pay taxes on the value of the benefits received. Few new businesses can afford to carry expensive benefit programs—a cost that typically more than offsets any tax advantage to the owners of a C corporation.

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