The Rush to Start a Business
Oftentimes, an entrepreneur will be so focused on a business idea or operations that legal or practical tasks to advance the business are marginalized. While such a person’s skills or interests may be best suited for business management, it is a mistake to disregard certain basic and legally required startup tasks.
Main Problems of Careless Startup
When a single individual begins business activity, he or she has formed a Sole Proprietorship. Likewise, when two or more people carry on as co-owners of a for-profit business, a General Partnership is formed. In both cases, the business owners remain personally liable for business-related debts and obligations. This means that a sole proprietor or partner could have personal bank accounts raided should the business go under. See, for example, the Partnership Act which states that “all partners are liable jointly and severally for all obligations of the partnership…” KRS 362.1-306(1).
In contrast, when a business is formed through a filing with the Secretary of State, the business owners gain personal liability protection provided by law. This means that the business owners cannot be forced to use their own funds to cover business defaults, legal judgments against the business, etc. See, for example, the LLC Act which states that “no member, manager, employee, or agent of a limited liability company… shall be personally liable… under a judgment, decree, or order of a court, agency, or tribunal of any type, or in any other manner, in this or any other state, or on any other basis, for a debt, obligation, or liability of the limited liability company, whether arising in contract, tort, or otherwise.” KRS 275.150(1). Thus, setting up a business as an LLC, corporation, or LLP may be thought of as a basic form of insurance for business owners.
There are four taxation methods: Sole Proprietorship, Partnership, C-Corp, and S-Corp. If a person begins a business without completing the formation filings, the business will only be able to be taxed one way. Sole Proprietorship and Partnership taxation is disadvantageous in many cases because owners must pay employment/payroll taxes on their entire share of business profits and cannot leave any funds within the business thereby avoiding personal income taxes.
Conversely, limited liability companies and corporations have the ability to file federal taxation elections to change the way in which they are taxed. Both have the opportunity to be taxed as either a C-Corp or as an S-Corp, but neither election has to be permanent. It may be the case that, throughout the life of the business, switching between different tax methods will greatly reduce the business’ tax burden.
Minimal Additional Startup Burden
All businesses must undertake certain startup tasks that will allow the business to be taxed. Most businesses acquire an employer identification number to separate business and personal finances and all are required to register with the Kentucky Department of Revenue and obtain a county business license. Businesses with a physical location must pass building and zoning inspection, most restaurants require alcoholic beverage licenses, most manufacturers must receive environmental permits, etc. Operating without filing a business formation document to become a legitimate entity does not exempt a business from such requirements. Businesses that try to get by without submitting mandatory filings are subject to fines and interest for non-registration.
Kentucky does not impose a franchise tax, business license requirement, or some other additional burden for the privilege of forming a business entity and operating within the state. The Kentucky corporate income tax rate is between four and six percent. KRS 141.040(6). For all other entity types, the corporate income tax is not charged, and business owners are taxed at the individual income tax rate. KRS 141.206(4). Kentucky does impose a limited liability entity tax on entity types which receive a liability shield upon formation: LLPs, Limited Partnerships, LLLPs, LLCs, and Corporations. However, these entities pay no tax at all if annual gross profits are $3 million or less. KRS 141.0401(2)(b)(1)(a).
It’s true a business does not need to have its own bank account, obtain certain types of insurance, have an accountant manage its finances, or have a lawyer make sure it is properly formed and compliant with all relevant laws. But taking the proper startup steps demonstrates the business’ credibility and its owners’ professionalism. A business can only get by doing the minimum for a short time anyway; when it eventually expands its activities or earns meaningful profits it will need to complete the tasks that should have been done initially.