Successful entrepreneurs start with a plan for where they want to go with their new venture. Life experiences, passions, or, on occasion, serendipity serve as the inspiration and motivation for them to launch out in pursuit of a goal. Putting more thought into planning your journey will often reduce the time it takes to achieve your goals, as well as minimize the challenges you face along the way. Taking the time to prepare a basic business plan and work out the major elements of your new venture, including the resources required to achieve a sustainable level of success, is fundamental to giving your new venture the best opportunity to succeed.
Developing a business plan takes time, but the process will help you clarify your vision and your objectives and also sharpen your grasp on the resources required for you to succeed. The basic elements of a good business plan include (a) a concise executive summary, (b) a background of the business and the management team, (c) your goals and objectives for the business, (d) a description of the products and/or services you will offer, (e) a profile of your target customers, (f) a brief analysis of the competitors in your target market(s) as well as the trends impacting these markets, (g) an overview of your sales and marketing strategies, (h) information regarding your anticipated budget and timeline as well as summary of the proposed use of fund, and (i) a preliminary forecast of your future revenue and profitability targets.
Establishing an appropriate legal structure for your new business is a key decision that you will make early in this journey. Understanding the options available and the advantages and disadvantages of each in the context of your unique business plan will help you avoid mistakes that can result in a waste of time and money. For example, starting your new business as a limited liability company (“LLC”) taxed as a partnership may provide great flexibility, but later converting the business to a corporation so that you can accommodate the desire of a potential private equity investor will come with a required change in your employer identification number—a seemingly innocuous event until it causes upheaval in your regulatory structure or with key customers, suppliers, and the IRS. This does not mean that choosing an LLC was not the best choice at the beginning, but you need to understand the ramifications of using an LLC and the consequences of converting to a different form of legal entity at a later date. A well-planned legal framework can also build confidence in your potential customers and investors, just as a series of bad decisions can quickly turn away the people and organizations vital to the success of your new venture.
In most cases, the legal structure of your new business is a question of state law, while the manner in which the business will be taxed is most influenced by federal tax laws. The most common types of business entities in Alabama are corporations, limited liability companies, and limited partnerships. The decision regarding which form of entity to use for your new venture will be influenced by a number of different factors, including the (a) purpose of the entity, (b) number and composition of the owners, (c) source of funding for the business, (d) governance structure for the business, (e) anticipated compensation and benefits, (f) licensing and regulatory requirements, and (g) other considerations unique to your particular circumstances.
Selecting an appropriate income tax classification for the new business venture is very important. Under federal laws, a new business entity will be classified as one of the following: (a) disregarded entity, (b) C corporation, (c) S corporation, or (d) partnership. State law entity classifications do not dictate the tax treatment of a business entity. For example, a limited liability company formed under state law may elect to be taxed as an S corporation or a partnership, and, in some circumstances, it may be treated as a disregarded entity, for federal (and, in many cases, state) income tax purposes.
Tax classification is a critical decision because of the very different tax rules that apply to each of the separate entity classifications. Important decisions regarding the source of potential investment capital, equity compensation for your key employees, tax treatment of compensation paid to owners, and the types of employee benefits available will all be impacted by classification of the business for tax purposes. The four primary classifications include:
- Disregarded entity: a separate legal entity with limited liability protection under state law with a single owner that is generally ignored for federal and state income tax purposes (although business franchise taxes and permit fees may apply under applicable state laws).
- C corporation: a state law corporation or limited liability company that incurs income tax liability at the entity level and to its owners on certain distributions. While the resulting potential double taxation is inefficient from a tax perspective, the impact is somewhat mitigated by the 21% corporate income tax rate effective January 1, 2018, under the Tax Cuts and Jobs Act.
- S corporation: a pass-through entity for income tax purposes that generally does not incur an entity-level income tax. The profits and losses of the business are instead allocated and passed through to the owners of the business in proportion to their stock ownership and reported on their individual income tax returns, regardless of whether the entity actually distributes cash profits to the owners. A state law corporation, limited liability company, or partnership may elect to be taxed as an S corporation for federal and Alabama state income tax purposes. Federal law restricts the number, type, and residence of owners of an entity seeking to elect S corporation status.
- Partnership: a pass-through entity for income tax purposes that generally does not incur an entity-level income tax. Similar to an S corporation, the profits and losses of the business are allocated and passed through to the owners of the business in accordance with the governing agreement and reported on their individual income tax returns regardless of whether the entity actually distributes cash profits to the owners. There are no restrictions on the maximum number (minimum of two), type, or residency of owners of a business entity taxed as a partnership, but the potentially complex legal documents and related tax considerations applicable to partnerships can make this form of entity less attractive in some cases.
Forming a new business entity generally requires planning, preparation, execution, and, in some cases, filing a series of documents and taking certain related steps. While many of the required elements in the process are relatively simple to accomplish, failure to complete them in a timely manner can result in significant cost for the business in the long run. Similarly, failure to establish a workable governance framework and impose reasonable restrictions on the actions of employees and business owners as part of the formation process may prove to be a costly omission difficult to remediate in subsequent years. The basic steps include the following:
- Select the type of entity to be formed (e.g., corporation, limited liability company, partnership);
- Select the state of formation;
- Select a federal tax classification;
- Choose a name for the business;
Note: Alabama requires a name reservation certificate to be filed with the formation document for your new entity. Like most states, Alabama law restricts the use of certain terms in entity names related to insurance, securities, and banking industries, among others, and the name must be distinguishable on the records of the Secretary of State from existing entities. You should also check the proposed name against similar names to avoid confusion or possible trademark infringement.
- Choose a registered agent;
- Prepare and file the primary formation document with the county’s judge of probate where the registered agent is located (if Alabama) and/or Secretary of State (certificate of incorporation or formation);
- Obtain a federal employer identification number from the Internal Revenue Service;
- Prepare and file initial Alabama Business Privilege Tax Return (or equivalent under applicable state law) due 2½ months after the date the taxpayer is organized or qualifies to do business in Alabama;
- Prepare the primary governance document (corporate bylaws, limited liability company agreement, or partnership agreement);
- Prepare minutes of the owners and directors / managers (required for a corporation; optional for a limited liability company, or limited partnership);
- Open a bank account for the new business;
- Receive initial capital contributions (in compliance with federal and state tax and securities laws);
- Issue ownership interests (which may be certificated or uncertificated);
- Prepare agreements among owners restricting transfer of ownership interests;
- Prepare agreements governing employment of key employees and operation of the new business venture;
- Prepare and timely file any applicable election for federal tax classification with the Internal Revenue Service (e.g., election to be classified as an S corporation must be filed within 75 days of the formation of the business entity);
- Qualify to do business in states other than state of formation, if applicable;
- Prepare and file applications to protect intellectual property rights in entity name under federal and state trademark and assumed name laws; and
- Prepare and timely file applicable Section 83(b) elections with the Internal Revenue Service.
Documenting and preserving a record of the above steps is an important part of respecting the separate identity for the business under state law. Failure to keep adequate records and respect the separate existence of the new business can result in courts failing to respect the limited liability protections associated with your new business vehicle and taxing authorities failing to apply the appropriate classification of the business for income tax purposes.
Download our Forming a New Business Entity Checklist.