13 legal and tax requirements for starting a small business
Is your head swirling with the legalities and taxes of running a small business? This guide can walk you through what you need to know step by step.
But that still doesn’t cover everything.
The small business laws and taxes are the pink elephant in the room that you can no longer afford to ignore.
(Even though you may want to.)
Have no fear. If you don’t know where to start when it comes to understanding laws and taxes for your small business, we’ve got you covered today -- without any technical mumbo-jumbo.
In this guide, we introduce you to the legal requirements for starting a small business and the basics of small business taxes.
First up, let’s unpack eight major legal steps involved in starting a small business.
8 legal requirements for starting a small business
Step #1: Pick your business structure
Before you officially start a business, you should first pick your business structure.
In the U.S., there are five main business types to choose from:
- Sole proprietorships
- Limited liability companies (LLC)
- S corporations
(Are you a resident of the E.U.? Then check out this guide to understand the requirements for starting a business in the E.U.)
If you’re curious about which type is the most popular among entrepreneurs, it’s sole proprietorships. 86.4% of non-employer firms (i.e., businesses with no employees) were sole proprietorships in 2015.
But, just because most small businesses are sole proprietorships doesn’t mean yours should be one, too.
Rather than jumping on the bandwagon, consider your liability, which is a big factor that comes into play when choosing your business structure.
As the Director of Planning at Legacy Business Advisors, Devin Langan, said: “The first thing to consider is how likely it is you’ll get sued. A web designer and a doctor have very different odds of facing legal action.”
Each business structure offers different levels of legal protection and tax benefits, so try to work with a lawyer to pick the structure that works best with your preferred level of risk and liability.
This entrepreneur also prefers LLCs since they generally require less paperwork than S corporations.
Once you’ve decided on your structure, you’ll need to file the relevant paperwork with your state, county, and/or city. You may want to seek your lawyer’s help since there are often many forms and requirements that go into a business filing.
And while you still have your lawyer’s ear, make sure to learn what other business rules you should follow, which brings us to our next step.
Step #2: Familiarize yourself with business rules specific to your state or situation
There’s no way to candy coat it: Researching and understanding business laws is about as fun as watching paint dry.
But, it’s better to proactively invest a few hours of research now to avoid fines or complications later on.
For example, figure out if you should file an annual report with your state, as Illinois requires LLCs to do. Otherwise, if you don’t file your report, you may be subject to a fine or legal penalty.
It’s also wise to brush up on tax-related requirements (more on taxes later). As an example, San Francisco charges contractors income tax if they work for seven days or more in the city.
Likewise, this Amazon seller received a surprise $1.6 million sales tax bill from the state of California, even though he lived in Pennsylvania.
The lesson here is that, though it’s easy to overlook and entirely unfun, do your due diligence and find out if there are specific licenses or permits you need for operating your business and offering your services.
Annual filing requirements, income and sales taxes, and labor laws are just a few things small business entrepreneurs should discuss with their lawyer and accountant.
Your next step is to give your newly born business a name.
Step #3: File a fictitious name
A doing-business-as (DBA) name, or fictitious name, is a name that differs from the business name on your legal paperwork. You use it to market your business or present yourself to customers.
For instance, let’s assume your business is legally named “Smith Accounting LLC”.
Rather than using your legal business name, it’s more fitting to use the name “Easy Peasy Accounting” on your website and marketing materials, which makes it your business’ fictitious name.
A fictitious name can do more than notify your city or state of your business’ alternative name, though.
A fictitious name also helps if you want to operate multiple lines of business from one legal business structure.
(Plus, coming up with a fictitious name sounds fun, am I right?
But I digress.)
As for an example, if you have a consulting business and a separate digital product business, fictitious names will help you differentiate them without filing separate paperwork.
In most cases, your next step after your fictitious name will be to get an identification number for your business.
Step #4: Get an EIN
An employer identification number (EIN) is like a social security number for your business, which is used to identify your business on tax documents and other official documents.
Even if you don’t need an EIN, there are benefits to getting an EIN, like increasing your credibility as a professional and building your business’ credit history.
Not sure if you need an EIN for your business?
Then use these questions from the IRS to determine if you need one or not (and of course, check with your lawyer), which include:
- Do you have employees?
- Do you operate your business as a corporation or a partnership?
- Do you withhold taxes on income?
Sure, it might feel like an interrogation, but it’s worth covering your bases to operate a legit business.
And it won’t cost you anything but time.
You can apply and receive an EIN from the IRS for free by using this link.
Aside from an EIN, your business may also need a sales tax ID.
Step #5: Get a sales tax ID
There’s a good chance your state will charge sales tax on at least some of the products or services you offer.
To collect sales tax, you’ll need a sales tax ID from your state and/or city, which lets you both collect sales tax from customers and send it to your state or local government.
We’ll go over sales tax more in our next section, but it’s suffice to say that collecting and remitting sales tax is no joke.
For instance, if you don’t collect sales tax, you may be subject to penalties and fines and owe a backlog of years’ worth of sales tax.
Or worse, your state might think you’re collecting sales tax and keeping it for yourself, which falls into the category of fraud and needing to hire a lawyer.
It goes without saying that it’s probably less costly to steer clear of legal trouble.
So, it’s worth getting a sales tax ID and collecting sales tax from your customers.
OK. While you’ll be sending sales tax to your government (and likely more than you’d like to), you do get to keep some of your earnings.
This means you’ll need somewhere safe and secure to keep your income.
Although it may feel safe and secure, that place is not your personal bank account. If you want to keep your books clean, anyway.
Step #6: Open a business bank account
A business account isn’t a legal requirement per se, but it makes things much easier in terms of getting loans, being viewed as more professional by financial institutions and clients, and managing your business’ finances.
For example, in the past two years, a whopping 70% of business owners who didn’t have a business bank account were straight denied loans.
On the plus side, there are plenty of small business banking options available, regardless of where you’re based or how much money your business earns.
But even though a business bank account can keep your earnings secure, it won’t protect them from lawsuits -- you’ll need business insurance for that.
Step #7: Get business insurance
Though business insurance isn’t obligatory either, it’s wise to have.
Business insurance offers some protection in case you’re sued by a competitor or customer.
It’s a protection that a lot of businesses -- too many of them -- don’t have. 44% of businesses operating for over a year don’t have business insurance.
That’s an awful lot of businesses that could lose years of effort and potential earnings without having insurance.
Even if you think there’s a low chance of your business getting sued, or you think your budget would be better spent elsewhere, business insurance could be one of the smartest investments you ever make.
According to employment attorney, Jamie Dukovna, "[Not purchasing business insurance is] often a case of being penny-wise but pound foolish.”
“For some small businesses, they look at the cost and they say, 'Well, it's a little expensive, so I'm willing to take the risk.' But it's not cheaper to forego insurance when you need it and wish you'd had it," Jamie warns.
To protect your privacy even further, consider our final step to legally setting up your business.
Step #8: Get a business address and/or registered agent
When you send out your email newsletter, you’ll need to include your business address at the bottom of your email.
You’ll also need to share your address when registering your business’ domain name and other public-facing documents.
To keep your personal address secure, you may want to get a business address or P.O. box to stand in for your personal address, even if you work from home.
Besides a business address, you may also want, or be required to have, a registered agent.
A registered agent is a third party that accepts legal and official documents on your behalf, such as tax and compliance notices.
The registered agent then passes these documents on to your business. Some states allow business owners to be their own registered agents (here’s how to decide if you should hire a registered agent or be your own).
The purpose of a registered agent is for the government, or another entity, to have a reliable way to contact your business.
It provides an extra layer of security for your business, just in case:
- A business has an outdated address on file
- A business owner isn’t available to accept documents
- There’s another situation where the business owner claims they didn’t receive appropriate documentation.
Look at it this way:
Is it obligatory to have a registered agent or business address? No. You can, technically, skip both if you act as your own agent and use your personal residential address.
But if you’re making sales, you’re open to a host of legal challenges, and the value of the safety net of never missing a heads-up about those challenges cannot be overstated.
5 items to know about taxes for small businesses
With the legalities of running a small business covered, let’s next turn to managing your business’ taxes.
Item #1: Federal taxes
32% of freelancers decided to start freelancing after realizing they can earn more money that way.
However, many new freelancers often forget that income taxes, including federal taxes, can take a larger chunk of their earnings than they’re used to seeing on their W-2 forms.
Self-employed individuals must pay federal tax to the IRS on their income regardless of whether those earnings are from a side-hustle or full-time position.
To make paying quarterly taxes less of a hassle (if it’s applicable), consider using a small-business-friendly accounting program that helps you calculate your estimated tax obligation.
If you’re an entrepreneur in the E.U., Europa.eu’s business tax page gives you an overview of the taxes you may be subject to.
Though many freelancers gasp at the percentage of their earnings that go toward federal and other income taxes, chances are, you may get some of it back when you file your annual taxes.
In fact, 65% of small businesses received a tax refund in 2018, so, odds are you could get a tax refund, too.
Just work with an accountant, keep clean financial records, and claim certain tax deductions, such as:
- Advertising and promotion
- Business meals
- Business insurance
- Your home office
- Legal and professional fees
- Rent expense
Look, with few exceptions, self-employed people will need to pay federal taxes on their income each quarter.
Along with your federal income tax payments, you’ll likely need to pay quarterly state and local income tax rates, too.
Item #2: State and local taxes
Unless you live in one of the nine states that don’t have an income tax, you need to pay state income taxes on your self-employment earnings.
Like federal taxes, your state will probably require you to pay your state income tax on a quarterly basis. (But, like most of these legal and tax details in your business, make sure to check your state’s Department of State or Department of Revenue website to confirm.)
The third type of income tax you may need to pay is local tax, or a tax collected by your city or county.
According to a 2019 article by Tax Foundation, only 4,964 jurisdictions in 17 U.S. states collect a local income tax.
That being said, an accountant can give you a more up-to-date answer as to whether you are responsible for paying local taxes.
As much as I’d like to tell you otherwise, your tax obligations don’t stop there. A portion of your self-employment income will go towards paying self-employment tax.
Item #3: Self-employment and payroll taxes
Besides income taxes, self-employed individuals must also pay self-employment tax. At the time of writing, this tax consists of the 12.4% social security tax and 2.9% Medicare tax.
Typically, if you work for an employer, you and your employer split this tax bill. But as a self-employed entrepreneur, you’ll need to pay the full tax on your self-employment income.
Fortunately, the IRS lightens the burden of paying this 15.3% tax by allowing self-employed people to deduct the employer-equivalent amount (7.65%) when calculating their adjusted gross income.
Keep in mind that once you hire your first employee, you’ll also need to withhold federal income tax, social security, and Medicare taxes, and possibly additional Medicare taxes from employees’ wages. You’ll also need to pay federal unemployment tax.
I know, I know. So many taxes, right?
Before getting overwhelmed, though, the IRS’ employment taxes page gives you an overview of what you should know about paying taxes when you have employees.
The fourth and fifth taxes that creatives should be aware of come into play when you make a sale or purchase.
Item #4: Sales and use taxes
Of all the taxes small business owners are subject to paying, sales and use taxes can be the most varied and confusing.
To help you gain clarity on the subject:
Sales tax is a tax business charge on an item or service they sell. Businesses must send this tax to their state and/or local government.
Currently, only five American states don’t charge a sales tax -- Alaska, Delaware, Montana, Oregon, and New Hampshire.
However, states don’t always charge sales tax for every item or service businesses sell, so (again) check with your accountant to understand which of your products are sales tax eligible.
Helpfully, this sales tax calculator provides a ballpark figure of what you may need to collect in sales tax, too.
But depending on where your customers are located, you may also need to pay sales tax, particularly internet sales tax, to other states. That’s something you should definitely talk to your accountant about.
Now, let’s look at the sister tax to sales tax -- use tax.
Whereas sales tax is collected from customers by a business, customers must pay use tax to their local or state government. You’ll need to pay use tax if you don’t already pay sales tax on an item you purchased for your business (or yourself).
As with all other tax matters, keep all of your business-related receipts and consult with your accountant. That way, you’ll know when you should collect sales tax or pay use tax and avoid fines and fees.
Now, while income, sales, and use taxes will probably be the majority of your tax-related concerns, make sure to learn about any other taxes so you can avoid unexpected tax bills -- or additional taxes.
And the only way to do that is to, broken record alert, talk to an accountant at least once.
Item #5: Keep tidy financial records and hire an accountant
That being said, it’s no secret that business taxes can get knotty quickly.
27% of small business owners said that tax complexity was a critical problem in operating their business.
What’s more, 34% of business owners said tasks like tax accounting and cash flow also took away time from managing their business.
To reclaim your time and keep cleaner financial records, consider hiring an accountant.
Accountants can save you hours of effort and stress managing your business books.
Accountants also help you pay the correct amount in taxes. This freelancer underestimated how much she needed to pay in tax on her self-employment income and owed around $6,000 -- not a nice surprise.
Even if you use an accounting program for your bookkeeping, periodically consulting with a professional accountant can only be beneficial.
Accountants give you more personalized financial advice than an accounting program does, and they can also help you identify less well-known deductions to claim.
But whether you use an accounting program, accountant, or both, make sure to keep clean records of all of your business purchases, receipts, and other sales- and purchase-related details, so you can maximize deductions and avoid fines.
No, it definitely isn’t as fun as creating products -- to me, anyway. I’m sure some people enjoy it, and more power to them -- but it’s going to be way less fun if you get hit with surprise fees as soon as you start making money.
Don’t fear the legal and tax requirements of starting a business
Starting a business can seem scary when you consider the many legal and financial rules you need to follow.
From a legal standpoint, to run your small business:
- Pick a business structure and file with your state
- Learn applicable business laws
- Register a fictitious name
- Get an EIN and sales tax ID
- Open a business bank account
- Purchase business insurance
- Get a business address and hire a registered agent
In regards to taxes, be aware of:
- Federal taxes
- State and local taxes
- Self-employment and employment taxes
- Sales and use taxes
- Benefits from keeping clean financial records and working with an accountant
Of course, for extra peace of mind, talk with a lawyer and accountant to make sure there aren’t any other steps or rules you should know about.
P.S. Speaking of peace of mind, if you don’t yet have a platform for managing your homepage, leverage this 14-day no-obligation trial.
The streamlined dashboard and robust support lets you tackle any business hurdle with ease, especially when you have taxes and legalities to deal with.
Here’s to being legally fit and healthy tax-wise.
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