Business Entity Formation

The first step in starting any business is choosing the right structure. Often, business owners will consult with a lawyer before they start a company to make sure that all of their forms are in order. Business owners can choose from common business structures like sole proprietorships, C corporations, partnerships, limited liability companies (LLC) and S corporations.

An LLC is considered an entirely separate entity from the business owner. This means that the corporation is responsible for the debts and keeps the profits. If the business fails, the owner is not liable for the losses. It is taxed like a sole proprietorship if there is one owner. When there are multiple owners, an LLC is taxed like a partnership. With an LLC, there is not limit to the number of owners in the company. It is governed by operating agreements and is not required to hold annual meetings. Business owners often choose this type of entity because it allows them to separate their business debts from their personal assets.

Benefits:

1. Pass-Through Treatment: Profits and losses enjoyed by an LLC can pass directly through to the owners.
2. Extremely Flexible: An LLC offers flexible ways to distribute and allocate assets.
3. Protects Against Personal Liability: Lawsuits and debts are held by the business instead of the owners.

Drawbacks:

1. Limited Capital Structure: It can be extremely expensive to grant options or issue securities in an LLC.
2. Complexity: General taxes, partnership tax rules and other regulations make an LLC exceptionally complex when it comes to accounting.
3. Unattractive to Investors: Venture capitalists generally do not invest in these companies because they are pass-through entities.

A sole proprietorship is when the owner is personally liable for any debts or lawsuits incurred by the business. States do not require a separate business form or taxes to be filed by the sole proprietorship. Instead, the owner reports all of the company's profits and losses on their own tax return. While a sole proprietorship is easier to create and operate, it does leave the business owner liable for any lawsuits or costs incurred by the company.

Benefits:

1. Inexpensive: Organizational documents, filing fees and legal fees are not required.
2. Avoid Double Taxation: Unlike a C corporation, the owner and the business pay taxes together. This means that the owner is not taxed twice on some of the company's income.
3. Simplicity: Owners do not have to file any documentation other than possibly registering the company's name.

Drawbacks:

1. High Personal Liability: The owner is liable for all of the debts, liabilities and lawsuits faced by the business.
2. No Continuity: If the owner dies or is incapacitated, the business stops existing.
3. No Equity Issuances: Sole proprietorships are owned by just one person, so the company cannot issue equity to investors or employees.

A C corporation is considered an independent tax and legal structure. This means that all of the company's debts are held by the business and not by the individual. A C corporation can have an unlimited number of shareholders. Shareholder dividends and corporate profits are taxed separately from the business owner. In addition, a C corporation is required to hold annual meetings and record their minutes from the meetings.

Benefits:

1. Protects Against Personal Liability: A C corporation ensures that investors and owners are only liable for the amount of their respective investment.
2. Flexible Capital Structure: C corporations allow businesses to issue stock and gain investors.
3. Attracting Venture Capital: Due to the way that a C corporation is designed, it is much easier to attract C corporations.

Drawbacks:

1. Expensive to Set Up: Compared to other business entities, C corporations cost more to set up and require more forms to be completed.
2. Not a Pass-Through Entity: Since this is not a pass-through entity, it is subject to double taxation.
3. Record Keeping and Formalities: Corporations are required to file a certificate of incorporation, elect a board of directors, hold annual meetings, adopt bylaws and follow a number of other laws. Without exceptional experience or legal advice, it can be challenging to comply with all of the regulations and formalities.

With an S corporation, the legal and tax structure is separate from the business owner. Unlike a C corporation, an S corporation can only have a limited number of shareholders. These shareholders must all by United States residents or citizens by law. Like a C corporation, an S corporation must record meeting minutes and host annual meetings. At the end of the fiscal year, the owner reports all of the profits and losses from the company on their personal tax return. One of the benefits of using an S corporation is that it allows you to separate your personal finances from business debts.

Benefits:

1. Pass-Through Treatment: Profits and losses from an S corporation flow directly to the shareholders. If the business is enjoying significant profits, this is ideal for individual shareholders.
2. Simple Conversion: As the business grows, owners may want to convert it to a C corporation to gain venture capital. With an S corporation, it is relatively easy to change to a C corporation.
3. Protects Against Personal Liability: Like a C corporation, an S corporation provides investors and owners protection against the company's debts and liabilities.

Drawbacks:

1. Significant Formalities: Similar to a C corporation, an S corporation requires the business to follow regulations regarding bylaws, annual meetings and record keeping.
2. Shareholder Limits: An S corporation limits shareholders to United States citizens or residents. Legally, shareholders are capped at 100.
3. Limited Capital Structures: An S corporation may only be able to have one type of stock and cannot issue common stock.

The last major business entity is the partnership. Like a sole proprietorship, partners in the business are liable for debts and lawsuits that are filed against the business. Any owners in the business have to report their part of the profits or losses on their personal tax returns. This type of business entity is typically chosen because it is easy to create and operate. There are generally minimal filing requirements in each state for a partnership, so it takes a short amount of time to set up.

Benefits:

1. Inexpensive: Most states have minimal laws regarding partnerships, so setting them up is relatively inexpensive. The main cost will be due to legal fees from drafting a partnership agreement and registering the company's name.
2. Simple to Create: Most states do not require a partnership to be registered, so it is fast to set one up.
3. Separate Legal Entity: In the majority of states, a partnership is a separate legal entity from the individual. Real estate and property can be owned in the name of the partnership.

Disadvantages:

1. No Investors: Outside investors are not allowed in a partnership, so the business cannot raise capital from outside investors without making them a partner.
2. Unlimited Liability: Each partner assumes unlimited liability for the business, their partner's actions, debts and lawsuits.
3. Fiduciary Obligations: Each partner has a fiduciary obligation to all of the other partners. They are held to a high standard regarding disclosing their finances, conflicts of interest and other business-related matters.

When starting a business, individuals should always begin by hiring a lawyer. Attorneys who are experienced with creating corporations can provide advice on the type of business entity that would work best in each situation. For more complicated business entities, a lawyer can also assist with filing the forms and complying with legal regulations regarding the company's operations.