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What Is Business Formation?
Gerri Detweiler
It’s easy to start a business in the U.S. In many cases, you can simply start selling the products or services you have to offer. Sure, there will be taxes to deal with and you may have to get a business license, and some businesses require startup capital, but in many cases you get a business up and running fairly easily.
Business formation is the process of legally forming a business structure such as an LLC, S Corporation, C Corporation, Limited Partnership or nonprofit corporation. Properly creating and maintaining a business entity can provide legal protection and tax benefits.
Forming a legal entity can also make it easier to build business credit and to get some types of financing. Certain lenders will not lend to individuals who have not set up an entity for their business.
The Benefit Of Using A Business Formation Service
Forming a business entity requires filing paperwork with the state, paying filing fees, and following certain procedures (“formalities”) to maintain the legal structure of the business. You may also be required to create and maintain certain documentation such as an operating agreement or articles of incorporation and bylaws, appoint a registered agent to receive legal documents for the business, and maintain certain records.
Setting up a business entity can be a DIY project: there are certainly many resources available online to help. However, a business formation service can streamline the process so you can focus on other aspects of your new business. It may also offer other services you may need, such as registered agent or trademark registration services, for additional fees.
Warning: A business formation service may or may not provide legal advice, depending on services offered. If you want legal advice for setting up your business, make sure you talk with an attorney or hire a law firm.
What Are The 4 Types Of Business Organizations?
There are myriad ways to run your business. We’ll cover the four most popular types of business structures here.
- Limited liability company (LLC)
- S Corporation
- C Corporation
- Partnerships
There are other business structures that may be used, including Professional Associations (PA), nonprofit corporations, or Benefit Corporations (B-Corp). Here we’ll focus on the four more common business structures listed above, but keep in mind there are others that may fit your business goals.
Comparing Business Entity Types
Here is a quick comparison of the most popular types of business structures. Be sure to get legal, tax or professional advice for your individual situation.
| Type of Entity | Formation Process | Personal Liability Protection | Taxes |
| Sole Proprietor | Not required to file with state, though business license or name may require registration | None | Taxes flow to personal income taxes |
| LLC | File with state, annual report filing typically required | Members are not personally liable | Taxes flow through to members. May elect to be taxed as a corporation |
| S Corp | File with state, annual report filing typically required | Shareholders not personally liable are not personally liable |
Taxes flow through to shareholders. Owners may be able to reduce taxes through payroll plus distributions |
| C Corp | File with state, annual report filing typically required | Shareholders not personally liable | Double taxation: corporate profit taxed at corporate rate and dividends pass through to shareholders taxes |
| Partnership | File with state, annual filing rarely required | None for general partners, limited partners not personally liable | Taxes flow through to partners |
Pros and Cons of Each Type of Entity
Each type of business structure has advantages and drawbacks. Here are some of the highlights.
Sole proprietorship
Although it’s not a legal entity, it’s worth mentioning the benefits of operating as a sole proprietor. This is the most common way U.S small businesses operate, especially businesses with few employees. There is no business entity formed; instead, an individual simply starts to conduct business. (A business license and a taxpayer identification number may be required.)
Taxes flow through to the personal tax return and the owner must pay the full share of Medicare and Social Security taxes. Don’t forget that as a sole proprietor you will likely have to file quarterly estimated taxes, which includes the full amount of Medicare and Social Security taxes which are normally split between the employee and employer.. (Learn about taxes at IRS.gov in the Small Business and Self-employed Tax Center.)
Even though it’s simple to set up, make sure you follow business licensing requirements and find out if you need to register your business name with your state. This is often done by filing a fictitious name (also called “DBA” or “doing business as”) with your state department of corporations or similar organization.
Pros
- Easy to start
- Inexpensive
- No state filing requirements
Cons
- No personal liability protection
- May limit financing options
- Can be harder to build business credit
- Business name will not be protected unless fictitious name is filed
LLC
This is a popular business entity due to its flexibility and the relatively easy requirements to form and maintain an LLC. An LLC will be managed by members. A single-member LLC is owned by one person, while multi-member LLCs can be owned by multiple individuals. An operating agreement outlining how the business will be run may be required in some states, but it is a good business practice even when it’s not required.
An LLC is a pass-through entity which means profits pass through to the member’s individual tax returns. Medicare and Social Security taxes may raise the tax burden of the individual member. An LLC may choose to be taxed as an S Corp or C Corp.
Pros
- Fairly easy to set up
- Easier to maintain than corporations
- Relatively inexpensive
- Limited liability
- Pass through taxation
- Can elect to be taxed as a corporation
Cons
- Filing fee required
- May require annual filing
- Individual taxes may be higher
S Corp
Technically an S Corporation isn’t a type of corporation, but instead you form a corporation then elect to be taxed as an S Corporation by filing IRS Form 2553. (Note that LLCs may also choose to be taxed as S Corps if they qualify.)
To qualify to be taxed this way, you’ll have to meet certain requirements. No more than 100 shareholders may own stock and shareholders can’t be other entities or nonresident foreign individuals.
You’ll file articles of incorporation (or a similar document) with your state, and bylaws will be required. Corporations require a board of directors, though in many states only one or two directors are required.
S Corps are also pass-through entities for tax purposes. It may be possible for owners to pay themselves a reasonable salary and also receive dividends (or distributions). Medicare and Social Security taxes must be paid on the salary, but not on dividends. (Consult with a tax professional if you pursue this strategy as it has received heightened scrutiny by the IRS in recent years.)
Pros
- Limited liability
- Pass through taxation
- Can elect to be taxed as C corporation
- May be able to reduce Social Security/Medicare taxes
- Easy to transfer ownership
Cons
- Limited to 100 shareholders
- Only one class of stock permitted
- Nonresident aliens may not be shareholders
- Profits and losses must be distributed in proportion to shares
- Annual filings and annual meeting required
- Corporate formalities must be followed
- Higher accounting fees
C Corp
A C corporation is a corporation that defaults to the taxation scheme found in the IRS code. With a C Corp you can have an unlimited number of owners and different classes of stock (such as preferred and common stock).
A C Corp is often the entity of choice for entrepreneurs that plan to raise significant amounts of investment capital or take a business public in the future.
Corporate taxes must be paid by the corporation, and shareholders will pay taxes on gains from dividends or sale of stock. This can result in what’s often referred to as “double taxation.”
Articles of incorporation or a similar document, such as articles of organization, and bylaws must be filed with the state. Most states also require corporations to file annual reports and pay fees ranging from $0 to several hundred dollars.
Pros
- Unlimited number of shareholders
- Foreign shareholders allowed
- Different classes of stock
- Attractive business entity for investment capital
Cons
- Expensive to form and maintain
- Significant corporate formalities
- Double taxation
- Higher accounting fees
Partnerships
Partnerships generally have two or more partners. There are three possible types of partnerships: limited partnership (LP), limited liability partnership (LLP) and general partnership. (General partnerships are equivalent to sole proprietorships, but with two or more people instead of one and we won’t elaborate on that option here.)
LLPs only have limited partners while LPs will have both general and limited partners. General partners have unlimited liability. Limited partners do not. LLPs may be a good option for legal or medical practices that do not want to form a corporation.
Taxes pass through to the individual’s income tax returns.
In most states you’ll file a certificate of limited partnership (or limited liability partnership). A partnership agreement will not be required by the state, but is still essential.
Pros
- Limited partners can invest in business without exerting control
- Limited partners generally avoid personal liability
- Limited partners may avoid self-employment taxes on profits
Cons
- General partners are personally liable for debts
- No option to be taxed as an S Corp
How To Choose The Right Business Entity For You
There are many considerations when setting up a business entity and no one size fits all. You’ll want to answer questions such as:
- How many owners or partners will the business have?
- Who will make decisions about the business?
- How many shareholders will the business have?
- Will any shareholders be other business entities or nonresident foreigners?
- Do you want flexibility in determining how profits or losses are distributed?
- Are you willing to devote time to adhering to corporate formalities such as annual meetings and corporate minutes?
- Which state is best to establish the business?
- What is the cost of setting up the entity and then maintaining it each year?
- What are the tax benefits of each structure?
- Do you plan to sell the business in the future?
- Will the business go public at some point?
- What happens if the business fails?
You can then discuss these answers with a business formation expert or an attorney if you want legal advice.
Sometimes it makes sense to create multiple business entities. For example, a real estate investor may hold individual properties in several LLCs but then also create an S Corp as a management and marketing firm.
FAQs
What is required of business entities?
Regardless of the entity you choose, keep these additional pointers in mind.
1. Always use a business bank account. That’s a good practice if your business is a sole prop, and absolutely essential if you are using a legal entity. Mixing business and personal finances can put your legal structure and personal assets at risk.
2. Get the right insurance. Business owners should consider an insurance policy as the first line of defense against the myriad claims business owners may face.
3. Get licenses. Depending on your state’s licensing requirements and the type of business you operate, you may need to get any number of licenses, such as a business license, professional license, occupational license or more. Failing to do so could result in fines, or in some cases, put you out of business.
4. Understand the requirements for maintaining your business structure. Making sure contracts or invoices are written in the name of your business, not personally, keeping up with annual filings if required, and making sure you file all required tax forms are all vital steps for maintaining the integrity of the legal structure you’ve created. Take time to understand and follow them.
5. Be aware of personal guarantees. Even though many legal entities offer personal asset protection, it’s still possible for the business owner to be held personally liable for business debts or for actions of the business. Usually that arises when the business owner signs a personal guarantee or pledges personal assets as collateral. If the business does not maintain corporate formalities, personal assets may be at risk.
When starting a new company, you may have to provide personal guarantees because the business doesn’t have its own track record of revenues or business credit. Most of the major small business credit card issuers require personal guarantees, for example. But as your business grows you’ll want to build business credit and strong revenues so the business can stand on its own.
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