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Corporate Formation

Starting a business requires careful consideration of many options. The type of legal structure selected will impact how much the entity and its owner(s) pay in taxes, the amount of paperwork that must be filed, the division of liability, and the ability to raise money. Even after selecting a type of entity, circumstances may change and make a different structure more favorable, so it’s a good idea to evaluate options periodically. Below, we highlight entity choices and their general characteristics, advantages, and disadvantages. This is an overview, and we recommend obtaining expert business, legal, and accounting advice when making business decisions.



Choice of Entity:

Sole Proprietorship:

This is the simplest business structure, involving one individual owning and operating an enterprise. Profits and losses from the business are recorded on a form called Schedule C, and this information is then transferred to the owner’s personal income tax return, Form 1040. Business earnings are taxed only once, unlike other business structures. Sole proprietors are personally responsible for business liabilities. Individuals who start a business as a sole proprietorship and later decide to take on partners can reorganize as a partnership or other entity.

Partnership:

Partnerships are owned and operated by several individuals and can be general or limited. Partners in a general partnership manage the company and assume responsibility for the partnership’s liabilities. A limited partnership has both general and limited partners. The general partners own and operate the partnership and assume responsibility for the partnership’s liabilities, whereas limited partners invest only and have no business control and limited liability. A partnership does not pay tax on its income. Instead it profits and losses pass through to the individual partners. The partnership must file a Form 1065 to report its income and loss to the IRS, and each partner reports his or her share of the income and loss on Schedule K-1 of the Form 1065.

Limited Liability Partnership (LLP):

LLPs are partnerships in which partners are not generally liable for damages caused by actions or misconduct of the other partners. This structure can work well for professional partnerships and practices, like law and accounting firms, and physicians.

Limited Liability Company (LLC):

LLCs have a flexible structure, so they are generally a good option for startup businesses, projects, and joint ventures between companies. LLCs provide business owners with the liability protection of a corporation without the double taxation. Earnings and losses pass through to owners and are included on their personal tax returns. There is no limitation on the number of owners (members) that an LLC can have, and members can fully participate in the operation of the business. LLCs do not issue shares, however, so it can be more difficult to issue equity broadly. LLCs are generally easy to convert to a corporation.                                             

Corporation:

Corporations are more complex than other business structures. A corporation is an independent legal entity that can own property, have a bank account, file suit, etc. Corporations provide liability protection to its owner(s) and can sell stock to raise funds. Shareholders of a C-Corp pay taxes on dividends they receive, and the corporation itself pays taxes. In an S-Corp, only dividends paid to shareholders are taxed.

C-Corp:

C-Corporations have a complex statutory structure with strict governance rules, but it is easier to issue equity incentives to employees, consultants, and advisors. This is generally a preferred structure for businesses that will have significant investors and employees. C-Corporations provide liability protection to owners (stockholders) but are subject to double taxation because the corporation must pay corporate income tax, and earnings distributed to shareholders are taxed on personal income tax returns, as well. Corporate operation is overseen by a Board of Directors. The directors make major policy and financial decisions for the corporation. Directors are typically appointed by initial owners (shareholders), and they elect officers.        

S-Corp:

S-Corporations generally provide a good structure for small businesses that have a few employees and a limited number of investors. They can have up to 100 shareholders, but owners cannot be entities. They are generally more attractive to small business owners than C-Corporations because income and losses are passed through to individual shareholders (taxed as a partnership), while still providing liability protection to owners. S-Corporations must file articles of incorporation, hold directors and shareholders meetings, keep corporate minutes, and allow shareholders to vote on major corporate decisions. S-Corporations may only issue one class of stock; there is no preferred stock. S-Corporations can be relatively easily converted to a C-Corp.

Non-Profit:

A non-profit corporation is carried out for a charitable, educational, religious, literary, or scientific purpose. It does not pay state or federal taxes.

 

Basic Formation Steps:

Forming a corporation:

1.       Select a name. The name must differ from any other corporation’s name and include the words “corporation,” “incorporated,” “company,” or an abbreviation of one of these.

2.       Appoint initial directors of the corporate board.

3.       File Articles of Incorporation with the relevant Secretary of State. They usually include: the corporation’s name, the corporation’s address, the registered agent’s name and address, the directors’ names and addresses.

4.       Create corporate bylaws, which set forth operating rules of the organization.

5.       Hold a meeting of the Board of Directors to set the corporation’s fiscal or accounting year, appoint officers, adopt the bylaws, and authorize issuance of shares of stock.

6.       Issue stock certificates to initial shareholders. Corporations must comply with securities laws, including registration of their stock offerings with the Securities and Exchange Commission (SEC) unless they are exempt.

7.       Obtain appropriate licenses or certifications for operating business.

8.       Draft legally binding policies.

Forming an LLC:

1.       Choose a name for the LLC. The name must differ from other LLCs on file, contain a designation such as “Limited Liability Company,” “Limited Company,” “LLC,” “L.L.C.,” or “Ltd. Liability Co.,” and comply with state rules.

2.       File Articles of Organization with the relevant Secretary of State. They usually include: the LLC’s name and address, the names of members, and the name and address of the registered agent.

3.       Some states require that LLCs also create and file an Operating Agreement, which sets out rights and responsibilities of members of the LLC. The Operating Agreement also generally includes information about how the LLC will be managed, the members’ voting power, allocation rules for profits and losses, rules for holding meetings and taking notes, and provisions about buying and selling membership interests.

4.       Some states require publication of notice of intent to create an LLC.

5.       Obtain appropriate licenses and permits.

This is merely an overview of complex rules and regulations that can vary by jurisdiction, so we recommend obtaining expert business, legal, and accounting advice when making business decisions.

 

FAQS

Q. Which type of entity do I need?

A.  Each situation is different and mutable. There are advantages and disadvantages to each type of structure, and selecting the appropriate entity for your organization requires that you weigh all benefits and drawbacks, not only upon creation, but also periodically throughout the life of the organization.

Q. Why incorporate?

A.  Incorporating offers a liability shield which protects personal assets.

B.  Tax saving opportunities may available through careful planning and entity selection.

C. A corporation can more easily raise funds through issuance of stock.

Q. Do I need an attorney?

A.  Though most states don’t require an attorney for corporate formation, an attorney can help you navigate the complex decision-making process and streamline formation document creation, registration, and other filings based on their familiarity with laws and regulations.  

 

Q. Do I need a registered agent?

A. Most states require that an entity have a registered agent with a physical address in the state of formation. A registered agent accepts legal documents on an organization’s behalf to ensure timely action and response.

 

Q. What is the difference between common stock and preferred stock?

A. Generally speaking, while both types of stock represent a piece of ownership in an organization, owners of common stock typically have voting rights, whereas owners of preferred stock do not.

             

 

Q. Where should I incorporate?

A.  This depends on many factors, and the answer varies for different organizations. Some jurisdictions, such as Delaware and Nevada, are popular for incorporation because of a number of business- and owner-friendly laws and regulations, such as added liability protection and limited taxation. However, there are advantages and disadvantages to most jurisdictions, and organizations should consider all relevant options with the help of expert legal, business, and tax advice.

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