Why Form A Business Entity?
The main reason to form a business is to earn profit. Whether you operate as your own business or as a company or corporation or any other formal legal entity, the same reason applies – earn money. However, the law offers various protections when forming a business. The informed business owner should be familiar with the legal issues.
There are many legal issues to form a business. If you are operating a business venture in your own name then you are legally at risk. When you form a formal legal business entity, there are advantages and protections. The law recognizes a formal legal business entity as if it is a separate individual. This provides protections to the individual. That is, a business entity is assigned an employer identification number (EIN) similar to a citizen’s social security number (SSN) for tax purposes. The business entity can own, buy, and sell property. The business entity can also file lawsuits against other people and businesses, and it can also be sued. In fact, a business entity can even be found guilty of committing criminal acts. In essence, the business is separate from any individual – this separation is beneficial.
It is important to decide on the right business entity. There are different entities that have advantages and disadvantages as compared to other business forms.
The main incentive of forming a legal business entity is to limit any exposure to personal debts and liabilities that could happen when running a business. Most business entities provide limited liability protection and a “veil” that separates an individual’s personal assets from the business assets. Civil judgments and debts of the business can only be satisfied by the assets held in the name of the business entity.
What Is Piercing The Corporate Shield?
The business entity must always be lawfully operated and maintained. There is an exception to the corporate shield protections. In the law, “piercing the corporate veil” is when the business owner’s personal assets can be used to satisfy any debts, obligations, or judgments. This happens when the business owner fails to comply with legal formalities, fails to adequately capitalize the business, commingles business and personal assets, or uses the business to commit a fraud. In these situations, the limited liability protection will be lost and individual business owners will be held personally liable.
What Are The Different Types Of Entities Used To Form A Business?
There are many different types of business creation formations. The most common are Sole Proprietorships, General Partnerships, Limited Partnerships, C Corporations, S Corporations, Limited Liability Companies, and Nonprofit Corporations.
A Sole Proprietorship is an unincorporated business that is run by a single person. Forming a Sole Proprietorship does not need formal action. It is the simplest and least expensive business form. Sole Proprietorships can automatically result from conducting business. There is no limited liability protection. A Sole Proprietorship does not create a legal separation between you and your business. Rather, you are personally liable for the business. All expenses, debts, and obligations of the business belong to you.
When two or more people want to conduct a business as co-owners this can be created by entering into a partnership agreement, or when the partners act in concert. There are no formal filing requirements to create a partnership. In fact, there does not even need to be a written partnership agreement for the parties to form a partnership. A partnership can be formed simply by the conduct of the parties. This is not always good because you can unknowingly find yourself liable for your “business” partner’s wrongful acts and debts even though you did not have a written agreement. Although the partnership acts as a separate entity, each partner has unlimited liability in respect to his own acts and the acts of other partners. This means creditors can also reach all partners’ personal assets to satisfy any partnership debts and obligations.
A Limited Partnership (LP) is another version of a partnership. A limited partnership includes a combination of general partners and limited partners. The general partners manage the business and take on personal liability for the business. The limited partners only contribute capital. The limited do not take part in the management of the business. As a result, limited partners only have limited liability up to the amount of their capital investment in the business.
A C Corporation offers a legal and formal separation of owners and the corporation so shareholders (the business owners) do not become personally liable for the corporation. C Corporations are subject to double taxation. The corporation is taxed on its net income. The shareholders are also taxed when the corporation distributes profit. C Corporations are best if you want to attract outside capital investment. C Corporations also allow the company to make public offerings of its shares. The corporation will need to select an underwriter to prepare an Initial Public Offering (IPO) and have the corporation’s shares placed on an exchange market such as the New York Stock Exchange (NYSE) or the National Association of Securities Dealers Automated Quotations (NASDAQ) Stock Market. Public investors can then purchase the shares.
S Corporations are formed when the business files a special tax status with the Internal Revenue Service (IRS). This allow for “pass through” taxation. The corporation files no tax on the corporate level. Rather, the shareholders are only subject to taxation on their personal level when the company distributes profit. However, S Corporations have specific restrictions on who can be a shareholder, the amount of shareholders, as well as the stock classes.
Limited Liability Company
A Limited Liability Company (LLC) provides for a combination of a corporation’s limited liability protection with the “pass through” tax efficiency and operational flexibility of a partnership. There are less formalities and filing requirements for an LLC as compared to a corporation. However, an LLC Operating Agreement should be drafted and signed by the members. The Operating Agreement dictates the rights of the members and how the company will be managed.
When you want to support a charitable cause with your company, a nonprofit corporation should be considered. A Nonprofit can give you benefits like grants, income exceptions for sales and property taxes, low-cost postage rates, and receive donations tax free. A nonprofit must be registered in the state it operates and be filed with the Internal Revenue Service in order to receive a tax-exempt status pursuant to Section 501(c)(3) of the Internal Revenue Code. The Nonprofit organization must generally be charitable and not-for-profit. It cannot benefit any private interests. It may make a profit, but it must be for a public interest. A Nonprofit must be organized and operated for religious, charitable, scientific, educational, or literary purposes.
Which Is The Best Entity To Form A Business?
The current trend has favored Limited Liability Company. This is because the LLC is very easy in terms of legal formalities, capable of raising capital, flexible tax treatment. This is good for small businesses. For large corporations, a C-Corporation is generally the best route to take if you want your business to raise investment in the future or offer ownership in your business to the public. This involves a lot of legal responsibility. If you want your business to achieve other goals, other business forms may be a better fit. There are a wide variety of business structures to choose from like corporations, limited liability partnerships, or limited liability companies. Choosing the correct business structure is important because it limits liability. It is best to seek the advice of an experienced business attorney.
What Is Needed To Form A Business?
Each business entity has specific formal filing requirements. Depending on the type of business entity, some of the documents that are part of the organization and structure of a new business entity can include:
- Articles of Incorporation
- Shareholder Agreements
- Articles of Organization
- Operating Agreements
- Partnership Agreements
- Employment Agreements and Policies
- Independent Contractor Agreements
What Are The Benefits To Form A Business?
Limited liability refers to the legal division between the individual owners of the business and the actual business entity. This protects the owners from personal responsibility, business debts, or a business issue. A business structure with limited liability means only the company can be sued, not the individual owners or investors.
Certain types of business entities offer more tax advantages than others. It is important to consult with an experienced accountant or tax professional when choosing which business form is best for your particular situation. The correct entity form and tax structure could lead to major savings.
Conducting business through a formal entity makes your business look more official to investors, customers, or vendors.
Transferring Interests of Ownership
If you do not form a business entity, you are by default conducting business as a sole proprietor or general partnership. In these situations, the business only exists as long as the sole proprietor or partners are active. The business terminates when they stop conducting business or pass away.
On the other hand, if you form a business entity, the business can survive in perpetuity. Ownership of a business entity can be transferred and the business can continue forever. Corporations are the most flexible business structures to transfer. C Corporations have no legal restrictions on the number or types of shareholders. Whereas if you choose the S Corporation Election, there will be restrictions on the number and type of shareholders but you will get the benefit of pass-through taxation. The S Election allows the business profits to pass through and only be taxed on the personal income level of the owners.
If your business consists of only a few owners, it is considered “closely held”. If you intend to only transfer ownership to an existing member, partner or an individual in the business, a Limited Liability Company may be the preferred business structure. LLCs provide the protection of the corporate shield but the flexibility of a partnership. LLCs are governed by agreements amongst the members which dictate how ownership may be transferred.
What Are The Costs To Form A Business?
There are various costs to form a business entity. Each state has its own required fees to register the business with the state’s Secretary of State and the cost to conduct business within a particular state.
In California, the types of fees to form a business entity include: government filing fees to the Secretary of State; state franchise tax; state and federal corporate tax; and attorney fees to draft bylaws, operating agreements, shareholder agreements, and other business contracts.
Government Filing Fees
In California, filing the Articles of Incorporation for a corporation or the Articles of Organization for an LLC with the Secretary of State is required. The initial filing fee is $100 payable to the California Secretary of State. Other states may charge different fees. In California, additional fees must also be paid to the Secretary of State. For instance, Statements of Information must be filed with the Secretary of State every year for corporations and twice a year for LLCs and nonprofits. The filing fee for corporations is $25. For LLCs and nonprofits, the filing fee is $20. If the Statement of Information is filed late, there is a $250 penalty. You can obtain the specific state’s filing and fee information by visiting the Secretary of State’s website.
Annual Franchise Tax
In California, the franchise tax is an annual $800 fee paid to the Franchise Tax Board (FTB) for the privilege of doing business in the state. In other states, this fee usually ranges from $800 to $1,000. Some states only charge this fee upon initiating a business and not yearly. Some states do not even charge this tax at all. For instance, Nevada does not have a franchise tax in order to attract business owners into the state.
A corporation is considered a separate legal entity. Therefore, the shareholders of a corporation only pay taxes on corporate profits paid to them. The shareholders are responsible to pay personal income tax on their salaries, bonuses and dividends. The corporation itself must pay taxes on any profits at the corporate rate.
It is important to work with an experienced attorney when forming and operating a business. It is not advisable for business owners to incorporate and draft agreements on their own. Mistakes can have significant legal consequences and it is best to work with an attorney.
Where Should I Form A Business?
Delaware seems to be the most preferred state to form a business. Delaware is favorable for venture capitalists because it has an extensive body of laws favorable to corporations.
Other states may be a better choice however because of different circumstances. For instance, if you intend to do business in only one state, it is best to incorporate in that particular state. If your business is incorporated in one state but conducts business in another state, that business will be subjected to two state tax requirements.
For example, in California all “foreign corporations” must still also pay an annual franchise tax if it conducts any business in the state, even though the entity may be formed in another state.
Other factors to consider when incorporating include: What is the tax rate in the state of incorporation? How do the government filing fees for incorporation compare to the state in which the business is based?
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