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Business Basics Series: Entity Formation and Documentation

Posted by Res Nova Law | Jun 10, 2021 | 0 Comments

What are the entity types and how do I select one?

Before you register your business, it's important to consider the best entity type to register. Choosing the appropriate business entity type is important because it can impact how your business is run. You need to consider the purpose of your business and the amount of control you would like to have. Your choice can also affect how much you pay in taxes, the forms you are required to file, your personal liability, and your ability to raise money. Although you may be able to convert to a different business structure later, it is important to carefully consider which structure is appropriate when starting your business because there may be some restrictions associated with changing entity types. The most common types of business entities are sole proprietorships, partnerships, limited liability companies (LLCs), corporations, and cooperatives.

A sole proprietorship is likely the most prevalent entity type and easy to form. By operation of law, your business is considered a sole proprietorship if you conduct business activities but do not register for any other type of business entity. However, because your business assets and liabilities are not separate from your personal ones, you may be personally liable for debts and obligations of your business. Your ability to raise money may also be limited because you won't be able to sell membership units or shares. However, a sole proprietorship is a good option if you want complete control of your business without any requirement for registration and renewal of a separate entity.

A partnership is for two or more people who own a business together. The two common types of partnerships are limited partnerships (LPs) and limited liability partnerships (LLPs). LPs have only one partner with unlimited liability, while all other partners have limited liability. The partners with limited liability will have limited control over the company as documented in the partnership agreement. Profits are passed through to the partners' personal tax returns and the partners with limited liability must also pay self-employment taxes. By contrast, LLPs gives limited liability to all partners and if the partnership fails, prevents your partner's creditors from coming after your personal assets and vice versa. Profits are passed through to personal tax returns.

Limited Liability Companies (LLCs) protect the owners (known as “members”) from personal liability in most case, including if the LLC faces bankruptcy or lawsuits. Profits and losses are passed through to the members without taxation of the business itself. LLCs can have a limited or perpetual existence in most states, although some states may require an LLC to be dissolved and reformed if a member joins or leaves the LLC.

The main types of corporations include a corporation (C Corp), an S corporation (S Corp), a benefit corporation (B Corp), close corporation, and a nonprofit corporation.

A C Corp is a legal entity that is separate in existence from its owners and can make a profit, be taxed, and be held liable separately from its owners. While C Corps provide the highest protection against personal liability, the cost to form a C corporation is higher than other entity types and requires more extensive reporting, record keeping, and reporting by its shareholders, officers and directors. C Corps are also subject to double taxation; once when a profit is made and again when dividends are paid to shareholders. C Corps can continue to do business even if a shareholder leaves, unlike LLCs in some states. C Corps can raise capital by selling shares in the business. An S Corp is a special type of corporation that allows its shareholders to avoid double taxation by allowing profits and some losses to be passed through to shareholders' personal income without being subject to corporate taxes. S Corps are restricted in that all shareholders must be U.S. citizens and the total number of shareholders cannot exceed 100.

A B Corp is recognized by most states and is a for-profit corporation. B Corps are similar to C Corps in how they are taxed; however they are different in purpose, accountability, and transparency. B Corps are accountable to their shareholders for a specified public benefit, as well as for a financial profit.

A nonprofit corporation is organized to do work that benefits the public and can receive tax exempt status as a result. The organizational rules for non-profits are similar to a regular C Corps, but there are special rules that must be followed regarding profits.

A cooperative is owned by and operated by those who use the services. It is not designed to maximize profits but to fill the needs of the members. An elected board of directors and officers run the cooperative while user-owners have voting rights. Shares can be purchased, but their ownership does not affect the amount of voting power a person may have.

What Formation Documents Do I Need?

Once you have decided on the best entity type for your business, you will need to register with the state in which you want to form your entity. In Oregon and Washington, this is done through the Secretary of State. A federal Employer Identification Number (EIN) is necessary for some business entities and can be obtained from the IRS. You may also need a tax ID number and to file for local and municipal business licenses and permits.

The main organizational documents for C Corps and S Corps are the Articles of Incorporation and the corporate Bylaws. The Articles of Incorporation need to be filed with the state of incorporation. The information contained in the document will vary per state but typically contains information such as the business name, address, purpose, registered agent, etc. Corporate bylaws explain how control within your organization is split and how your business is to be run on a daily basis.

The organizational documents for LLCs are the Articles of Organization and the Operating Agreement. Articles of Organization establish the LLC in the state of filing and contain the same basic business information as the Articles of Incorporation, i.e., business name, address, registered agent, and purpose. Like Bylaws, an LLC operating agreement will provide information about how control within your organization is split and how the business is to be operated on a daily basis.

For assistance with entity formation and organizational documents, be sure to consult an experienced business lawyer. Res Nova Law attorneys can help you with that or we can refer you on if it's not a good fit.

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