One of the first steps in starting a business is to pick the type of entity you will use for your business. There are many options for entity selection, and advantages and disadvantages for each option.
The majority of for-profit companies are corporations. Corporations are formed under the laws of a state or the District of Columbia and each state’s rules vary. Corporations must follow the rules of that state – which can be stringent. Corporations are governed by a Board of Directors, require annual meetings and have certain limitations on the issuance of stock. Additionally, corporations are subject to a “double taxation” – the corporation is taxed on its profits and then the shareholders are taxed on their distributions. Corporate entities, however, provide limits on liability of shareholders, directors, and officers for the debts and obligations of the corporation and easily accommodate future growth and investment.
If certain requirements are met, corporations may elect to be treated as “S” corporations and have the corporation’s income and losses passed through to the shareholders who report such income and losses on their individual income tax returns. This effectively eliminates the “double tax” found in “C” corporations. To elect to be treated as an “S” corporation, among other requirements, a corporation must have fewer than 100 shareholders, have one class of stock and its shareholders must be natural persons (subject to some exceptions). “S” corporations are frequently used in situations where the owners want the advantage of pass-through taxation now, but want to maintain the ability to easily convert to a “C” corporation if preferred stock is desired or venture capital funding is obtained in the future.
Many businesses are formed as partnerships between two or more individuals. General partnerships provide for the same flow-through taxation as “S” corporations, but come with the disadvantage that all the partners remain personally liable for the debts and obligations of the partnership. With a limited partnership or limited liability partnership structure, the limited partners can insulate the investors from liability, but the investors are not able to participate in the management of the business.
Limited liability companies have fast become the preferred form of entity for businesses with the advantages of both partnerships and corporations. With “check the box” regulations from the IRS, LLCs can opt to be treated as partnerships (with “flow through taxation”) or corporations for federal income tax purposes while providing “corporate-style” limitations on liability for owners. Members of the LLC enter into an operating agreement providing for the management and operation of the LLC. Most state laws provide maximum flexibility in drafting these agreements with very few mandatory provisions. LLCs are not typically used in situations where you intend to raise additional money from new investors in the future, or when you intend to grant options to employees or consultants.
With respect to whichever entity choice works in your situation, formation is typically a straightforward process. A public document – Articles of Incorporation or Certificate of Formation – is prepared and signed by a representative of the entity. That public document is then filed with the state of formation. Depending on the state, filing results can come back the same day or within a few days. Next, the organizational documents of the entity are prepared and signed. For a corporation, that entails bylaws and organizational consents signed by a Board of Directors. For LLCs and partnerships, an Operating Agreement or Partnership Agreement is prepared and signed by all the members or partners detailing the rights and obligations of the owners and describing the governance of the entity. Typically the bylaws, Operating Agreement or Partnership Agreement are not made publicly available; but are kept with the organizational records of the entity.