Business Entity Formation: What is it and Why is it Important

Perhaps the most important choice business owners face is choosing which type of business entity to operate under. Forming a business entity is an essential way to protect yourself from liability, to save money on taxes, to create structured business operations, and to build a solid foundation for your business. Everyone wants their business to succeed, so choosing the correct type of business entity for your goals can significantly affect your business’s success and its ability to meet future needs.

A business entity refers to how the business is structured and managed rather than what it does. Business entity formation is the process of choosing what type of structure and management will be best for the business as well as accomplishing the economic and legal steps to form that entity. Legally speaking, a business entity is considered a separate “person” from the owner.

What are my Options?

Sole Proprietorship: You may have heard of sole proprietorships. A sole proprietorship is a single entrepreneur (or married couple) who owns an unincorporated business. Often a common choice for start-ups, sole proprietorships are inexpensive and flexible since there are fewer legal controls. Sole proprietors are personally liable for the debts of the business. It is very important to note that a sole proprietorship offers no protection to its operators because it is not actually a business entity at all. In fact, it designates that no formal entity has been created.

Partnerships: A partnership is the relationship between two or more people to do trade or business. A partnership is formed when each member contributes money, property, labor or skill, and shares in the profits and losses of the business. Generally, the partners have equal say in business decisions and are equally personally liable for business debts. However, the partners can decide to draft a Partnership Agreement, which may designate percentages of ownership corresponding to the value contributed (in cash, property, etc.) by that partner. Many states offer protection to the partners if the entity is formed as a “Limited Partnership” or “LP.”

Limited Liability Company (LLC): Probably the most popular of all entity types, a limited liability company is formed by one or several individuals or entities coming together to form a business. Most states do not restrict ownership, so members may include individuals, corporations, other LLCs, and foreign entities, and there is no maximum number of members. Most states also permit “single-member” LLCs, or a business with one owner. An LLC is usually governed by an Operating Agreement that details the management of the business, the distribution of the profits and losses, and the appointing of interests.

In many states, the LLC can be managed by either the members or by designated managers. The Operating Agreement will state that both owners and managers of the LLC are not personally liable for business debts. Many people choose an LLC because of its tax advantages. An LLC can choose to be taxed as a partnership (pass through), as an S-Coproration, or as a Corporation.

When compared to a corporation, an LLC’s company records are easier to manage, but it is more difficult to transfer LLC membership than it is corporate stock. Professional LLCs (PLLC) are designated in some states for professional classes such as architects, attorneys, and engineers.

Corporations: In forming a corporation, prospective shareholders exchange money, property, or both, for the corporation’s capital stock. It is relatively easy to add new shareholders to the corporation or to transfer shares from one person to another. If a business is seeking investment capital from banks, private investors or angel funds, corporations are often the best entity to attract them. Those who form the corporation are not personally liable for the corporation’s debts. However, it costs more to form a corporation, and to keep the extensive corporate records up to date. Corporations must have a board of directors that sets policies, oversees the business, and chooses the President or Chief Executive Officer of the company.

Depending on the state in which you form your corporation, there are variations, such as Close Corporations and Subchapter S Corporations.

Choosing the Right Entity for Your Business

Different business needs naturally require different entity formations. As a business owner, it is critical to know these needs in order to select the right entity for your business. How important is it for you to be protected from personal liability? How much flexibility do you want as an owner? Do you plan on having investors? How important is tax protection?

It is risky for small business owners to operate as sole proprietorships or in general partnerships because they offer no protection from creditors, and the owners are personally liable for business debts. Corporations and LLCs are popular business entities because they shield business owners from personal liability and have similar taxation codes.

There are endless pros and cons to every business entity. However, what works for one business might not be the best fit for yours. And as your business pivots or changes over time, the wrong entity could restrain its growth and hinder its success.

Next Steps

Need a little more help? If you want to make sure you are choosing the right entity at the right time (or you are in the right entity for your pivot), set up a 15-minute entity review meeting with Snyder Law to discuss your business’s needs and to find the best option for your business’s success. Click here for a one-time meeting. You’ll receive our Entity Formation document to prepare you for the call, and you’ll have a firm idea of which direction to go by the end of the meeting.

More interested in a DIY option? We created a comprehensive flow chart to point you in the right direction. The Entity Formation document takes you from where you are to where you want to be in just a few simple steps. And it’s only $14.97. Request yours here.

If you would like to learn more about any of the topics mentioned here, please call or text 484-801-0021 or reach out to Cassandra Ortner at cassandra.ortner@peytonlaw.com. We proudly support the nation’s business owners.

*Janelle Peyton is the CEO and Managing Partner of Peyton Law, a leading boutique law firm designed to provide the highest quality branding, business, and legal services to companies via quarterly subscription called Strategic Legal Solution. Peyton Law offers brand building strategies through corporate and intellectual property law, including business entity formation, buy+sell, contracts, joint ventures, trademarks, patents, licensing, and other growth-related transactions.