7 Steps to Setting Up a Business Entity
If you are starting a business, you probably already have a business plan and a budget in mind. But do you have the right business entity? Here's how to figure it all out.
Step 1: Pick Your JurisdictionUltimately, when you select a particular state to be the home of your business, you are submitting your company and yourself to the jurisdiction of that state's courts. So ask yourself, "Where am I willing to be sued? How far will I travel to engage in a lawsuit?"
Other considerations may include: whether you are talking to out-of-state venture capital investors, which may require that you incorporate in a particular state in order to invest; where you and your employees live and work; where your customers live and work; whether one state's laws are preferable over another state's laws for your type of business; and whether personal anonymity is a critical concern.
In Florida, where I practice, the laws are very pro-employer and anti-union, which may not sit well with certain types of businesses where union labor is the norm. Otherwise, Florida law is very friendly to business owners, making it an ideal location for most small businesses. We do have "Online Sunshine," which means that the names and business addresses of the managers, directors, and/or officers will be public record (though there are ways to avoid that issue by, for example, establishing a family trust to own the business).
Step 2: Pick Your Business EntityGenerally speaking, there are four main types of business entities in the U.S.: the sole proprietorship, the partnership, the corporation, and the limited liability company. Every state recognizes some variation of these four entities, and how you incorporate a business entity is always a matter of state law.
A sole proprietorship is just what it sounds like: an individual starts doing business under his or her own name (or a fictitious or d/b/a name) without forming a separate entity. No registration gets filed with the state and all the taxes, liabilities, profits, and losses pass through to the business owner.
A partnership is when two or more individuals join together to do business without forming a separate entity. The business partners may or may not register the partnership with the state, and all the taxes, liabilities, profits, and losses pass through to the business owners.
A corporation is the oldest form of business entity. It is a completely separate legal "person" from its owners (the "shareholders"). It reports and pays its own taxes (more on that in a minute!). It must be registered with the state in which it is formed and it must have organizing documents, including articles or organization, minutes, and bylaws. Shareholders, directors, and officers are shielded from the liabilities of the corporation so long as they exercise good business judgment.
A limited liability company ("LLC") is a newer corporate entity structure with legal variations state-to-state. However, generally speaking, it is a hybrid of the corporation and a partnership. An LLC is a separate legal "person" from its owners (the "members"), but The business partners may or may not register the partnership with the state, but all the taxes, liabilities, profits, and losses pass through to the business owners. The LLC should have an Operating Agreement amongst the members, but in most states it is not required. Members and officers are shielded from the liabilities of the LLC so long as they exercise good business judgment.
Step 3: Make a Tax ElectionSole proprietors and partnerships can skip this section because the individuals who own the business are taxed individually on the profits/losses of the business by default.
Corporate entities must make an election under the Internal Revenue Code (the "Code"), however. An election to be taxed as a small business corporation under Subchapter S of the Code (an "S Election") means that the corporation will report its income, deductions, and profits or losses to the IRS, and pass them through to the shareholders, who will pay taxes on the income. There are restrictions on who can own an S Corporation, so a deeper discussion with your lawyer and accountant is advised. An election to be taxed as a "regular" corporation under Subchapter C of the Code (a C Election") means that the corporation pays its own income taxes, then pays the profits to the shareholders as dividends after taxes. The shareholders then pay income taxes on the dividends.
If you formed an LLC, you can elect to be taxed under the Code either as a partnership (e.g., the individual members are taxed on the business profits/losses individually) or as a corporation making an S Election. LLCs cannot be taxed as C corporations.
Step 4: Register with the State and Federal GovernmentEvery state has its own system for registering your corporate entity. Check with a lawyer in your jurisdiction.
You should obtain your Employer Identification Number from the IRS right away. It is a simple online form.
Step 5: Assemble a Corporate Record BookEvery business entity - even sole proprietorships - should keep a corporate record book.
Essentially, this is just a binder that contains official corporate documents. For a sole proprietor, that may simply be tax information, key business contracts, and any other official documents. For a partnership, it should also include a detailed, written partnership agreement. For a corporation, that also includes Bylaws, a Shareholders' Agreement, Articles, Meeting Minutes, and Stock Certificates. And for an LLC, it also includes an Operating Agreement, Articles, and Annual Minutes.
The corporate documents referenced above are what protect corporate shareholders and LLC members from liability for the activities of the business. Since laws change regularly, don't rely on online forms to protect your business. Consult a lawyer in your jurisdiction and get a proper set of corporate documents.
Step 6: Take Care of Local ConcernsOnce you have established a business operation or a separate corporate entity, don't forget to handle local concerns such as business occupancy licenses, local taxes, zoning permits, etc. Even if you are running the business from your kitchen table, you have to seek the permission of local government to do that.
Also, remember to register to pay state and local sales tax, if applicable, and to set up payroll services if you will have employees (even if it's just you).
Step 7: Plan to Protect Your IPIf you are concerned about protecting the intellectual property associated with your business (e.g. patents, trademarks, copyrights, and/or trade secrets), contact a lawyer right away. In the case of patents and copyrights, there are strict deadlines to meet for registration. For trademarks, you have to perform due diligence before adopting the mark in your business. And for trade secrets, there are certain steps you must take to protect the "secret sauce" in order to keep it out of the hands of your competitors. Don't wing it. Hire a professional.