Throughout my career, I have received many questions around business entity formation. There are many different types of business entities, including partnerships, professional organizations, sole proprietorships, corporations and limited liability companies.
I have often noticed a misconception of how and where entities are formed, so let’s take a few minutes to learn the ins and outs of entity formation.
Where do I form my business?
Entities are formed at the state level, and every state has some statute that allows for the formation of an entity. For instance, in Michigan, forming an LLC is found under the Michigan Limited Liability Company Act, and in Texas it is established by the Texas Business Organization Code Title 3, Chapter 101.
Many entrepreneurs find Delaware to be the best state in which to incorporate their business, because there is no state income tax for corporations formed in Delaware but that do not conduct business there.
Regardless of where the filing occurs, the important first step is to set up your entity. Once you have created the business entity, you can continue the development process.
Where do I develop my business entity?
Usually the very first action under development is drafting a corporate governance. In the case of a limited liability company, that includes an operating agreement. Corporations, on the other hand, would draft a shareholder agreement.
Regardless of which type of business you have set up, it is important to have a document that governs operations, the way the ownership is treated, how the relationship will be managed and how it could ultimately be unwound. Remember, a business is like a marriage, so choose your partners wisely. Those individuals who helped create the entity receive their ownership in the form of membership units in an LLC and shares in a corporation.
Another aspect of creating the entity is securing an employer identification number (EIN). Similar to an individual receiving a social security number, the EIN is the federal identification number that represents your business. It is utilized for taxes, financing, business credit and other business-related reporting.
At this time, documentation for employment agreements or independent contractor agreements will also be drawn up. This will define how parties are to work to grow and develop the entity. During this time, ownership restrictions and vesting are also created to protect partners from each other and also to ensure the longevity of the business.
During this developmental stage, it should be determined how the entity will be taxed, either as an S Corp. or a C Corp. It is best to speak with a tax professional or your CPA to discuss the pros and cons around these choices.
Delivering the entity
When all legal documents are ready, they are submitted to the business owner for review on behalf of a legal professional, and the execution of documents is handled. It is very important that the parties involved in creating the entity take the time to sign all of the documents, not just the entity formation documents or the EIN filings. Being thorough in the formation of an entity will alleviate confusion down the road, should problems arise.
It is an entrepreneur’s responsibility to nurture a new business venture with the proper resources including funding, staffing, management and leadership to ensure its growth and success. Entities take work to be created and more importantly, once created, require dedication and commitment to truly develop into successful and thriving businesses.