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Starting a Business: An Introduction to Business Entities
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Starting a Business: An Intoduction to Business Entities
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Starting a business anywhere can be a daunting proposition–we know since we've done just that ourselves. One of the first decisions that you have to make is whether to incorporate or choose some other kind of legally recognized entity as a framework for your corporation. Although it may not be a comfort to you at this point, you have a lot of choices. You might want to operate as a sole proprietor, a corporation, a partnership, an LLC, and the list goes from there.
This discussion is intended to highlight some basic features of more common types of entities–it does not provide an exhaustive description of each type or even all types of entities that exist. It is intended more to familiarize you with some of the basics. The type of entity that is best for you will depend on your specific business and financial plan and likely will include discussions with professionals who know you and your business such as your lawyer and your accountant.
If you already know what kind of entity you want to form and are merely looking for state requirements and forms, you may want to jump to State sites that are designed to assist you with the actual requirements of setting up a business. In Maryland, you can go to Maryland's Checklist for New Businesses. In Virginia, go to Virginia Business Registration Guide. In Pennsylvania, go to Pennsylvania General Filing Guidelines. And in the District of Columbia, go to District of Columbia Department of Consumer and Regulatory Affairs–Corporation Division of the Business Regulation Administration.
Sole Proprietorship. A sole proprietorship is a very basic form of business. As its name implies, there is only one owner in a sole proprietorship. There are no formal documents that are required to create a sole proprietorship. If the business will be operating under a trade name, however, there may some filing requirements with which you will need to comply. Also, as with any business, there may be licensing and other state requirements that you must fulfill before you can operate your business.
In a sole proprietorship, all profits are passed through to and taxed at the rate of the individual owner.
A sole proprietorship is a fairly easy kind of business to start because it is so informal. One of the biggest disadvantages of a sole proprietorship, however, is that liability to the individual owner is unlimited. The individual owner is liable in full for all obligations of the business. For example, if the business is sued, both the individual owner's business assets and the owner's personal assets are at risk.
Corporations and Subchapter S Corporations. A corporation is a legal entity formed by one or more owners–usually called stockholders or shareholders. To form a corporation, an incorporator must file articles of incorporation (sometimes called a "charter") with the appropriate state filing office and pay all fees required by the state. Articles of incorporation provide information such as the name of the corporation, the business purpose of the corporation, the resident agent of the corporation (that is, the person who can be served with papers if the corporation is sued), and the initial board of directors of the corporation. The specific information required in articles of incorporation and the amount of the fee required, however, will vary from state to state.
In addition to filing articles of incorporation with the state, the initial board of directors for the corporation must meet and formally adopt bylaws for the corporation. The corporation's bylaws will establish how the corporation will be run and will address matters such as how and when directors and officers will be elected, and when meetings will be held. Although the bylaws are not filed with the state, it is important for a corporation to adopt bylaws as part of the formal process of incorporation.
If you are a sole owner, forming a corporation takes a little more work than operating a sole proprietorship. There are some critical advantages, however, provided by a corporate structure. The main advantage of the corporate structure is that owners of a corporation (the stockholders) generally are not liable for debts of the corporation. Each stockholder could lose his or her investment in the corporation but a stockholder's personal assets usually are not at risk.
A main disadvantage is that corporate earnings are taxed twice–once when they are earned by the corporation and then a second time when they are distributed to the stockholders. A corporation may be able to avoid this tax disadvantage by making a Subchapter S election with the Internal Revenue Service. In a so-called "Subchapter S corporation," corporate earnings are passed through to and taxed only once at the rates of the individual stockholders. Subchapter S status, however, is not available for all corporations.
Limited Liability Companies. A limited liability company ("LLC") is a legal entity that is formed when the owners–called members–file articles of organization with the appropriate state filing office and pay all fees required by the state. As with corporations, the specific information required in the articles of organization and the amount of the fee will vary from state to state.
No formal documents other than the articles of organization are required to organize an LLC; however, unless you plan to form a single member LLC, it is usually prudent to have a written operating agreement that describes such things as the rights and obligations of the members, how money will be contributed to the business and distributed to members, and how business decisions will be made.
In an LLC, all members of the company are shielded from liability for company debt. At the same time, profits from the company are passed through to the members and taxed only once at the individual members' rates.
General Partnerships/Joint Ventures. A general partnership is an association of two or more people who conduct a business for profit. A joint venture is a general partnership that is formed for a specific purpose. The requirements for forming a joint venture are the same as for forming a general partnership.
No formal documents are necessary to create a partnership. If two or more people are conducting a business for profit–even if they haven't signed any kind of agreement–they are operating as a general partnership. However, because more than one person is involved in the business, it is usually prudent to have a written partnership agreement that describes such things as the rights and obligations of the partners, how money will be contributed to the business and distributed to members, and how business decisions will be made.
All profits from a general partnership are passed through to and taxed at the rates of the individual partners. Like the owner of a sole proprietorship, general partners in a general partnership or joint venture have unlimited personal liability for all obligations and debts of the partnership.
Limited Liability Partnerships. A limited liability partnership ("LLP") is a general partnership that has filed a special limited liability election with the appropriate state filing office and paid all required state fees. All of the partners of an LLP are general partners. By filing the limited liability election, however, the general partners shield themselves from liability for partnership debts.
In addition to required state filings, it usually is prudent for the partners of an LLP to enter into a written partnership agreement that describes such things as the rights and obligations of the partners, how money will be contributed to the business and distributed to members, and how business decisions will be made.
All profits from an LLP are passed through to and taxed at the rates of the individual partners.
Limited Partnerships. A limited partnership is a partnership that is made up of one ore more general partners and one or more limited partners. As a general rule, the general partners manage the day to day affairs of the limited partnership and have unlimited liability for debts of the partnership. Limited partners generally are not permitted to be involved in the day to day operation of the partnership and are shielded from liability for partnership debt.
To form a limited partnership, the partners must file a certificate of limited partnership with the appropriate state filing office and pay all fees required by the state. In addition, although no formal partnership agreement is required, as with other forms of partnerships, it is prudent to have a written partnership agreement that describes such things as the rights and obligations of the partners, how money will be contributed to the business and distributed to members, and how business decisions will be made.
All profits from a limited partnership are passed through to and taxed at the rates of the individual partners.
Limited Liability Limited Partnerships. A limited liability limited partnership ("LLLP") is a limited partnership that has filed a special limited liability election with the appropriate state filing office and paid all fees required by the state. The structure, operation and taxation of an LLLP is the same as that described for a limited partnership. The general partners in an LLLP, however, like the limited partners, are shielded from liability for partnership debt.
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