How to Form a Business: What You Need To Know
Understand the differences between different company types and the pros and cons of hiring a professional to form your business
The first step in forming a business is deciding what kind of business entity you want to form. Do you want to run an LLC or start a corporation? Maybe you want to create a non-profit. Each entity has its own unique advantages and disadvantages. Next, you'll need to decide if you want to form your business on your own or hire someone else to do it for you.
The following guide is designed to help you understand the differences between different entities, the pros and cons of hiring a professional to form your business for you, as well as exactly what goes into the process of forming a business in the first place.
What Kind of Business Should I Form?
There are a wide array of business entity types, but we will focus on the most common two here: corporations and LLCs.
Why Form an LLC?
LLCs are the most common type of business entities. LLCs are considered ideal for small to medium sized businesses, as they do not require the same amount of administrative structure. For example, an LLC has no Board of Directors, and there is no requirement to hold annual shareholder meetings.
This makes LLCs easier to manage. In addition, the owners of an LLC (called members), receive their profits as part of their personal income. This makes an LLC a pass-through-entity, meaning that the company itself does not pay tax on its profits. The profits pass through the entity to the members, and the members pay taxes on their personal tax returns.
Why Form a Corporation?
At first glance it may seem like corporations are a poor choice. There is much more administrative structure and legal requirements (Board of Directors, executive administrators, shareholder meetings), and corporations are taxed twice: first as an entity, and then again when shareholders collect profits on their earnings.
However, corporations come with many advantages. Corporations are the perfect choice for raising investment capital. They can issue shares of stock to be sold to investors at any time. Corporations have been around far longer than LLCs, and thus corporate law is much clearer and easier to understand than LLC law. Corporations also have great prestige. Nothing quite rings like the title CEO.
What About Non-profits?
There are two things to understand about non-profits. First is that a non-profit is not a specific entity type. For example, you can't form a non-profit, but you can form a nonprofit corporation. Non-profit describes a particular type of LLC or corporation.
Second is that when most people think of non-profit they are thinking of a specific type of non-profit: the 501(c)(3), so called for the section of the IRS tax code that designates them. A 501(c)(3) is a non-profit organization that is exempt from paying taxes.
However, the vast majority of non-profit organizations are not 501(c)(3). Nearly all non-profit companies pay taxes. The NFL, for example, is a non-profit organization, and it pays taxes every year. 501(c)(3) status is granted only to very specific types of businesses and requires a lengthy and arduous application process.
Should I Form My Business Myself or Hire Someone to Do It?
Many business owners have paid thousands of dollars to have their companies formed by attorneys or business formation services. The truth is that you can save yourself a bundle and start your business all by yourself. You don't need specialized know-how or a fancy degree. In fact, in most states you can easily and quickly file all the paperwork you need online without any hassle.
Pros and Cons to Hiring a Professional Service
If you hire a lawyer or business formation service, they should know precisely which documents need to be filed, the fastest way to submit them, as well as any oddities that are required in your state. A business attorney, in particular, can supply you with a customized Operating Agreement or Bylaws. In addition, most professionals offer an array of other services: corporate books, EINs, accounting software, etc. Some may be services they provide themselves, while others they farm out to third parties.
On the other hand, hiring a professional business formation service can be expensive. Sometimes very expensive. Lawyers, in particular, charge a bundle. Also, what no professional service will tell you is that much of what they are doing on your behalf is both fast and easy. Many business owners are frustrated later when they learn they paid $100 for an EIN that they could have got themselves for free with five-minutes of effort.
Pros and Cons of Forming Your Business Yourself
Cost. If you form your business yourself, you will save a lot of money, potentially thousands of dollars.
The flip-side is that if you aren't paying attention you may forget about a particular filing, which will likely result in a penalty fee. As well, while you can find plenty of Operating Agreement and Bylaws templates online, it is undoubtedly better to have this document drawn up by a business lawyer who can work through all the specific details of your business with you.
Business Formation Steps
Pick Your Business Type
LLC or corporation? Which suits your needs better? Once you know which business type you want, you can find the proper formation documents on your Secretary of State's website.
Name Your Company
The first step in forming a business is choosing a name for your company. Every state has restrictions on how your name must be formatted, as well as certain words you are not allowed to use.
For example, most states will not allow you to use the word Bank in your company name, unless of course you're actually forming a bank.
What are the business name requirements in my state?
You can generally find the business name requirements on the Secretary of State website. While each state is a little different, the most basic requirements are usually that you must include in your company name a business identifier: Limited Liability Company or LLC, Corporation or Incorporated.
In addition, you normally cannot register a name that is already in use by another entity within the state. To see if the name you want is already in use, you can do a Business Name Search (also usually found on the Secretary of State website).
File Your Formation Documents
To form a business you file formation documents with the Secretary of State. This can be done in most states online, and the cost is often quite minimal. If you are forming an LLC, you will file a Certificate of Formation. If you are forming a corporation, you will file Articles of Incorporation.
Some states have slightly different names for these documents, but their purpose is the same.
What is a registered agent?
You will notice on your formation documents that you will be required to designate a registered agent for your business. A registered agent accepts legal documents, service of process and official notifications on behalf of your company. Basically, if your company is ever sued, the court will send a notice to your registered agent, who will then inform you of the lawsuit.
In most states, you can simply designate yourself as the registered agent and list your physical business address as your registered address. Be aware that these details will become public information. If you want to keep your name and contact details private, you'll need to appoint a professional registered agent.
Write Your Operating Agreement or Bylaws
When you form a business you need to write an ownership document. This is known as an Operating Agreement (LLC) or Bylaws (corporation). This document lays out who owns your company, their ownership share and voting rights, and how ownership can change hands. It also details management responsibilities and administrative procedures.
An LLC should have an Operating Agreement, although it is not required by law. A corporation, however, is legally bound to write Bylaws.
Is my ownership document filed with the state?
No. This is an internal document and is not filed with any agency.
If Necessary, File Your Initial Report
Nearly every state requires a business to file an Annual Report. This report is submitted to the Secretary of State's office and is used to update business information. Some states--though not all--require a business to file this report immediately after formation. This is called an Initial Report.
It is important to check and see if you are required to file an Initial Report in your state. Some states do not make it clear that the report is required within 90 days of formation, and your business can be dissolved if you fail to file within that window.
Congratulations! These are the most basic steps to forming your own business. While there are still other essential elements that your business will need to get up and running, the actual formation of your company is now complete.
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