How to Create a Business Entity

By Katie Martens

Abstract: the differences and similarities between LLCs, corporations, and partnerships, and the process to create a business entity.

Man oh man do I love helping people with their small businesses. Whether it’s operating a new trash service in the area or opening your own practice as a mental health therapist, small businesses are the cogs that keep the American economy turning. If you have a business, and you haven’t created a business entity yet for that business, this is the article for you. We will be discussing:

  1. What business entities are and their differences; and

  2. How to create the business entity of your choice.

Key takeaways:

  • There are generally 3 types of business entities you can choose, and a few hallmarks of each entity:

    • LLC

      • Owned and managed by members

      • More flexible than corporations tax-wise and paperwork-wise

    • Corporation

      • Divided between board of directors and the shareholders

      • “Double” taxation as the corporation is taxed as well as the shareholders, making it less appealing for small business owners

    • Partnership

What are business entities?

First, I’d like to note that I often refer to setting up a business entity as “incorporating.” This doesn’t mean you’re only picking a corporation – “incorporating” is an umbrella term for the process of turning your side hustle, business idea, or service that’s generating income for you, into a business entity with formal requirements you must follow in order to maintain that business entity. I think of it like this:

Here we have an entrepreneurial food truck owner, waiting to take the next order of someone craving BBQ. This food truck owner is a sole proprietor, which means he has not incorporated. He has not chosen and created a business entity for his food truck and the food truck services. This means that all of the work he does within the food truck - whether it’s ordering food from brokers or cooking that food or ordering the equipment needed to run a food truck or paying for the city permits if he lives in a city that requires food trucks to have special permits - will be reported on his personal tax return. What he does for work is inseparable from whatever he owns personally. So, if he has a customer who chokes on food from his truck that wasn’t prepared correctly, not only are his work assets on the line if he’s sued, but any of his personal assets are on the line, too.

Say the choking customer sues our BBQ food truck owner. Our sole proprietor food truck owner is sued, and the attorney doing the suing, includes not only “BBQ Food Truck,” but also Mr. Food Truck Owner personally. If the choking patron convinces a judge or jury that the business was liable, then the judge will announce a verdict in the patron’s favor. Then there will be another legal fight over how much Mr. Food Truck and BBQ Food Truck owe in damages to choking patron. Damages is a legal term to describe the amount of money courts award to the prevailing party meant to restore that damaged party to its condition before the damage occurred. In this case, the court would try to award a damage amount that would put the choking patron back to his or her situation before that piece of food lodged in his or her throat. A difficult analysis for anyone.

Once the damage award is determined, the choking patron’s attorney will look for assets to pay for the damage amount. Say the judge determines the choking patron is entitled to $100,000 for the damage caused by BBQ Food Truck and Mr. Food Truck Owner. That attorney will look at the bank accounts of the business, but he or she will also look at the personal bank accounts of Mr. Food Truck Owner. If the bank accounts are insufficient, there could be more litigation to liquidate business or personal assets owned by Mr. Food Truck Owner. To say that you could lose your home because of a customer who can’t chew their food correctly would be wildly overstating the situation, but would also be true if it followed the fact pattern I just gave you.

So what do business owners do in order to avoid these costly litigation situations? Incorporate, or choose a business entity.

 

Now, Mr. Food Truck Owner has chosen to incorporate his business, which acts as a shield, or as a barbed wire fence. His business stays inside the fence, and all of his personal assets are separated from his business assets. The attorney for the choking patron can only tap into the business assets to pay for the damage award of his or her client. Here are the incorporation vehicles you can choose for your business:

  1. Corporation

  2. LLC

  3. Partnership

Your choice of business entity often pivots around 1 or many of these factors:

  1. Whether you’ll have employees;

  2. Your business’ level of profit;

  3. Tax consequences for owners of the business;

  4. Liability reasons;

  5. Your industry in which your business is in requires certain business entity vehicles.

Often, the best resources to determine the appropriate business entity for your business is to consult (1) your CPA, or a CPA you trust, and (2) an attorney. A CPA can explain the tax consequences to you of an LLC vs. a corporation, and an attorney can explain the liability and employment consequences of however you decide to incorporate. Let’s get into the meat (BBQ anyone?) of each business entity.

Corporations

Corporations have been around a long time, and in the early days, your only choice was to become a C-Corporation. The “C” in C-Corporation stands for the subchapter “C” of the Internal Revenue Code. Remember the barbed wire around the BBQ food truck? The C Corporation is that barbed wire. The owner and the business are separate from the personal assets or debts of the owner. But inside the barbed wire, the structure and tax consequences look different from LLCs and partnerships and sole proprietorships.

A corporation is owned by shareholders and run by directors and officers. I often think of this as the activity behind a stage curtain, and the performance in front of the stage curtain. The shareholders own portions of the corporation, and don’t usually have much to do with the daily operation of the corporation. The shareholders are behind the stage curtain. The directors and officers are the employees who get the work done for the corporation, and are responsible if something goes sideways in the business.

If BBQ Food Truck was a C corporation, the shareholders could be the friends who loaned money to Mr. Food Truck Owner, or thought of it as an investment. Either way, those friends do not help make the food or sell the food. They don’t even help Mr. Food Truck Owner get more gas for his food truck. In exchange for their money, the corporation gave them shares in the corporation and the corporation wants to keep its shareholders happy by creating a profit that shareholders can all share in every once in a while - these are called dividends.

In our food truck example, Mr. Food Truck Owner would be the director and all necessary officers. You don’t have to hire anyone to fill a director or ownership rule, but there are often state laws regarding how many directors are required for corporations.

For small business owners, like Mr. Food Truck Owner, if he chooses to incorporate as a C Corporation, he would be both the shareholder and the director and officer. Here are the reasons why I’d advise Mr. Food Truck Owner not to incorporate as a C Corporation:

  • A C Corporation’s profit is taxed twice - as business income at the corporation level and then at the shareholder level when distributed as dividends or realized as capital gains. Double taxation is not fun when you’re the only one running the business.

  • There is a lot of documentation that has to happen for corporations required by state law - biennial reports, filing a statement of how much outstanding stock there is in the company (so that the company and its shareholders can be taxed appropriately), annual meeting minutes, and authorization documents for any draw or payment you make to yourself as the business owner.

  • If you’re not aiming to ultimately become a publicly traded company, why deal with the inflexibility of C corporations?

LLCs

Limited Liability Companies (LLCs) arrived around 20 years ago and changed the landscape of business entity formation. Here is a company that shed many of the inflexibilities of the C Corporate model, while retaining some of the good things about the C Corporation.

The best thing that LLCs kept from corporations was the liability protection - the barbed wire or shield around Mr. Food Truck Owner. As long as you follow your state’s requirements to maintain an LLC or corporation, you can shield your personal assets from any liabilities created by your business.

Where the LLC differs is how it is owned and its tax consequences. An LLC is run and owned by its members - the people who invest money and receive money back from the LLC are usually the same people who are running the business. There is no stage curtain.

As for LLC taxation, the IRS treats an LLC either as a corporation, partnership, or a “disregarded entity.” The classification will depend on the elections made by the LLC and the number of LLC members. Here is a breakdown of each classification:

  1. Disregarded entity: this is the classification for LLCs with only one member AND the LLC has not elected to be treated as a corporation (you have to use Form 8832 from the IRS to make that election). This means that the activities of the LLC will show up on the individual member’s tax return. The individual is subject to the tax on net earnings from self employment in the same manner as sole proprietorship. In other words, the money flows through to the owner of the business and is only taxed once.

  2. Partnership: the IRS will treat any 2 member LLC as a partnership unless the LLC files Form 8832 to elect to be treated as a corporation. If the LLC is a partnership, normal partnership tax rules will apply to the LLC and each partner/member will file a Schedule K-1 on their personal tax returns. Again, you still have liability protection as an LLC, and the profits flow through to the owners of the LLC.

  3. Corporation: no matter the size of the LLC, the member or members of the LLC can elect to be taxed as a corporation. You have to file Form 8832 with the IRS in order to get the corporation treatment for an LLC. But what the IRS now has is a choice between 2 corporation structures - C corporation or S corporation. We’ve already discussed C Corporations earlier in this article. S corporations are a popular choice for LLCs because S corporations elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Again, the tax consequences of the business flow through to the owners of the LLC, which is its members. This avoids what C Corporations can’t avoid: double taxation on the corporate income.

Partnerships

Generally, there isn’t the same legal documentation required of partnerships as there is for LLCs and corporations. In some states, a partnership can be recognized just by the actions of the parties, whether or not there is paperwork supporting that. Sometimes, partnerships are cloaked as “joint ventures” or “business opportunities,” but you should be careful about the intermixing of those terms. They are not the same. Partnerships typically involve 2 people working together, and you’re on the hook for whatever your partner does. And the partner is on the hook for whatever you do. Partnerships require a high level of trust between the partners and great communication. As discussed earlier in the article, partnerships are taxed at the individual level.

What documents do I need to form a business entity?

Consult your state’s Secretary of State’s website. Practically every state’s Secretary of State’s website has forms, that are free, anyone can use to form their corporation or LLC or partnership. If it feels unnerving, here are the steps:

  1. Find the forms for the type of entity you want to create;

    1. Corporation = Articles of Incorporation

    2. LLC = Certificate of Organization

    3. Partnership = Statement of Partnership Authority

  2. Fill out the form;

  3. If your state offers electronic filing, electronically file the completed form and expect to pay the filing fee + whatever credit card processing fees your state charges for the electronic filing (for example, Nebraska’s is $107, and Kansas’ is $150. Every state is different);

  4. This is where things may differ by state - for some states, once the Secretary of State’s office files your organizing document, you are official. You have formed your business entity. For other states, you have to go through more procedures to be formally recognized as a business entity in the state you operate your business.

    1. Some states require you to publish notice of your incorporation, which is an additional fee that you pay to the local publisher of a newspaper in your area.

  5. Once you have formed your entity, make sure to do all of the other administrative tasks that shows anyone (and especially the IRS and potential judges or juries) that you’re following the legal requirements to maintain your business entity. This includes:

    1. Creating your bylaws, any buy-sell agreements, and shareholder agreements for a corporation;

    2. Creating your operating agreement for an LLC;

    3. Creating a partnership agreement for a partnership.

    4. For all business entities, keep your address and contact information current with the Secretary of State’s office. It’s important that the Secretary of State is able to find you to make sure you’re keeping up with any incorporation requirements your state requires.