Forming a Legal Entity/Corporation/LLC/ETC – The Basics
(The author provides legal services related to the topic of this post. In some jurisdictions this may be considered ATTORNEY ADVERTISING.)
A Tweet I got this evening:
@legalinspire Would you happen to have a blog entry explaining the difference between incorporating and an LLC… maybe?
— Namie’s Books (@NamiesBooks) August 6, 2018
Well, I am nothing if not accommodating, as long as it doesn’t, you know, involve much actual work. And for a transactional lawyer, answering this question doesn’t really involve much work. So here we go!
You may have heard the term “legal entity” or “corporate entity,” or even the somewhat ominous “corporate person.” These all mean basically the same thing. Under the law, there are two sorts of entities that have legal rights and legal obligations: “natural persons,” also known as human beings, and… the other kind, which is some sort of association (like a general partnership) or a corporate entity (like a corporation) which is composed of a group of natural persons acting in common cause somehow. (Note This post is about for-profit or business corporations. Not-for-profit corporations, though they have many similarities with for-profit corporations, are an entirely separate subject.)
The first thing I should point out is that if you start working with other people, and don’t pick a legal entity, in many cases, the state will pick one for you. And to quote my colleague @indiegamelawyer, it will usually pick the worst possible one. Namely, a general partnership.
A general partnership is the oldest form of legal entity. Once two or more people start engaging in a common business enterprise they can form a general partnership without even realizing it – it happens by operation of law in many jurisdictions. (Alternately, you can formally form one by entering into a partnership agreement.) Basically, everyone participating is a general partner, usually able to contract on behalf of the partnership, usually having an equal right to manage the partnership, and usually liable for all debts incurred by the partnership. The takeaway here is that if you’re going to go into business with someone, you need to form an entity deliberately or you may very well enter into a general partnership without even knowing it and without any control over the form of the partnership.
NOTE: Formally created General Partnerships are usually identified by the word “Partners” or “Partnership” in their names. They are governed either by the law of the state where they form, or by their Partnership Agreements. They are owned and operated by Partners.
The next legal entity I’ll describe is the limited partnership. A limited partnership is a partnership with one or more general partners, for whom the limited partnership acts as a general partnership, and one or more limited partners. Limited partners are usually investors. They can buy into the limited partnership, and in exchange they are entitled to a share of the partnership’s profits. Unlike the general partners, though, they are not liable for the partnership’s debts. In exchange for this protection, they are not allowed to participate in the ownership or management of the partnership. Limited partnerships used to be very common, but have fallen out of favor due to the emergence of more modern, streamlined corporate entities about which more in a second. The last thing I’ll note about limited partnerships is that for quite a while in the 20th Century, at least in the U.S., it was common to form a limited partnership and make its only general partner a corporation. This was mostly related to tax treatment. It’s much less common to do now, but there are still a LOT of these dual entities around.
NOTE: Limited Partnerships are usually identified by the word “Limited,” “Ltd.,” or “Limited Partnership” in their names. They are governed by Partnership Agreements. They are owned by both the General and Limited Partners, but operated by the General Partners only.
Now we get into corporate entities, which are different from associations like partnerships. In the U.S., corporate entities are created by filing a registration with a state regulator, usually but not always the Secretary of State. In other countries they are usually formed by filing a registration with some national government agency. They are creations of statute: if a state had no business corporation act or other similar law, corporations could not be formed there, as opposed to partnerships, which are often created by the common law.
The most common form of corporate entity is the corporation. There are two kinds of corporations in the U.S. – “S Corporations,” and “C Corporations.” The differences are fairly technical: the main distinction is that if you think you’re going to have a lot of shareholders, and especially if you think you might want the corporation’s shares to be sold publicly someday, it should be a C Corporation. S Corporations are for smaller groups of owners and have (usually) simpler tax treatment. For purposes of this very introductory summary, I won’t make further distinctions.
A corporation is a legal entity, recognized as having many of the same legal rights and responsibilities as a natural person. They can form contracts, buy and sell property, sue and be sued, and must pay separate income taxes. (Partnerships usually get “pass-through” tax treatment – their income is imputed to the partners, who claim it on their own separate tax returns.) They also provide legal protection from liability for their shareholders, which is one of the major advantages of creating them. If a corporation, acting as a corporation, does something which incurs legal liability, like defaulting on a contract, assuming the corporate forms have been followed the individual shareholders cannot be held liable, even though they have limited management powers in that they elect the Board of Directors of the corporation and can sometimes vote on large general actions of the corporation.
If the forms are not upheld, say by a shareholder comingling their funds with those of the corporation, something called “piercing the corporate veil” can happen, which means that the corporate liability protection fails and the shareholders can be reached. This happens a lot where a corporation is formed with only a few shareholders who also actively participate in the business operations of the corporation. If you’re not going to follow the rules, frankly, you probably shouldn’t bother with forming a corporation. Ask a friendly corporate lawyer for more information about how to stay out of trouble in this area.
NOTE: Corporations are usually identified by the word “Incorporated,” “Inc.,” “Corporation,” or “Corp.” in their names. In most states it is required that one of these words appear in the name of a corporation to allow it to be registered. The word “Company” may or may not also be acceptable. Corporations are formed by filing Articles of Incorporation, and are governed by their Bylaws. They are owned by shareholders, governed by a Board of Directors, and operated by Officers.
A newer type of corporate entity, and one very popular with small businesses, is the Limited Liability Company (“LLC” for short.) This is also a statutory (formed under a law making it possible) corporate entity, but it is usually easier and cheaper to form than a traditional corporation. It usually also offers the “pass through” taxation of a partnership and the liability protection of a traditional corporation. This is the corporate form modern corporate lawyers will advise most small businesses to use unless there are specific reasons that a traditional corporation (or even a partnership of some kind) would be better for the client’s purposes. Note that while traditional corporations have “shareholders” and “officers,” LLC have “members” and “managers.” To make it even more fun, some jurisdictions have “member managed” LLC and “manager managed” LLC. Which sort you should have, and the rules which should govern it, will vary. You should consult an experienced corporate attorney for more information.
NOTE: LLC are usually identified by the words “Limited Liability Company” or “LLC” in their names. In most states it is required that one of these words appear in the name of an LLC to allow it to be registered. LLC are created by filing Articles of Organization, and are governed by their Member Agreements. LLC are owned by Members, and operated by either Members or Managers.
Whichever form of corporation you may use, they have some common characteristics which are really important to be aware of:
- First, last, and always, they must be treated as separate entities. They should have their own bank accounts. It may be a good idea for them to have their own EIN (which is like a Social Security number for a legal entity.) They must be held out as the entity entering into transactions and conducting business at all times. THIS IS REALLY IMPORTANT.
- They will have at least one annual filing with the regulating agency (in many states, this is an “Annual Report” which is filed with the Secretary of State’s office.) If it is not made properly and on time, the corporation may lose its legal status. THIS IS ALSO REALLY IMPORTANT.
- Whatever their articles of incorporation or articles of organization and bylaws or member agreements say are the rules under which they are to operate, they must be observed. For example, an annual meeting of the shareholders, and an annual meeting of the board of directors, may be required. THIS IS ALSO REALLY IMPORTANT.
- Corporate entities can be shareholders in other corporate entities, and corporate entities can be converted from one form to another, so depending on context it’s usually not the end of the world if you pick one form and it turns out that another form would be better for some reason.
Any reasonably intelligent layperson can fill out the registration forms for a corporate entity – most of them can be filed online these days. However, while they are easy to fill out they are also easy to fill out wrong, and this can come back to bite you years later. You should really ask an experienced attorney for help deciding on a corporate form factor, registering it, and creating its governing documents. You should also talk to an accountant about the financial ramifications of creating a business, including but not limited to the tax consequences of the various forms of corporate entity in relation to the tax picture of the individual owners/members/shareholders.
There are companies, like LegalZoom, which will “help” you file for corporate entity status, claiming to be cheaper and offering the same benefits as a traditional attorney. Now, as an attorney in private practice, obviously I am not unbiased on this topic. But I and every other corporate lawyer I know have seen people use these discount corporate formation entities and be severely burned by them. The hundreds you save can turn into thousands to fix mistakes later. One size does not fit all when it comes to your business. If you don’t hire me, hire a lawyer who will take the time to discuss your business with you and give you the solution that’s the best, not just the fastest and easiest.
And there you have it: a very brief, high-level summary of the basic corporate forms. Keep in mind that Corporations is an entire semester course in law school and that barely scratches the surface of the topic: like with most things in life, it is more complicated than it appears.
As always, questions are welcome in the comments. Thanks for reading!