CHOOSING AN ENTITY FOR YOUR BUSINESS
One of the first steps in creating a successful business is choosing the legal structure that will best suit
your needs and the needs of the business. Listed below are four principal kinds of structures: (A) the sole
proprietorship; (B) the corporation; (C) the limited liability company and (D) the general partnership,
along with a brief overview of other available options. Each structure has advantages and disadvantages
that must be weighed in view of the specific goals and needs of your business; however, the relative ease
with which a corporation can accommodate outside investment will often make this structure the
preferred alternative if you are positioning your business for rapid growth. You should consult with an
accountant/tax advisor and an attorney to help you decide which type of business structure/entity is best
for you.
BRIEF COMPARISON
Sole
Proprietorship
Corporation
Limited Liability
Company
General
Partnership
Owners
Proprietor
Stockholders or
Shareholders
Members
Partners
Governed by
Proprietor
Articles of
Incorporation
and By-Laws
Operating Agreement
Partnership
Agreement
File with State to Form
Nothing
Articles of
Incorporation
Certificate of Formation
Nothing
Managed by
Proprietor
Directors &
Officers
Members and/or
Managers
Partners
Taxation
Pass-through
Entity or Passthrough
Pass-through
Pass-through
A. The Sole Proprietorship
This is the simplest and most commonly used form of business entity. The sole proprietorship is usually
defined as a business that is owned and operated by one person, though, of course, the proprietor may
have any number of employees. If you choose this legal structure for your business then, from a legal
perspective, you and your business are one and the same.
1. Requirements for Formation
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Obtain whatever licenses are required to begin operation. Generally, no documents need to be filed
with the state. Certain professions and types of business, however, are regulated by the state or on a
local level (e.g., attorneys, engineers, restaurants/food related businesses).
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If doing business under a name other than your legal name, a “doing business as” or “d/b/a”
certificate must be filed in every city or town in which an office of the business is located. These
certificates generally cost less than a few hundred dollars and can last for several years.
Proprietorship is not regulated by statute, but any laws governing the business in which the proprietor
is engaged will apply.
It is advisable to get separate federal (www.irs.gov) and state tax ID numbers even if you structure
your business as a sole proprietorship.
It is also advisable and a good business practice to maintain separate bank accounts and books and
records for a sole proprietorship.
2. Advantages of Sole Proprietorship
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It’s easy
Sole ownership of profits
Flexibility. Control and decision-making authority vested in one person
3. Disadvantages of Sole Proprietorship
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Financing Issues: The sole proprietor may have difficulty in obtaining long-term financing and/or
initial capital. Venture capital investors typically prefer investing in an entity that is a corporation.
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Unlimited liability: The sole proprietor is personally liable for the debts and obligations of the
business. This liability extends to all of the proprietor’s assets (e.g., house, car and investments).
Additional liabilities such as physical loss or personal injury may be lessened by obtaining insurance
coverage.
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Instability: The business might be crippled or terminated upon illness or death of the owner.
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Tax Issues: The sole proprietor and the business are a single entity for tax purposes. This means that
the income of the business is taxed to the sole proprietor in the year that the business receives it,
whether or not the money is removed from the business.
Note that a business may start as a sole proprietorship and then change over to a corporation or limited
liability company later if the disadvantages of sole proprietorship begin to outweigh the advantages.
B. The Corporation
A corporation offers advantages in internal management structure over the other forms of business
entities. A corporation’s most important feature is that legally it is a separate entity from the individuals
who own or operate it.
One person (or legal entity) may own all the stock of a corporation, and such person may be its only
director and hold all required officer positions. If you follow the proper organizational and operating
procedures, you and your corporation will be treated as separate legal entities.
1. Requirements for the Formation of a Corporation
The authority of a state government forms a corporation. The procedure ordinarily required to form a
corporation is typically quite basic. Approval must be obtained from the Secretary of State in the state in
which the corporation is to be formed. When the state approves a corporation, the Secretary of State
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grants a charter, which states the powers and limitations of the corporation. Generally, the requirements to
form a corporation are as follows.
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Hold organizational meeting of incorporators; draft minutes related to same for corporate minute
book.
Hold initial meeting of Board of Directors (elect officers, adopt By-Laws, authorize filing of Articles
of Incorporation, opening bank accounts, etc.); draft minutes related to same for corporate minute
book.
Complete and file Articles of Incorporation with Secretary of State.
Get tax ID number from IRS (Form SS-4). (www.irs.gov)
Obtain state tax ID number.
If desired, file Form 2553 with IRS for treatment as S-Corporation. * Time limits apply – this must
be done within 75 days of formation in order to gain the benefits of this election.
2. Advantages of the Corporation
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Limitations of the stockholder’s liability: One of the main advantages of incorporating is that, in
most circumstances, it limits personal liability both as a stockholder and as a corporate actor. If a
court judgment is entered against the corporation, as a stockholder you stand to lose only the money
that you have invested individually. Generally, as long as you have followed corporate formalities
(see below) and have acted in your corporate capacity with respect to the corporation (as an
employee, officer, director) and without intent to defraud, your home, personal bank accounts, and
other personal property cannot be accessed by a creditor that has won a lawsuit against the
corporation. (However, do not confuse corporate liability with appropriate liability insurance
considerations.)
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Relative ease of accommodating capital investment: Capital may be acquired through the issuance
of various types of stock and debt instruments. It is often easier for corporations to secure long term
financing from lending institutions by taking advantage of corporate assets and, if required, personal
assets of stockholders and principals who may act as guarantors. In addition, venture capital investors
typically prefer investing in an entity that is a corporation.
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Ownership is readily transferable: Ownership of a corporation can be bought and sold with relative
ease.
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Stability and relative permanence of existence: In the case of illness, death, or other cause for loss
of a principal officer or owner, the corporation continues to exist and do business.
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Delegated authority: Centralized control is secured when owners delegate authority to hired
managers, although they are often initially one and the same individual.
3. Disadvantages of the Corporation
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Double taxation (C Corporation only): Tax is levied against the corporation’s net income and on
individual employee salary and stockholder dividends. See tax considerations below.
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Must adhere to corporate formalities: A corporation is required to file various local, state, and
federal reports and must hold annual and special meetings. Furthermore, the corporation’s Board of
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Directors must approve material actions and authorized officers must execute documents on behalf of
the corporation. A corporation should have its own bank account and separate books and records.
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Expense of forming a corporation: Corporations can be more costly to form and run than other
business entities.
4. Tax Considerations
Corporate taxation is a complicated subject. Generally, the federal tax laws distinguish between two
types of corporations. A Subchapter C corporation is treated as a tax paying entity separate from its
stockholders and must pay corporate income tax. By contrast, a Subchapter S corporation does not pay
federal income tax (but may pay state income tax), and instead the corporation’s stockholders pay income
taxes.
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The C Corporation: Since a regular subchapter (C) corporation ( “C corporation”) is a separate
entity from its stockholders, the corporation pays taxes on any income that is left after business
expenses have been paid: its income, deductions, losses and credits are recognized by the corporation,
not the stockholders. In addition, if income is distributed to stockholders (for example, through
dividends) the stockholders pay tax on the dividends received. In practice, however, a C corporation
may not have to pay any income tax even though it is a separate taxable entity. This is because in
most incorporated small businesses, the owners are also employees who receive salary and bonuses as
compensation for the services they perform for the corporation. The corporation then deducts this
compensation (which must be reasonable) as a business expense. In many small corporations,
compensation to owner-employees eats up all the corporate profits so there is no taxable income left
for the corporation to pay taxes on.
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The S Corporation: For non-tax purposes, subchapter (S) corporations (“S corporations”) generally
possess the same advantages and disadvantages as C corporations. However, S corporations have the
tax advantages of a sole proprietorship. The S corporation’s income, losses, deductions and credits
“pass through” to the individual stockholders in proportion to their stockholdings in the corporation
and are reflected on their personal income tax returns. Among other things, this means that as long as
you actively participate in the business of the S corporation, business losses can be used as an offset
against your other income. This may reduce or eliminate your tax burden. The corporation itself
does not pay taxes, but instead files an informational tax return detailing what each stockholder’s
portion of the corporate income is. There are several conditions that must be satisfied in order to
qualify as an S corporation, including (1) it must have no more than 100 stockholders, (2) each
stockholder must be a United States citizen, resident, or certain type of trust, and (3) it can only have
one class of stock outstanding. * Again, time limits apply to S corporation elections – this must be
done within 75 days of formation in order to gain the benefits of this election.
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Choosing between the C and the S Corporation: For federal tax purposes, for small start-ups it is
often best to elect to be an S corporation rather than a C corporation, although each individual
circumstance may be different. Starting as an S corporation is usually wise because in the early stage
of your business, your business may have an operating loss. With an S corporation you can pass that
loss through to your personal income tax return, using it to offset income that you (and your spouse, if
you are married) may have from other sources. In later tax years, if there are tax advantages to being
a C corporation, you can easily drop your S corporation status.
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C. The Limited Liability Company (“LLC”)
LLCs have recently emerged as an alternative to corporations and partnerships. LLCs combine some of
the advantages of corporations (limited liability for all equity holders) with some of the advantages of
partnerships (flexibility and a single level of tax). A primary feature of the LLC, like corporations, is that
its members have no liability beyond their initial investment, even if they actively participate in or control
the firm’s management. LLCs, however, also share some of the disadvantages of partnership (complexity
and tax issues for tax-exempt and non-U.S. investors).
1. Requirements for Formation
An LLC is formed by the authority of state law. A certificate of formation is required to form an LLC.
As with partnerships (as described more fully below), it is almost always desirable to organize an LLC by
means of a written agreement that specifically explains the relationship among the parties. LLCs are
governed by an Operating Agreement or Limited Liability Company Agreement which contains the
agreement among the members on such issues as management, economics and voting. LLCs can be
managed by their members, by managers or you can set up a structure with directors and officers (like a
corporation). LLCs are very flexible in this regard.
2. Advantages of a Limited Liability Company
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Limited Liability for all Members
Flexibility regarding “Pass-Through” Tax Treatment
3. Disadvantages of a Limited Liability Company
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Relative complexity of accommodating outside investors: Venture capital investors typically
prefer investing in an entity that is a corporation.
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Flexibility can breed complexity and cost: Given the flexibility afforded by the entity, formation
can be more complex and costly and may require more analysis, particularly regarding tax treatment.
D. The General Partnership
1. Requirements for Formation
A partnership is an association of two or more people who carry on as co-owners of a business for profit.
This co-ownership entails both profit-sharing and sharing in control. Partnerships come in two varieties,
general partnerships and limited partnerships.
2. Advantages of a General Partnership
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It’s easy
Direct sharing of profits among partners
Flexibility
“Pass-through” tax treatment
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3. Disadvantages of a General Partnership
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Unlimited Liability: General partners are personally liable for the debts and obligations of the
business. This liability extends to all of the partners’ assets (e.g., house, car and investments).
Additional liabilities such as physical loss or personal injury may be lessened by obtaining insurance
coverage.
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Instability: Elimination of any partner constitutes automatic dissolution of the partnership unless the
partners have provided in advance for this contingency. However, the partnership can continue based
on right of survivorship and possible creation of a new partnership. The partners might also consider
partnership insurance.
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Control Issues (Joint and Several Liability): Any partner may take action that legally binds the
partnership as a whole. This means that the partnership is obligated to cover payments or liabilities
made or incurred by any single partner. Partners can narrow or broaden this obligation through a
partnership agreement. However, creditors will not generally be bound by this agreement and may
therefore seek full damages from any single partner in satisfaction of a debt incurred by any other
partner(s).
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Limits on Transfer of Interest: Partnership interests are not readily transferable and buying a
partner’s interest can be difficult unless specifically provided for in the partnership agreement.
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Duty Owed: Each partner is entitled to full information about the affairs of the partnership and all
partners have a “fiduciary relationship” with one another. This means that each partner owes the
others the highest legal duty of good faith, loyalty and fairness in all matters pertaining to the
partnership.
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Must Adhere to Certain Formalities: Partnerships must maintain separate books and file separate
tax returns.
E. Other Options (Brief Overview)
Limited Partnership (“LP”): A Limited Partnership is another type of entity that may be formed by the
authority of state law. A Limited Partnership is not the appropriate type of legal entity for most small
businesses. This form of legal entity permits investors to share the profits of the business, while limiting
their risk of loss to their investment (if investors comply with certain legal formalities). A Limited
Partnership has two classes of partners: (1) one or more general partners who have complete control,
manage the enterprise and are subject to full liability; and (2) one or more limited partners who are very
similar to creditors (but are subordinate to creditors if the firm becomes insolvent or liquidated). The
limited partner(s) does not take part in the control of the business. A certificate of limited partnership
naming at least one person as a general partner is required to form a Limited Partnership. As mentioned
above, the liability of limited partners is capped at the amount they have agreed to contribute to the
partnership. The liability of the general partner(s) is unlimited, as in a general partnership. As with
general partnerships, it is almost always desirable to organize a limited partnership by means of a written
partnership agreement that specifically explains the relationship among the parties.
Limited Liability Partnerships (“LLPs”) and Professional Corporations (“PCs”): In most states you
can also form a LLP or PC. These are special types of business entities that are only appropriate for
certain types of businesses. The laws for these types of entities vary from state to state. If you think one
of these may be an appropriate entity for your business, you should consult with your legal advisor.
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Non-Profit/Not-for-Profit Corporations (“NFPs”): Most states also provide for the formation of nonprofit or not-for-profit corporations. These are special types of corporations that are formed for a
charitable purpose and may or may not have members or owners (in the corporate sense). You can also
petition the IRS to seek tax exempt (501(c)(3)) status for an NFP formed under state law. Federal tax
exempt status is not automatic, and requires submission of a detailed application regarding the operation
and activities of your business. See www.irs.gov for more information.
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CHOOSING AN ENTITY FOR YOUR BUSINESS
Corporate Formalities
To protect equityholders and corporate representatives from personal liability, directors, officers and
managers need to be aware of the following obligations. This is not intended to be an exhaustive list of
everything required in order to operate a limited liability entity (corporation, LLC, etc.) but merely to set
forth some of the major items that the owners and managers of a company need to be aware of and
follow. These formalities apply regardless of the form of legal entity (with some variations depending on
your structure).
General Guidelines:
Holding Scheduled Meetings
• Corporations: The date for your annual shareholders’ meeting should be in the corporation’s
Bylaws. Bylaws typically call for an annual board of directors meeting to be held immediately
after the annual shareholders’ meeting.
• LLCs: If applicable, the date for your annual meeting should be in the LLC’s operating agreement.
• Holding special meetings of the Board of Directors (for corporations) or members/managers (LLCs)
when matters of importance come up such as:
o Entering into a new lease
o Entering into a substantial funding commitment
o Opening a new bank account
o Filing an S-Corporation election (flow-through tax treatment – not necessary for LLCs)
o Entering into any other significant contractual agreement
o Changing an officer’s salary
o Filling a vacancy on the Board of Directors or appointing a new officer
o Entering into a significant new venture
o Considering the sale, in whole or in part, of the assets or the dissolution of the business
o Issues of new equity interests (stock or membership interests)
Keeping good records
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Take minutes of meetings and maintain a corporate record book.
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Keep good financial records.
Keeping things close to the vest
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Directors and officers owe a fiduciary duty to the corporation, meaning that they must at all times
do what is in the best interest of the corporate entity and its shareholders.
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Keep corporate matters confidential.
Developing a Planning Routine
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Review each year’s activities during the final month of the fiscal year.
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Budget ahead for the longest period reasonably possible and review and analyze results at least
semi-annually.
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Review operations with your accountant to ensure tax planning is properly emphasized.
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Develop formal long-range planning capacities beyond the budgeting process.
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Signing all contracts in the name of the corporation or LLC with a signature block in substantially the
following form:
[NAME OF CORPORATION], [INC.] [LLC]
By: ______________________________
Name: [PRINT NAME]
Title: [PRINT TITLE]
And company representatives should also:
• Adopt a corporate resolution that authorizes an officer to sign a contract.
• Make all corporate purchases in the name of the corporation
• Maintain corporate funds in a corporate account or accounts separate and apart from any other
account
• Carry reasonable insurance on the corporation, considering the risks inherent in the corporation’s
business
• Make sure you fund the corporation at the time of incorporation with enough money to keep it
going during an initial phase of operations
• Set up a review mechanism for decision-making, so that all aspects of a proposed course of action
will be considered
Be sure to comply with Articles of Incorporation, Bylaws, and other organizational documents (e.g.
Operating Agreement) and any contractual restrictions.
What Not To Do:
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Don’t commingle corporate and personal funds.
Don’t use corporate accounts for personal loans or other personal purposes.
Don’t do insider deals on loans, leases, etc., between the corporation and a principal other than on
an “arm’s length” basis (just as you would with someone not associated with the corporation).
Don’t use corporate assets for personal use.
This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is
provided with the understanding that it does not constitute the rendering of legal advice or other
professional advice by Goodwin Procter LLP or its attorneys. Additionally, the foregoing discussion does
not constitute tax advice. Any discussion of tax matters contained in this publication is not intended or
written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue
Code or promoting, marketing or recommending to another party any transaction or matter. © 2009
Goodwin Procter LLP. All rights reserved
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CHOOSING AN ENTITY FOR YOUR BUSINESS
GLOSSARY
Board of Directors:
primary governing body of a corporation. The Board appoints officers and
approves important corporate actions such as sales of assets, loans to and
from the corporation and sales of shares. LLCs and LLPs may also have
Boards of Directors or Managers, if their operating agreements so provide.
Corporation:
legally separate business entity that is owned by shareholders/stockholders,
each holding interests in the corporation called shares or stock. A
corporation may be classified for IRS purposes as a Subchapter C
corporation (“double taxation”) or Subchapter S corporation (“passthrough taxation”).
D/B/A:
“doing business as.” A d/b/a is required when an individual or a business
entity wants to do business under a name that is different than her or its legal
name. A d/b/a may be obtained at city hall in the city in which the business
is located.
Double taxation:
two layers of tax that occur in Subchapter C corporations. The corporation is
taxed as it generates taxable income; the shareholders are taxed on those
same dollars when they receive cash dividends (i.e., distributions of profits).
LLC:
limited liability company. LLCs are legally separate business entities whose
owners are called members. LLCs receive pass-through taxation treatment.
Governed by an operating agreement rather than by-laws.
LLP:
limited liability partnership. LLPs are legally separate business entities,
similar to LLCs, whose owners are called partners. LLPs receive passthrough taxation treatment.
General Partnership:
default structure for a business owned by two or more persons or legal
entities. Often evidenced by a partnership agreement.
Pass-through taxation:
occurs when the entity itself pays no tax on the income it generates. Tax
liability for the entity’s income is passed through to the owners of the entity,
who report the income on their individual tax returns.
Shares/Stock:
equity interests in a corporation. Shareholders/stockholders own a
corporation. Shares may or may not be represented by paper certificates (if
not, they are called “uncertificated shares”). Shares are also sometimes
referred to as “shares of stock.”
Sole proprietorship:
default structure for a business owned by a single person. Sole
proprietorships are not separate legal entities.