As the phrase itself suggests, business formation is the starting process of establishing how a new business is structured to function. Business formation also includes the creation of a legal structure as well. This process is extremely important as the specific legal structure established will effect (and ultimately determine) the legal liability of the business founders. State to state, the requirements and definitions for forming a specific type of business can vary drastically. That said, it is vitally important to know the business formation laws pertaining to the location of the business to be formed. Some examples of business legal structures are as follows:
- Sole Proprietorships are the simplest form of business structures. Typically, sole proprietorships are formed when freelance or ‘contract’ work is performed by a business owner under his/her own name. In most states, no further action is required than to be working under your own name to establish yourself as the sole proprietor of a business.
- Partnerships are formed when two or more parties start a business together. This is where it’s important to pay close attention to the details surrounding business formation. In forming a partnership, questions such as “who will run the business?”, “how will profits be split?”, and “what happens to the business during dissolution?” will be addressed. The business formation stage of a partnership will establish protocols and procedures that protect and benefit all parties involved.
- Corporations are split into two general categories. C corporations are usually formed for business’ with multiple employees, whereas S corporations tend to be formed by smaller business’. Primarily the major difference in C and S corporations is the way business taxes are paid. C corporations are taxed as an entity, where S corporations are taxed “passing through” to the individual tax return of the business owner.
- Nonprofit Organizations are defined as business where the owners, shareholders, or investors do not profit off of “excess revenue” generated by the business. Nonprofit business’ typically use excess revenue to pay employees, owners, and further the organization’s original mission. There are various types of nonprofit organizations, but commonly nonprofits are established as a 501(c)(3) as per IRS tax code.
- Franchises (unlike traditional business structures) licence the trade secrets, logo, name, and various aspects of already existing business’. This allows a small business owner to pay a larger corporation for the right to use the larger corporation’s name to sell the larger corporation’s products or services as a business for him/herself. Often times franchises are started as LLCs, partnerships, or S corporations.
- Limited Liability Company (LLC) Normally, LLCs are formed combining the features of business structures like corporations and partnerships. LLCs establish management agreements, protect individuals from business debt, and protect owners from certain liabilities.
When starting a business, business formation should be among the first steps taken to ensure the business and its structure are clearly defined. This should be done well before employees are hired and business is conducted. By clearly and legally defining the structure of a business’ formation, owners, partners, shareholders, investors, and employees are all on the same page as to the business’ structure. Through business formation law, a business and it’s entities are privy to protections from liability. Furthermore, by establishing a business’ structure through business formation, expectations and roles of partners, investors, employees, etc, are laid-out. This is imperative should a dispute need be resolved after the business formation.
With a clear structure laid out during business formation, any disputes or disagreements can quickly be resolved as per the agreements and arrangements set during the business’ organization.