What is a Business Entity and Why Do I Need to Form One?

While it is possible to conduct business in your personal capacity, in most cases, it is strongly advised to create an entity, separate from yourself, when conducting business.

Lerae Funderburg
July 24, 2018

 

[1] What is a Business Entity and Why Do I Need to Form One?

 

While it is possible to conduct business in your personal capacity, in most cases, it is strongly advised to create an entity, separate from yourself, when conducting business. One of the most important reasons to create a separate business entity is to protect yourself from personal liability for the acts of the business. For example, if your company becomes the subject of a personal injury claim and you did not create a separate entity for your business, the plaintiff can come after your personal assets as well as the assets of your business. However, if you created a business entity and properly maintained the distinction between yourself and your business entity, the plaintiff can be restricted to only the assets of the business. Another reason to create a business entity is to simplify management and governance of the business organization. A business that involves more than one owner means there will be ownership shares and rights particular to each person. It is much easier to have an organizational document that stipulates the rights and responsibilities of owners as opposed to having separate and complicated contracts to define the relationships between the parties. Also, entity formation is typically a requirement if your business intends to raise outside capital. The business entity facilitates this by pooling all the business assets and liabilities into the organization instead of dealing with the finances and claims of everyone involved. Lastly, business formation greatly increases your level of professionalism in dealing with the public; it bolsters confidence in your business so that your clients and customers can rely on the stability of your business.

 

The different types of business entities are sole proprietorship, partnerships, corporations, and limited liability companies. 

 

Sole Proprietorship: This type of business form is the simplest form of business entity. It is run by a single individual for that individual’s sole benefit. Sole proprietorships are not separate legal entities and do not exist apart from the owner. The owner is personally liable for all debts and claims of the business. Sole proprietorships are however considered separate entities for accounting purposes so that financial activities of the business must be separately maintained from the proprietor’s personal finances unrelated to the business. Sole proprietorships terminate upon the owner’s death.

 

Partnership: A partnership is formed when two or more people associate for the purpose of carrying on a business for a profit. Partnerships can be based on express, implied or oral agreements between the parties. Each partner contributes property, money, labor or skill to the partnership and shares equally in the profits and losses of the business, unless stipulated by agreement. Each partner is also personally liable, individually and severally, for the debts and liabilities of the business. Partners are taxed on their share of the business and profits are filed on their individual tax returns. Learn more (link to partnership basics).

 

Corporations: Corporations are separate legal entities governed by state law. To create a corporation, Articles of Incorporation must be filed with the Secretary of State. Owners of a corporation (shareholders) are shielded from personal liability for corporate acts. The majority of corporations are Subchapter C Corporations (C-Corps), and they are subject to double taxation: corporate profits are taxed first and capital gains are taxed when shareholders receive their dividends. Subchapter S Corporations (S-Corps) are closely held corporations with a small number of owners. S-Corp status is obtained through the Internal Revenue Service (IRS) and where certain IRS requirements are met, these S-Corps are not subject to double taxation and are instead taxed like partnerships. Taxes on the corporate level are eliminated altogether and the individual owners report profits on their individual tax returns, thereby avoiding double taxation. Learn more (link to Corporations).

 

Limited Liability Company (LLC): Limited Liability Companies are a favored business form for small businesses. They contain qualities of a corporation and a partnership. The management and governance of LLC’s has the same flexibility as a partnership, while maintaining the same limited personal liability as a corporation.

 

There are advantages and disadvantages to each business organization. The choice of business entity is shaped largely by how you intend to finance the business, the likelihood of major profits, and the number of people involved in the business. Other factors to consider are the flexibility of maintaining the business entity and taxation. Consultation with a tax professional is strongly advised.

 

[2] What is a Fictitious Business Name Statement?

 

A DBA, “Doing Business As”, is a fictitious business name filing, stating the name that the company operates under, when it is different from the legal name of the company. Some states require DBA filings because they are made in order to protect consumers who conduct business with the company. DBA’s are common in sole proprietorships or partnerships, to provide a name for your business separate from your own. Some banks require DBA’s in order to open and operate a business account. The procedures for filing a DBA vary among the jurisdictions, but it generally requires a visit to your local county clerk’s office where you pay a registration fee. Some states require publication in a local paper for a certain period of time as well, to put the public on notice of your intent to do business under your selected business name.

 

[3] Partnership Basics

 

A partnership is an association of two or more people carrying on a business for a profit. This is the easiest and cheapest legal entity to set up. Partnerships are created by default whenever two or more people go into business together without setting up a formal legal entity with the Secretary of State. They are created by express, oral or implied terms between the parties. Without a written agreement to the contrary, partners share equally in the management and control of the partnership.  Each partner contributes property, time, skill, money or some contribution to the partnership. Partners also share equally in the gains and losses of the partnership, and they are jointly, severally and individually liable for the debts and liabilities of the partnership unless otherwise stipulated in writing. This means that a person suing a partnership, can go after one or more partners and also reach their personal assets outside of the partnership. This entity offers no protection from liability. The Partnership Agreement is the document that governs the partnership, distribution of assets, duties of the partners, and termination of the partnership. The main benefit of a partnership is that it offers pass through taxation whereby the partnership is not taxed and the partners are only taxed on their share of the business, so their profits are filed on their individual tax returns.

 

Types of Partnerships:

 

  1. General Partnership – previously described hereinabove.
  2. Limited Partnership - partnerships whereby the personal liability of certain individual partners (limited partner) is limited to the amount of their capital investment; limited partners generally do not have any rights to control or management of the partnership, which is how they maintain their limited liability; most states require filing of Certificate of Limited Partnership with SOS.
  3. Limited Liability Partnership – similar in all respects to a general partnership; shields partners from the negligence of another partner; used most commonly in law and accountant firms; ensures that a grieving client or patient cannot come after the professional’s business partners for acts they did not commit.
  4. Limited Liability Limited Partnership – partnership whereby neither the general partners nor the limited partners have personal individual liability for the debts of the partnership during the time period of the LLLP election; most states require filing of Certificate of Limited Liability Limited Partnership with SOS; more costly to form than a Limited Partnership; fairly new entity and not commonly used.
  5. Joint Venture - association between two or more people for the purpose of making a profit, solely for a specified period of time or to carry out a specific goal or project; essentially a General Partnership that is limited in scope and/or duration.

 

[4] How to Set Up an Entertainment Loan Out Company for Your Entertainment Services

 

  1. Become acquainted with your state’s Secretary of State (“SOS”) website. It has a wealth of information to guide you in creating your corporate structure. Most states allow for you to form businesses online by filling out contact information and providing the applicable fee.
  2. Do a name search just to be sure that your business name of choice is available in your state.
  3. Locate the corporations tab on the relevant SOS website and follow the prompts to creating the corporate structure of your choice.
  4. You must have a registered agent in the state of registration of the business. There are entities that provide this service for a yearly fee. If you are filing a business in the state in which you reside, you may be your own registered agent. The registered agent is the individual responsible for receipt of service of process for your business. All this means is that if you are sued and have to be personally served, someone has to be on file as a person authorized to receive summons on behalf of your business. Contact us if you need a registered agent in the state of Georgia.
  5. Wait for confirmation from the SOS that your business entity has been formed.
  6. Draft entity documentation (Operating Agreement for LLC, Bylaws for Corporation, Partnership Agreement for Partnerships, Joint Venture Agreement for Joint Ventures) Contact us for all of your drafting needs.
  7. Apply to the Internal Revenue Service (IRS) for an Employer Identification Number (EIN). The application is fairly simple and straight forward and can be done online at www.irs.gov, or you can file a paper application (Form SS-4) and mail it in to the IRS. More information can be found on the IRS website. An EIN provides the business with an identification number for income tax purposes so that you do not have to use your social security number on financial documents related to your business. You will need this to set up a business bank account.
  8. Open up a business banking account with an accredited financial institution (e.g. Bank of America, Wells Fargo, PNC, Suntrust, etc.). You will need a copy of your organizational documents (i.e. Operating Agreement, Articles of Organization, DBA certificate, etc.) indicating that you are a registered entity and describing people who will be authorized to transact with the bank on your company’s behalf. Shop around to different banks to find out their account requirements and associated fees in order to ensure you select an account type that is best suited for your needs.
  9. Manage all business-related operations through your loan out company. This means sign all contracts in the name of your business. Pay yourself a salary from your business account to your personal account – DO NOT just use your business bank account as your personal account. Your business bank account statement should only contain transactions related to your business!
  10. Affiliate with SoundExchange and register all the songs in which you perform as a recording artist on them. Contact us to order our E-Books entitled “Monetize Your Music” and “Music Publishing” for more details.

 

[5] Should You Incorporate?

 

Corporations are governed by state law. They are created by filing Articles of Incorporation with your Secretary of State (“SOS”) and paying the associated fees. Depending on your state, additional documents may need to be filed with the SOS as well, so be sure to check your state’s requirements to be in compliance. Generally, corporations are owned by its shareholders, governed by its Board of Directors and run by its officers. The Shareholder’s Agreement is an internal document that governs the corporation and includes information regarding the purpose of the corporation, ownership shares, voting for new members officers and the Board, capital and contribution, allocation of profits and losses, roles and duties of officers, shareholders and the Board, and dissolution. In addition to the Shareholder’s Agreement, the corporation must have employment agreements between the corporation and those employed by the corporation.

 

Corporations are required to maintain corporate formalities as required by the state of its establishment. There is a requisite number of Board members and roles to be held by the Board. Annual meetings of the shareholders must be held in strict compliance with notice and meeting procedures and protocols. Meeting minutes must be taken and kept on file at the principal place of business for a certain period of time. These are just some of the corporate formalities that are uniform across the states, but it is important that you inquire into what your state’s corporate requirements are and to do all acts to maintain the separation between you as an individual and you as a business owner.  

 

The main advantage of a corporation is that it offers limited liability to its owners, meaning that the shareholders are not individually responsible for the debts of the company. Where a corporation is sued, the plaintiff may only go after the debts of the corporation and cannot reach the assets of the individual owners of the corporation. Corporations undergo double taxation, meaning that taxes are paid once on the corporate level and again on the personal level when shareholders receive their dividends. Because there are so many corporate formalities (which may vary by state law), corporations are more expensive to set up and maintain. People usually set up their corporations in the state in which they reside or plan to do business, but there is a trend for larger companies to incorporate in Delaware or Nevada due to their low costs and minimal taxes.

 

Failure to maintain the separation between yourself and your entity will expose you to individual personal liability. Where a party can show that you created a corporation for the sole purpose of avoiding individual personal liability, the corporate veil can be pierced, and you will be subject to personal liability. In laymen’s terms, if you create a business and run the business as an extension of yourself, and your business is sued, and the other party can prove that your business is really a sham - as you are just incurring debts and liabilities in the name of a company that does not really exist, then not only can that party come after all of the assets of your business, but it can come after you and all of your personal assets as well. If the business is sued, a grieving party only has rights to what the business has, so if your business has $48 of assets, that’s all they’re getting. But if the business is sued and corporate formalities were not maintained, and the corporate veil is pierced, a grieving party can come after you, your house, your car, your bank account, and your dog (lol, you get the point).

 

Types of Corporations

 

There are three (3) different types of corporations, and they are for profit corporations, non-profit corporations and closely held corporations. Profit Corporations are the ones previously described hereinabove, and they may or may not sell shares in an open market. Non-Profit Corporations typically run to further an ideal or goal and are less centered on making a profit. They usually serve the interests of the public interest. Some non-profits do engage in private sector activities. Closely Held Corporations are corporations with a limited number of shareholders. These are usually family owned business where the owners actually operate the business from day to day. There are limits on the number of shares of stock and strict rules against transferability.

 

Corporations can additionally be divided into two (2) categories: C-Corporations and S-Corporations. C-Corp’s are the ones I’ve just previously described. The majority of corporations fall into this category. C-corps are subject to double taxation where funds are taxed first at the corporate level and again once dividends are distributed to its owners (shareholders). Then we have S-Corps. S-Corps are not registered with the SOS, instead they are filed with the Internal Revenue Service. S-Corp is a tax designation that can be granted to a corporation or limited liability company. If certain requirements are met, and S-Corp status is granted and maintained, corporations can avoid double taxation and be taxed the same manner as partnerships. The requirements of S-Corp status are:

 

  1. There must be 100 shareholders (owners) or less (closely held corporations);
  2. All shareholders must be individuals (no corporate entities, trusts, etc.);
  3. The corporation must be domestic (US citizenship for shareholders); and,
  4. The corporation is limited to one class of stock.

 

The benefits of an S-Corp include:

 

  • It creates credibility with potential consumers, investors, and employees by showing a commitment to the company;
  • The shareholders may be employees and receive tax-free distributions in relation to their ownership share;
  • The characterization of distributions as salary or dividend may save owners with employment taxes;
  • Federal taxes are not paid at corporate level. They are only paid once distributed to owners who then pay for their individual tax based on their share, which can also be offset by other income on shareholder’s taxes; and,
  • Interests in an S-Corp are easily transferable without adverse tax consequences (e.g. change in property basis).

 

There are some drawbacks to S-Corp status, and they include:

 

  1. Since it is an IRS designation and the IRS doesn’t play about granting benefits, this S-Corp status is under strict IRS scrutiny;
  2. You can lose S-Corp status if there are mistakes in filing, stock ownership, notification, consent, etc.
  3. There are some fees (not excessive, but some) associated with S-Corp including, registration of the corporation or LLC with SOS, annual report fees, state franchise fees, etc.
About The Author
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Funderburg Law is an Atlanta based boutique transactional law firm that focuses on entertainment law, business law and estate planning law. We bring excellence, professionalism, integrity, and humility to every issue presented. Our philosophy for success is providing individualized service, ...

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