The Fundamentals of Company Formation

Company formation is the first step in opening a business. It helps companies answer
several questions, including:
• Who will make decisions?
• How will income be taxed?
• Do the owners bear personal responsibility for the company's debts and actions?
• How long will the company exist?
Note: here, “company” refers to the legal structure of a business.

Agent: can legal bind the entity by signing contracts, obtaining loans, etc. in the
ordinary course of business

The Sole Proprietorship

Any individual who opens a business alone is operating a sole proprietorship.
• owner is called the proprietor
• proprietor and company do not have separate legal existences, company is alter
ego of proprietor
• owner has the prerogative to make any business decision, but the owner also
shoulders sole responsibility for the acts or omissions of the company
• official registration is typically not required but registration
o (1) grants mark of legitimacy & competency,
o (2) provides a solid legal foundation for expansion
o (3) may be required by law
o for example, using initials or just first name would require registering a DBA
• Steps to form sole proprietorship (only general partner needs to sign registration
form):
o (1) give notice to relevant local, state, & national tax agencies (like the U.S.’s
IRS)
o (2) by obtaining a local government-issued business license or permit
o name registration may also be required, but only if proprietor decides
against using legal name as part of company’s name, the registered names
are “doing business as” (“DBA”) names (fictitious names).
• once company is set up, proprietor may still need to complete steps such as
registering to withhold employee payroll taxes, but these tasks are business
specific and aren’t inherent to sole proprietorships
• Tax implications: Income from the business is taxed as the personal income of
the proprietor.
• Appropriate to use if:
o Want zero downtime between formation and operation
o Require little outside capital
o Will be selling a low-risk product or service

Partnership
A partnership exists when two or more people create a company.
• 2 types:
o General partnership
 A general partnership is equal, where partners share investment,
work, and more. Each partner is an agent of the company.
 Partners are jointly and severally liable
 o Limited partnership
 has two types of partners:
 General partners: personally liable for obligations of the
partnership; responsible for day-to-day management & control of
the company; typically exercise the powers of agent on behalf of
the company
 Limited partners (“passive partners”): typically do not
participate in managing the company; liability if sued is limited
to the value of their original investment
 Must have at least 1 general partner
• Partnerships may be formed by filing a registration document with the relevant
governmental agency.
• Partnership agreement: defines the partners' relationships & sets basic
company policies, including how profits will be shared amongst partners.
o are reached in both general and limited partnerships, and are made before—
or immediately after—registration.
• Partnerships are legally distinguishable from owners
• Advantages:
o Capital can be raised by admitting new partners
o Each partner can contribute their skills to the venture
• Disadvantages:
o 1 partner’s bad decision can create liability for all
o Disagreement amongst partners can lead to deadlock

Corporation
Corporation: A legal entity separate from the people who own and operate it, didn’t
exist in practice until the law created them
 2 types:
o C corporations: Income is taxed through the corporation and shareholders
also pay tax on income earned through company profits.
o S corporations allow corporate profits, losses, and tax credits to flow
through the company to its shareholders.
 shareholders, directors, and officers have limited liability
 Ownership of a corporation is divided into pieces called shares (owners are known
as shareholders)
o Shares can be sold, given, or willed, meaning that passing on a corporation is
easy.
 created by filing articles of incorporation, after which the company must set its
operating rules, called bylaws.
 Directors oversee the corporation and make decisions
 officers are responsible for the day-to-day.

Remember: The ability to sell shares gives corporations a money-raising advantage

over other types of companies.

A corporation’s

Limited Liability Company

SMARTLY
Limited Liability Company: A hybrid of the other types of multi-owner companies,
which is a separate legal entity from its owner(s).
 The owners of an LLC are known as members.
 Often, an LLC doesn't need a formal set of rules. They are designed to have less
formality to facilitate a flat organizational structure.
 The company ends when a member retires, quits, or dies.

Articles of Organization: A document that needs to be filed with a state agency to

start an LLC.

Members can delegate management authority to one person, who becomes the
managing member.
 For members, personal liability is normally limited to their original investment.

Forming an LLC has several requirements, including:

• filing articles of organization
• creating a solid operating agreement
• keeping good records

Owner Taxes Durability Personal

(s) Liability?
Sole 1 Owner pays; Life of owner Yes
Propriet business income = (when proprietor
or personal income dies, company
dissolves but
company assets
can be
inherited);
simple to
sell/transfer
Partners 2+ (i.e. Partners pay but Indefinite (with Yes; jointly and
hip 2 or partnership must conditions) severally liable
more) also file a tax (each partner’s
return for money & property
informational could be taken to
purposes; income pay damages and
or loss “passes even death of a
through” company partner doesn’t
to the partners, excuse those
each partner obligations)
reports his or her
share of income
(or loss) on their
personal income
tax return
Corporat 1+ Company/Sharehol Indefinite No
ion ders pay
LLC 1+ Members pay; Indefinite (with No
Profits and losses conditions)
are reported on
the members'
individual returns
and are taxed at
their personal
income tax rate