Many people are confused when the topic of business entities and legal formation arise. For most people, the question begins with “what even is a business entity, and why is it important to have one?” From there, people often wonder if the process is as long and dubious as other legal process, and if so, how they will take on this gargantuan task. In terms of legal formation, there are Limited Liability Company (LLC), General Partnerships, and Limited Partnerships (amongst many more). However, while legal formation is not simple, it also does not have to be this hazy, complex, and misunderstood concept. This guide will break down the basics and essentials of legal formations and becoming a business entity.

Importance of Legal Formation

Legal formation can occur in a few different ways, depending on the kind of business someone is in, the legal precautions they choose to take, and a few other factors. However, regardless of the kind of legal formation someone chooses to undertake, they should take some sort of formation. Legal business formation “will determine the personal liability of the founders, how taxes are paid, and other important details”(Cite #1).

Legal Formation Basics

There are five main legal structures  for businesses, in most cases. These structures differ greatly in what they encompass, and are as follows:

• Sole Proprietorship, in regards to business formation, is someone who owns an unincorporated business by themselves. This type of enterprise is owned and run by one person and there is no legal distinction between the owner and the business entity.
• Partnership is “the relationship between two or more people to do trade or business. Each person contributes money, property, labor or skill, and shares in the profits and losses of the business” (cite #2). In terms of business formation, this means two or more participants taking ownership of the business.
• Limited Liability Company (LLC) is a legal status that relieves “business owners of personal responsibility for their company’s debts or liabilities and establishes the business as its own legal entity” (cite #3).
• Corporation, in this sense, is similar to an LLC in the fact that it relieves business owners of personal liability due to business logistics. However, a corporation is owned by shareholders, as opposed to an LLC.
• Non-Profit is a business that has been classified as a legal entity and “has been incorporated under state laws to operate for purposes other than making profits”(cite w/ #4).

An LLC is the legal formation that fits most situations of legal formation the best, at least in terms of for-profit businesses. However, make sure to seek further counseling before deciding which form of legal formation to pursue for your business!

Documents and Essentials

Initial Documents and Information

A small business owner needs some essential information prior to embarking on the journey to legal formation. Potential first steps and questions to consider in the legal formation process are:

• Solidify name of your business
• How much start-up cash will you/did you need to begin?
• How many employees will you/did you have during your first year of business?
• What US State will you form in?
• Will you have any “partners” who have ownership stake in your business?

These questions and considerations are not all encompassing. However, they do lay down a good framework for small businesses and start-ups to begin their journey to legal formation, while minimizing mistakes and roadblocks.

Employee Identification Number (EIN)

An Employee Identification Number (EIN) is the equivalent of a Social Security Number (SSN), but for your business. Whereas people have SSNs, business entities and legal formations register with the IRS with their EIN. An EIN will allow the IRS to identify your business. Furthermore, an EIN is an essential item before next steps within the business process, such as creating a business bank account, gaining a small business loan, etc.

Bank Account

Other essentials, such as an EIN, are required before being able to start a bank account for your business. Therefore, meeting all prior requirements (business name, EIN, business license, etc.) is of the utmost importance when considering obtaining a bank account specifically for your business. This business will aid in legal formations as it takes a step to further clarify the divide between personal and business finances.

Lawyers and Logistics

In terms of legal formation, a lawyer is not essential — none of the numerous processes outlined within this blog specifically or legally requires a lawyer to carry-out. However, legal formation is a cumbersome and thorough task, with much room for errors — these errors are easily alleviated and/or avoided on the front-end, but can be costly to fix and reverse at a later-date. Therefore, it is suggested that you do not treat legal formation like a DIY-project — instead, involve the help of a legal professional if possible.

There are a few focal points when searching for the aide of a legal professional that is right for your business and yourself. Aside from how the professional relates to you personally, it is important to find a lawyer that:

• Has a lot of experience in the field of legal formation and business-law. As with anyone you seek to hire, experience stands out — you do not want someone who is just learning the ropes of legal formations themselves handling the process of turning your small business into a business entity. Therefore, seek someone with tenured experience and quantifiable past-results when searching for a legal professional to aide in the legal formation process.
• Can connect and communicate with you easily, clearly, and frequently.  Any professional, no matter how good or experienced they are, will not be able to assist you in the legal formation process if communication is foggy. Sometimes, people just do not see eye-to-eye about communication. Therefore, it is essential to find someone that you can easily communicate with in order to remove the possibility of miscommunications and avoidable errors.
• Asks a lot of questions. This is another sign of an experienced, detailed-oriented professional. Furthermore, this trait shows the your legal professional has an interest in not only the legal formation process, but your business as well.

If you have any other questions related to business formation, starting a business, or anything else small-business related — take the time to schedule an appointment with your local Pennsylvania Small Business Development Center today!

Works Cited

1. https://www.findlaw.com/smallbusiness/incorporation-and-legal-structures/business-formation-quickstart.html#:~:text=Business%20formation%20is%20a%20necessary,paid%2C%20and%20other%20important%20details.
2. https://www.irs.gov/businesses/partnerships#:~:text=A%20partnership%20is%20the%20relationship,Form%20a%20partnership
3. https://www.legalzoom.com/articles/what-is-a-limited-liability-company-llc?kid=_k_CjwKCAjwyaWZBhBGEiwACslQo54DzgfVOgGG1QF-dU5o7SOhcxtOTmtEyhXvysceIX2FMJGlFnevuRoCalwQAvD_BwE_k_&utm_source=google&utm_medium=cpc&utm_term=what%20is%20an%20llc&utm_content=548885737853&utm_campaign=SMB%20|%20LLC%20|%20Exact&kpid=go_428417887_38523822182_548885737853_kwd-250860798_c&gclid=CjwKCAjwyaWZBhBGEiwACslQo54DzgfVOgGG1QF-dU5o7SOhcxtOTmtEyhXvysceIX2FMJGlFnevuRoCalwQAvD_BwE
4. https://www.law.cornell.edu/wex/nonprofit_corporation#:~:text=A%20nonprofit%20corporation%20is%20a,nonprofit%20corporations%20vary%20by%20state.

Written by Brian Kennerly, Pennsylvania SBDC Lead Office Marketing Team

Brian Kennerly is currently a Graduate Assistant at Kutztown University of Pennsylvania while pursuing his Master’s in Business Administration. His hometown is Upper Darby, PA, and he attended the University of Virginia for his undergraduate career.