What are business formation documents?
When starting a new business, one of the most important steps to take is to make sure that the business is properly organized and protected. This process usually ends up involving the creation and filing of a number of basic legal documents that have been determined by a state or government entity to be necessary to the formation and protection of any business. These "business formation documents" usually include items such as Articles of Organization, Certificates of Formation , and Certificates of Incorporation. While the types and required number of documents vary from state to state, these business formation requirements generally apply to any legal business entity, regardless of whether they are corporations, LLCs, or some other kind of formal business entity. Properly preparing and maintaining these documents is essential to the long-term success of the business; failure to prepare or keep up with these documents can affect the day-to-day functioning of the business as well as the legal protections afforded to the business and its owners.
Types of businesses requiring business formation documents
The four most common types of business entities are sole proprietorships, partnerships, corporations, and LLCs.
Sole Proprietorships
The simplest form of business is the sole proprietorship because there are no legal formalities required. However, aside from basic business identification documents like a fictitious business name statement or other business licenses and permits, there are no formation documents for a sole proprietorship as a business entity. Instead, a sole proprietorship is simply created when a natural person transacts business in his or her own name and an assumption name. When necessary, the fictitious business name statement is filed with the county in which the business will operate. Because there are no formalities required for a sole proprietorship, you can start and end a sole proprietorship without having to take legal steps. That said, you are personally liable for the debts and obligations of the business.
Partnerships
Partnerships can be create without formalities, just like sole proprietorships by simply transacting business in a name other than your own. If a partnership is established without formalities, you will have liabilities similar to that of a sole proprietorship. Alternatively, a specific partnership agreement can be created to govern the agreement. The specific partnership agreement should be in writing, with all material terms agreed to and signed by the partners. A specific partnership is not required by law and is not necessary unless the partnership agreement is complex. Limited Partnerships require formation documents including a certificate of limited partnership that must be filed with the Secretary of State. The limited partnership must have at least one general partner who has unlimited liability for the debts and obligations of the partnership, and at least one limited partner who has limited liability. Thus, a limited partnership is required to have general partners. In addition to a certificate of limited partnership, a limited partnership agreement is also recommended to govern the relationship among the partners. A limited partnership can include "general partners" who manage the business and are personally liable for all of the debts and obligations of the business, and "limited partners" who have limited liability but do not participate in the management of the business.
Corporations
Corporations are managed directly by the shareholders, officers, and directors. Corporations require articles of incorporation that must be filed with the Secretary of State. The basic corporate document is the bylaws that govern the relationships among the shareholders and corporate officers. Shareholders of the corporation elect the directors, and the directors appoint the officers. A corporation is organized in various states as a C corporation, S corporation, or other type of specific corporation. Regardless of the type, corporations are required to follow corporate formalities including holding annual meetings, keeping corporate minutes, etc.
LLCs
LLCs are managed by their members or managers. A limited liability company requires articles of organization to be filed with the Secretary of State. The basic organizational document is an operating agreement. Members of an LLC appoint managers who manage the day-to-day operations. Limited liability companies are required by statute to have an established management structure. Members should follow internal processes and procedures to retain the liability protection of the business organization.
The articles of incorporation, what are they?
The articles of incorporation is the document used to create a corporation and is provided to the state of incorporation. The articles of incorporation or certificate of incorporation (where "certificate" is often used as a substitute for the word "articles") require approval by the secretary of state of the jurisdiction where the company will be incorporated. Each state has its own requirements for what must be included in this document, but each requires certain material provisions.
Material Provisions Under § 10A-3-2.01(a) of the Alabama Business Corporation Act, a document of incorporation must include:
- (1) The name of the corporation including the word "corporation", "incorporated", "company", "limited" or an abbreviation thereof in the form of "corp.", "inc.", "co.," "ltd.", "lb." or "ltd."
- (2) The number of shares the corporation is authorized to issue.
- (3) The street address of the initial registered office and the name of the initial registered agent at that address, or the name and address of the initial commercial registered agent and the county of the initial registered office.
- (4) The name of each incorporator.
- (5) The name and address of each director.
- (6) The date and time when the corporation will start conducting business, which can be a date certain and as much as 90 days after filing.
- (7) The name of the "trading end" principal office. There are many other optional provisions that can also be included like the names of the officers, directors, indemnification provisions, or any other provision not prohibited by law. These provisions require more thought and aren’t appropriate just to file a basic document with the state.
Importance of Filing This Document File this document passed at the first organizational meeting or by unanimous consent of the incorporators before doing business at your own risk to the extent your actions are challenged either by private or government actors. By filing this document with the secretary of state you are recognized as a legal entity.
Operating agreements and bylaws
When it comes to business formation documents, the most commonly overlooked part is the Operating Agreement or the Bylaws. In general, an Operating Agreement or a Bylaw is akin to the company’s "rulebook" for how the company will be run and what rights everyone has. The Operating Agreement and Bylaws of a company can include the requirement of the company to do things like annual meetings or establish quorum requirements.
Operating Agreements
If you form a Limited Liability Company (LLC), you should have an Operating Agreement. Generally, an Operating Agreement establishes the rules of the operation of an LLC. In addition to establishing general rules like annual meetings, required quorum votes, and anything else management deemed necessary to run the company, an Operating Agreement should also include the voting rights of each member, the distribution of profits, and what happens if a member wishes to leave the company.
In Nevada, an Operating Agreement does not have to be written down – so theoretically it could be verbal, but I have never heard of any company that did not have a written Operating Agreement.
Bylaws
If you formed a corporation, you likely have a set of Bylaws. The Bylaws are a lot like an LLC Operating Agreement, and will establish rules of operations for scene following the same topics above (quorum, meetings, voting rights, distribution of profits, etc.). The Bylaws of a corporation are also where you will find the corporate officer designations (President, Secretary, Treasurer, etc.) and their responsibilities.
It is always recommended to have Bylaws written down, and despite Nevada not requiring Written Operating Agreements, all the corporations I’ve helped form have them.
EIN and other business licenses
If you’ve recently created your business formation documents and registered the business, the next step is to obtain an Employer Identification Number or EIN. All businesses with employees must have an EIN. It is similar to a social security number; it identifies the business for employing people and reporting to the government. It also helps the IRS track your business’ tax filings and payments. Additionally, creditors use EINs to check credit histories of other businesses. You can easily apply for an EIN online through the IRS website and you generally do not need to hire a lawyer to do it for you or require any additional corporation documents.
However, there are other business licenses and permits required of many businesses. Not all types of businesses will require all of the licenses and permits listed below. You should also note that generally you should get the licenses before you start operations. The business location can therefore affect whether the license is necessary. Many cities and counties require businesses in their areas to obtain licenses and/or permits before you start operating. Also, the formation documents required for the business may be dependent on the location of the business and its type. Therefore, it is highly recommended that you consult with experienced business lawyers to determine what other additional documents or permits will be required. The list below contains general examples of forms, permits, licenses, and documents that many businesses need:
• Business license
• Business permit
• Signs
• Public health licenses
• Sales tax licenses
• Employee Health & Safety permits
• Fire permits
• Alcohol and beverage permits
• Health permits
• Zoning permit or zoning variance
• Workers’ compensation insurance
• Hazard insurance
• Building permits
• Professional licenses such as bar admission and bar association membership
Filing business formation documents, step-by-step
Once you’ve determined the right business structure for your company, and you’ve prepared the required formation documents, it’s time to file them with the state. This process is relatively straightforward and is similar for most entity types. With each different type of business entity, there are two basic ways that the formation documents can be filed:
Filing by mail
The simplest and most inexpensive way to file your business formation documents with the state is simply to mail it in. The Secretary of State has all the forms and filing directions that you need right on their website. In most cases, you’ll need to attach a filing fee to the documents – typically ranging from $10 to $125 depending on the state and entity type. Generally, it takes anywhere from 2-5 business days for the state to process your filing, after which they will send you a notice confirming that your filing was approved. Generally, the filing instructions for corporations and limited liability companies are pretty straightforward, with a few simple exceptions. One of these exceptions is the requirement for certain businesses (known as professional entities) to obtain an additional approval from a regulatory agency or the state head of the agency relating to the profession. These businesses include accountants, lawyers, architects, psychologists, veterinarians, and certain healthcare providers. Additional forms and filings are often required in order to create these entities. Any businesses that are using a name other than their legal name also need to file a Fictitious Name Certificate (also known as Filing a DBA or "doing business as") with the state, depending on the state’s requirements. Fictitious Name Certificates let your customers and other companies know your company’s business name rather than your legal name. The Fictitious Name Certificate is typically a short document, a small filing fee, and a 2-5 day waiting period.
In some states, it’s also possible to file business formation documents in person. Most entrepreneurs avoid this solely for the sheer inconvenience of having to get to the Secretary of State’s office during business hours. But if you are forming your business on a trip or there’s another reason to get it filed immediately, this might be your best option. Many entrepreneurs hire an attorney to file the business formation documents for them. This is often helpful for companies that require special tax treatment , or that have special considerations regarding their formation documents. However, generally speaking, hiring an attorney to do the routine filing of business formation documents doesn’t provide any measurable benefit to the entrepreneurs. Additionally, hiring an attorney can be costly, and most routine business formation document filings cost less than attorney fees alone. As a result, it’s often more practical for most entrepreneurs to file the formation documents themselves on their own. However, in some cases a lawyer may be necessary to prepare the formation documents, particularly where certain regulatory approvals or applications are needed in order to create the desired entity. In those cases, most business formation attorneys offer a complete package that includes both preparing and filing the formation documents with the state.
The principal advantage of having a business attorney file the formation documents for you is to make sure that there aren’t any mistakes or omissions in the documents. Mistakes and omissions in business formation documents, especially those relating to corporations and limited liability companies, can cause major problems down the road, and in some cases result in the loss of limited liability protection. Additionally, having your formation documents reviewed by an experienced attorney can save you money by making sure you are adequately prepared to handle the taxes and regulatory compliance applicable to your new business. Once the forming documents are approved, you will likely receive a Certificate of Incorporation (for corporations) or a Certificate of Formation (for limited liability companies). These have no practical effect other than acknowledging limited liability protection, but it is necessary to receive these certificates so you are in position to take full advantage of the protections awarded by the limited liability company or corporation filing. Once you obtain your Certificate of Incorporation or Formation, you’ll want to move quickly to finalize your business entity formation. While the new business entity is limited from the moment these formation documents are approved, you are limited from taking full advantage of the limited liability protection until you hold a subsequent meeting and adopt bylaws and issue stock certificates or member interest certificates.
Common errors in business formation, how to avoid them
Mistake #1: Not Scheduling Time to Handle the Filing
As with other important tasks, you should schedule time to collect the necessary business information, fill out the paperwork and submit it. Many new business owners set up a corporation or LLC within minutes due to online service availability. Because of this, they often don’t fully consider the importance of their decisions, the fact that formation documents cannot be amended without delay and expense, and the limited liability protection they are giving up if the document is not prepared properly.
Mistake #2: Choosing the Wrong Entity Type
Many owners enter the setup process having decided which type of company they need based on what they’ve heard or read. Choosing the correct entity type for your company can affect everything from the amount of taxes your business will owe, your potential personal liability in the event of a lawsuit, how easy it is to bring on new owners and managers, and how much it will cost to operate your business. Therefore, any solid business plan should start with a discussion of the type of business and entity you should create. Your choice should be based on your goals, funds and desire to comply with various state and federal laws. There is no textbook answer for all businesses. However, a business formation lawyer can provide you with advice on what will work best for you.
Mistake #3: Vesting Ownership Interests
Many owners designate their children or other family members as co-owners, even where it doesn’t serve any valid business purpose. They don’t realize that simply naming individuals as owners could have the unintended consequence of transferring ownership of the business to someone who doesn’t contribute to that goal. Further, without due consideration, vesting business ownership interests may serve as a trap for the unwary. In the absence of properly drafted and executed vesting agreements, all business owners, regardless of the circumstances of their ownership interests, are fully vested as of the date shown on the formation documents. So, if the relationship between co-owners deteriorates, one owner could file a lawsuit against the other co-owners forcing them to purchase his or her interest at full value, even if the departing owner hasn’t contributed to the business and has been caught embezzling funds. Without the assistance of an experienced business formation lawyer, it’s easy to make mistakes that will negatively create disappointed actions that are difficult and expensive to reverse.
Mistake #4: Not Adding Bullet Point Ownership Interests to LLC Operating Agreements or Creating Rolling Majority Control
If you are going to offer ownership in multiple classes, bearing different conditions or control interests, it is imperative that it be clearly identified in the operating agreement. If the LLC is authorized to issue multiple classes of membership interest, LLC members must be ready to accept the terms of the operating agreement without relying on additional voting rights. Members must exercise due diligence by reading, comprehending and fully executing the operating agreement to ensure that the terms are understood by all parties, and that the parties’ intent and understanding are preserved.
Mistake #5: Misunderstanding the Tax Status of Different Entities
Another area where business owners often run into issues is when it comes to understanding the tax implications of the different entities and what they mean for your business. Often, one or more owners don’t realize that simply forming an LLC or corporation does not guarantee you the tax status that your business requires. The LLC options are: pass-through taxation, C Corporation, S Corporation, and a C/S Hybrid, but must be formally elected.
Why retain legal and professional help?
The business formation documents discussed above are typically drafted with the assistance of an attorney (or CPAs and business consultants). Consulting with legal professionals or business formation services is essential if you are filing with the state in which you plan to do business. These professionals can help you assess what type of business entity is most suitable for your needs, draft all necessary documents, file the articles of incorporation, and apply for the required licenses, permits, and tax identifications. They can also help you maintain these documents when there are changes in ownership, structure, or other business growth.
Business formation services are especially useful if the business has more than one owner or partner. Since these documents provide the foundation for any business, it is crucial that they conform to both state and federal laws, and that they accurately cover the intentions and expectations of the business owners. Failure to do so can cause financial and/or legal harm to the business later on.
When purchasing a business through a business broker, the business formation documents will be reviewed by a legal professional. If you work with a business professional, they also will have a list of consultants who can help with these documents.
Conclusion, building a strong foundation
The formation documents of a business may not be glamorous, but they are crucially important. Over many years I have found that the CLB’s clients and prospective clients do not understand many aspects of business entity formation. We have found (even in this age of ubiquitous information) that many people don’t know much more about the process than they get from their best friend or neighbor. As we outlined in this post, both federal and state governmental agencies require various elements be included in your business formation documents. Not only will you have to file information with various governmental agencies, but as well, you will need to have some documentation showing that your business follows their rules. The unfortunate truth is that most of this information is not intuitive, will not become second nature, and much of it will likely be forgotten after a short time . But the price of forgetting can be your company’s demise. Keeping track of these various requirements is one of the reasons that you should consider hiring a lawyer who specializes in these issues.
Over the past several decades, we have seen clients who have formed their entities on their own without engaging a lawyer. Frequently we have clients who used a online company which quickly prepares documents for a very nominal expense. But this nominal price can come with a huge cost if something goes wrong. To ensure your business has a solid foundation, it is vital that you invest the time necessary to put together your business formation documents in accordance with all federal, state, and local requirements. Hiring a knowledgeable attorney can help ensure that all issues are addressed and will save you future legal fees and headaches down the line.
