Starting a new business is exhilarating, but forming the wrong entity could cost you thousands of dollars in taxes, put your personal assets at risk of lawsuits and give you a major headache down the road.
Here’s the thing…
The legal aspects of business entity formation are more than just paperwork. The business structure you choose as an entrepreneur when getting your company off the ground, dictates how the business functions, how it gets taxed and who is held responsible in case of legal issues.
And with record-breaking business applications of 478,800 businesses a month in 2025, there’s more entrepreneurs than ever that need to understand how it all works.
In This Guide:
- Why the Legal Structure of Your Business Matters
- The Different Types of Business Entities
- The Key Legal Requirements Owners Need to Know
- How to Choose the Right Structure
Why the Legal Structure of Your Business Matters
Business entity formation law dictates the way companies are legally formed and recognized. Each state has its own statutes that outline the requirements to form different types of business entities.
And this matters, because the legal structure you choose will affect everything from daily operations to long-term growth potential. By understanding the intricacies of entity formation, business owners can make more informed decisions from the start.
The legal framework of business entity formation covers:
- Personal liability protection – Some structures protect personal assets from business debts
- Tax obligations – The way the entity is taxed by federal and state government
- Management flexibility – How the company is run day-to-day
- Ability to raise capital – How a business can attract investors
The specific legal requirements will vary based on the selected structure. By getting it wrong from the beginning, problems will arise that will be expensive to fix later.
The Different Types of Business Entities
Business structures are not all created equal. Each legal structure has different characteristics, formation requirements and ongoing obligations.
Sole Proprietorship
The simplest business structure of all is the sole proprietorship. Legally, there’s no distinction between the business and the owner.
The good news? Formation is a breeze. Most sole proprietors don’t do anything at all to form their business.
The bad news? There’s zero personal liability protection. If the business gets sued or can’t pay its debts, the owner’s personal assets like homes, savings accounts, etc. are at risk.
Partnership
Partnerships are businesses with two or more owners who share in the profits and losses. Legally, there are two main types of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).
In a limited partnership, at least one partner has unlimited personal liability for the business debts. The other partners typically have limited liability but are also prohibited from taking part in the management of the business.
LLPs, on the other hand, provide more protection. All partners enjoy some level of personal liability protection from the business debts and obligations.
Limited Liability Company (LLC)
LLCs have become very popular in recent years. According to recent data, there are around 21.6 million active LLCs in the United States, making it the most common business structure in the country.
Why are LLCs so popular?
Because they provide liability protection for owners while also offering tax flexibility. Owners, known as members, are not personally responsible for business debts. And the LLC entity itself doesn’t pay taxes. Profits and losses pass through to the members’ personal tax returns.
Formation of LLCs requires filing Articles of Organization with the state. Most states also require the creation of an operating agreement, an internal document that spells out the operating procedures for the LLC.
Corporation
Corporations are separate legal entities from their owners. Legally, corporations can own property, enter into contracts and sue or be sued in their own name.
There are two main types:
C Corporations are subject to “double taxation”. First, the corporation itself pays taxes on its profits. Then, shareholders pay taxes again when they receive dividends.
S Corporations avoid double taxation by passing income through to shareholders, similar to LLCs. S Corps can’t have more than 100 shareholders and all shareholders must be US citizens or residents.
Corporations face more formalities, like board meetings, corporate minutes and annual reports. These formalities exist to maintain the legal separation between the business and its owners.
The Key Legal Requirements Every Owner Should Know
Business entity formation is just the start. The law places ongoing obligations on businesses that must be adhered to if they wish to remain in good standing.
State Registration
Every entity, except sole proprietorships, must register with the state. This process usually involves:
- Filing formation documents with the Secretary of State
- Paying filing fees (generally ranging from $40 to $500 depending on the state)
- Designating a registered agent for legal correspondence
Operating Agreements and Bylaws
LLCs should have operating agreements. Corporations should have bylaws. While not required in some states, it’s best practice to put these documents in place.
They may not be legally required, but having these internal documents on file protects against disputes between owners and shows legitimacy to banks, potential partners and more.
Employer Identification Number (EIN)
Most entities will need an EIN from the IRS. This 9-digit number is used for tax filing, opening business bank accounts, hiring employees and more.
Obtaining an EIN is free and simple to do through the IRS website.
Business Licenses and Permits
Certain industries and locations require specific licenses and permits to operate legally. Depending on where the business is located, owners may need any combination of state, county and city licenses.
Operating without the proper licenses can result in fines, penalties or forced closure.
How to Choose the Right Structure
Choosing the right business entity requires consideration of a few different factors.
Liability Exposure
If your business has a high risk of lawsuits or debt, structures with strong personal asset protection are a better choice. LLCs and corporations provide more liability protection than sole proprietorships.
Tax Considerations
Pass-through entities like LLCs and S Corps help avoid double taxation. But which one is better depends on personal circumstances and income level.
Growth Plans
If the business plans to attract outside investment, incorporation is usually required. Venture capitalists and angel investors typically only invest in C Corps, as they offer stock options and more ownership flexibility.
Administrative Burden
Some business owners simply want things to be as simple as possible. Others don’t mind extra paperwork in exchange for other benefits. Corporations require more ongoing formalities than LLCs, for example.
Putting It All Together
Business entity formation law provides the legal foundation for every business. The structure chosen in the early days shapes tax liabilities, liability exposure, management rights and growth potential for years to come.
Here are some takeaways for every prospective business owner:
- Sole proprietorships are easy but offer no personal liability protection
- Partnerships are great for co-owners but must be structured carefully
- LLCs provide flexibility and protection for most small businesses
- Corporations are a good fit for businesses that plan to raise capital or go public
The legal requirements don’t end with formation. Maintaining good standing requires ongoing compliance with state filing requirements, tax obligations and internal governance rules.
By taking the time to understand the legal framework in the beginning, owners can save money, avoid unnecessary risk and set their businesses up for long-term success. Choosing the right entity structure is not just a legal formality, it’s a strategic business decision that impacts every area of the operation.
