Entity Formation (The Solopreneur's Checklist, Part 2)
Getting your business started is a big step, but getting all your legal ducks in a row can be as intimidating as it is important. This checklist is meant to serve as a guide to the main hurdles you’re likely to encounter, how much you actually need to worry about them, and how to clear them like a champ.
This is Part 2 of the Solopreneur’s Checklist series. You can find the other parts (once they’re live) here:
1. Name vs. DBA vs. Trademark
2. Entity Formation
3. Registered Agents and Virtual Offices
4. (coming soon!) Banking and payment processing
5. (coming soon!) Business tax basics
6. (coming soon!) Business insurance
7. (coming soon!) Website terms and policies
8. (coming soon!) Licenses and permits
Disclaimer: This guide is for informational and educational purposes only and should not be considered a substitute for personalized legal advice from a licensed attorney in your jurisdiction. Every situation is unique, and legal requirements can vary significantly based on your specific facts, industry, and location, so it's highly recommended that you consult with a qualified attorney in your jurisdiction. This guide is not intended to be legal advice, and no attorney-client relationship is formed by reading or otherwise using it.
Also, it’s written primarily from a California perspective. These issues are likely very similar in other states, but the particulars may vary.
Entity Formation
The first thing to know is that it’s not strictly necessary to form an entity. It’s a good idea for a lot of reasons that we’ll get into, but it’s not mandatory. If you decide not to form an entity, your business will be what’s called a sole proprietorship. Basically all that means is that for almost all purposes (except for some tax stuff), there’s no legal distinction at all between you personally and your business.
For the purposes of this guide, I’ll assume you’re going to formalize an entity for your business. Let’s talk about why we create legal entities, what kinds of entities you have to choose from, how to actually go through the process, roughly how much it’s likely to set you back, and how to pick the state in which you file the paperwork.
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The main job of legal entities like LLCs and corporations is to limit your liability in case something goes wrong. Let’s say you’ve got yourself a little housesitting business, and a client’s house has some catastrophic plumbing problem on your watch, costing the client $10,000 to repair. If the client sues you to recover the loss, whether or not you’ve formed a legal entity can make a very big difference. If the lawsuit is against Acme Housesitting LLC, the most you can lose is whatever money and assets you have in the business itself; if it’s against Jane Housesitter, Human Person, your personal savings, income from other sources, and maybe even the cabin you inherited from sweet Aunt Maude are all potentially on the hook.
So it’s not legally mandatory to create an entity, but it’s generally a good idea, especially if you’re not flat broke to begin with (i.e., you have assets to potentially lose).
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There’s a handful of different kinds of entities to choose from, with the most common ones being corporations and LLCs. There are differences between them and reasons to prefer one over another in a given situation, but for most small (and especially solopreneurial) businesses, they’re… pretty much the same. LLCs are generally more flexible and slightly less paperworky than corporations, which is part of why they’re such a popular choice.
LLCs and corporations are formed at the state level by filing a handful of forms with the relevant agency in that state. In California, that’s the California Secretary of State; in some other states, there are dedicated departments of corporations, etc.
In general, it’s also possible (though not always without tax implications) to convert one entity type into another, so you’re not locked in forever if some situation arises later that makes some entity type significantly preferable. For example, if you’ve formed an LLC you’ve been running solo and suddenly you meet someone who wants to give you a substantial investment but they only invest in corporations… you don’t have to just shrug and walk away.
(Special bonus: many states, like California, also have Professional LLCs and/or corporations. They’re basically the same thing, but are specifically for businesses doing licensed-profession stuff. That’s mostly folks like lawyers, doctors, architects, accountants, and so on. So if the business you’re setting up is, say, a therapy practice or a vet clinic, you may need to form a PC or PLLC instead. As long as you’re the sole owner, there’s very little difference between an LLC and a PLLC for most purposes, except that the PLLC or PC’s liability protections may not extend to professional negligence or malpractice.)
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Entity formation can seem scary or Very Official™, but there’s lots of options for getting it done with minimal headache. The tl;dr is that this is an important step, but also you shouldn’t let it freak you out because there’s a lot of ways to take it and they’re all basically good enough for a small or solo business.
In principle, most states have tried to make this process DIY-able. There’s lots of great resources on the internet that you don’t need me to duplicate here; a search for “[your state] incorporation checklist” or “[your state] llc formation checklist” should get you squared away. A major benefit of not DIY-ing it, though – aside from avoiding the “did I do it wrong?” stress – is that outsourcing the formation usually also gets you external reminders for the annual/biannual maintenance filings, which can otherwise be easy to forget.
You can always hire a lawyer to handle your formation paperwork. Most lawyers that work with startups and corporate clients also provide formation services. This option is almost certainly more expensive than the others, but is also almost certain to result in the right things getting done the right way. My usual posture is that it’s worth paying this premium if your company is structured in some complex or involved way (for example, a real estate business creating a bunch of subsidiary entities to hold individual properties) or seeking venture capital, but… maybe not so worth it if you’re just forming an LLC to run your solo business through.
In addition to lawyers, many Certified Public Accountants (CPAs) also offer basic entity formation services, since they’re tax professionals and these legal entities can be an effective way of structuring your tax obligations. If you’re planning to work with a CPA, make sure to ask whether this is something they can help you with during your early conversations.
There’s many online services that will handle your entity formation for a fee. Some are standalone, while others (Rocket Lawyer and LegalZoom are the biggest names in this space) offer a range of startup-related legal services. Even some payment processors are getting in on the action. Stripe, for example, has an entity formation process built in. I’m neither endorsing nor condemning any of these services, but I will say that as a general rule, what you gain in convenience, you pay for in customization. These services tend to be very one-size-fits-all, with all of the benefits and all of the pitfalls that entails.
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There’ll be a one-time filing fee to register your LLC or corporation – the fee varies from state to state, but is in the ballpark of $100. You’ll also need to make yearly (or every-other-year-ly) filings with the state that basically say “I’m still here, doing business, and this is what I’ve been up to”; these filings also come with fees which also vary from state to state, but are in the ballpark of $1,000 in California and $300 or less everywhere else.
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“Why would I pay California’s $1k/year fee when I could register somewhere else and pay way less?”, you might ask. Where to form your entity is largely a question of where you’re physically based and where you’re doing business. Because entities are formed and exist only in the state in which they’re registered, doing business across state borders can mean having to register as a “foreign corporation/LLC” in that state, which comes with its own filing requirements carrying suspiciously-similar fees.
For example, if I’m living in California and my warehouse is in California and most of my customers are in California… it’s not really going to help me to form my LLC in Arizona, even though it’s cheaper, because California will still require me to register as a foreign LLC and pay the $800ish annual fees, anyway – on top of whatever I’m paying in Arizona.
Now, this doesn’t mean that you have to register in every state where you have a customer. But if you’re targeting residents of a specific state, and/or a significant portion of your business operations are in a specific state, you may need to register in that state. There’s some very helpful resources out there for learning more about this, like this one, but the short of it is that in most cases, if you’re starting or formalizing a solo business, you’ll want to form it in the state you’re physically in when you’re doing the work.
A quick note on nonprofits: a nonprofit, or not-for-profit, isn't a separate kind of entity.
"Nonprofit" is a status that an entity — usually a corporation — can have. So if you'd like to start
a not-for-profit project, you'll still likely start by forming a corporation in your state,
and then applying to state and federal agencies for nonprofit status.
Nonprofits generally have stricter requirements and have to do more
paperwork and make more disclosures, etc. That's why the normally
more flexible LLC approach is less appropriate for a nonprofit entity.
I know that’s a lot to take in, but don’t get discouraged. Every part of this process is eminently manageable; if you’ve gotten this far, you’re entirely capable of doing everything that needs doing.
One important warning before you continue: the information you provide to the state when forming your entity will, in almost all cases, become part of the public record. This includes the address you put on your filing. If, like many solopreneurs, you’re planning to work out of your home, but would (reasonably) prefer not to make your personal address known to the public… there are some options for you in part 3 of this series.
Stay tuned for part 3 of the Solopreneur’s Checklist: Registered Agents and Virtual Offices!