Introduction
A common question for anyone starting a small business is whether or not they should incorporate their new venture. This article will explain exactly what a corporation is, delve into the different types of corporations, and explore alternatives to incorporating your business.
What Is a Corporation?
A corporation is essentially just a company which is legally separate from the people who own it. According to Investopedia, “Incorporation is the legal process used to form a corporate entity or company. A corporation is the resulting legal entity that separates the firm’s assets and income from its owners and investors.” Incorporating your company is a way to protect yourself from financial culpability connected to the company. Once a company is incorporated, its owners’ or shareholders’ personal assets are independent of the assets of the corporation. A corporation can also sell stock, which means multiple investors can be shareholders, and thus “owners are generally only liable for the amount that they’ve invested in the company,” as per Advisors Block.
While incorporating protects individual shareholders from a good amount of legal liability, it also places more responsibility on the company itself. Advisors Block also states, “[U]nder the law, corporations possess many of the same rights and responsibilities as individuals. They have a board of directors, issue stock to shareholders and investors, pay taxes, and hire employees.” Keep reading to learn more about how to incorporate your business, and the unique expectations for a corporation.
How to Incorporate Your Business
The first step of incorporating your business is making the simple decision of where your business will be. Investopedia notes that different cities and states have different zoning laws, tax policies, and permit requirements. Next, you’ll have to choose a name for your business that is not trademarked, and is not the same as any other nearby business. Once you make the comparatively simple decisions about where your corporation will be located and what it will be called, you must find someone to handle the paperwork for your company. This person is called a “registered agent.” Investopedia states that the registered agent “does not need to be the business owner” and is often the company’s attorney. This person will be authorized by the state and the company to receive official legal communications about business operations.
The next, and arguably most important steps to incorporation are filing “Articles of Incorporation” and “Corporate Bylaws.” Articles of Incorporation essentially just contain the above information (the corporation name, operating zones, registered agent, shareholder information) and are filed with the state to officially incorporate your business. Corporate bylaws are a set of standards to ensure that the company follows its own internal rules, as a corporation is not run by just one person.
According to the Corporate Finance Institute, the important components of a set of corporate bylaws include the responsibilities and limitations of the Board of Directors, the management and leadership framework, board meeting schedules, and legal contract procedures. Corporate bylaws serve to hold corporations responsible and ensure that operations remain internally consistent, despite the governing body of the corporation being subject to change.
Types of Corporations
Corporations come in many shapes and sizes, with a large range of taxation policies. The primary types of corporations are C Corps, S Corps, and Benefit Corporations. This section will explore the nuances of each type of corporation, so that you can determine which, if any, is right for your business.
C Corp
A C Corp is a legal entity separate from its owners, which can accrue high costs, but also garners protection for its owners and shareholders. The SBA states, “Corporations [C Corps] have a completely independent life separate from its shareholders. If a shareholder leaves the company or sells his or her shares, the C corp can continue doing business relatively undisturbed.”
This also means that C Corps can “go public,” which means that company stock can be publicly traded, which is typically done to “raise additional capital,” according to the U.S. Securities and Exchange Commission (SEC.) An important financial aspect of C Corps to consider is that they can sometimes be taxed twice: when the company initially earns money, and when shareholders are paid out, as per the SBA.
S Corp
S Corps avoid the double taxation that C Corps can be subject to, and thus, there are very specific requirements to become an S Corp. The IRS requirements for an S Corp are as follows:
- S Corps must have a maximum of 100 shareholders
- Shareholders can only be U.S. citizens and/or certain specific trusts/estates
- S Corps can only have “one class of stock,” which, according to Pearson, means that all purchases of stock confer equal voting power within the company
- S Corps must “be a domestic corporation” (IRS)
- S Corps cannot fall under the umbrella of “ineligible” corporations, which the IRS lists as “certain financial institutions, insurance companies, and domestic international sales corporations”
If a corporation meets these criteria, it can be an S Corp, which allows its “profits, and some losses, to be passed through directly to owners’ personal income without ever being subject to corporate tax rates,” according to the SBA.
Benefit Corp
A Benefit Corp is a for-profit corporation that is taxed like a C Corp but purports to do some public good, and thus is held to different transparency and accountability standards, as per the SBA. Shareholders in a Benefit Corp have a responsibility to hold the corporation accountable to its mission, as well as having the standard responsibilities of a shareholder in a C Corp.
Alternatives to Incorporating
Now you know the primary types of corporations and the major differences between them, but incorporating your business isn’t the only option. In fact, you may be thinking that none of the above pathways are right for your business. So, what are some alternatives to incorporating?
LLC
LLC stands for “Limited Liability Company.” LLCs are considered a good option for smaller companies with individual owners, as they do not need a board of directors, according to Investopedia. LLCs protect the owners from personal liability while still allowing them to maintain sole ownership.
The Small Business Administration (SBA) explains that LLCs avoid corporate taxes, but also demand certain taxation requirements from their owners that corporations do not, stating: “Profits and losses can get passed through to your personal income without facing corporate taxes. However, members of an LLC are considered self-employed and must pay self-employment tax contributions towards Medicare and Social Security.” Thus, an LLC is a good option for a business owner who doesn’t want to maintain full personal liability for their business, but also isn’t looking for shareholders for their company.
Sole Proprietorship
According to the SBA, you can be a “Sole Proprietorship,” which means that you don’t officially register as a business. There are pros and cons to operating as a sole proprietorship. A major ‘pro’ is that you’re able to test the waters in terms of your business’ viability without going through all of the hassle and cost of officially registering your business. Some cons are that your personal finances and assets are tied to those of your business, you can’t sell stock, and it can be more difficult to get a loan.
Partnerships
Another non-incorporated option is a partnership. This is similar to a sole proprietorship, but, as the name suggests, there are two owners. The SBA states that “There are two common kinds of partnerships: limited partnerships (LP) and limited liability partnerships (LLP).” Limited partnerships give one partner the bulk of the authority as well as the bulk of the liability, whereas the other partner has less personal liability but also less decision making power.
The “general partner” (the partner with more control and more liability) is the only one who pays self-employment taxes. An LLP, on the other hand, “give[s] limited liability to every owner. An LLP protects each partner from debts against the partnership, they won’t be responsible for the actions of other partners,” says the SBA.
Should You Incorporate Your Business?
The choice of whether or not to incorporate your business is a deeply complicated one, with many moving parts. Knowing all of your options is the most important first step in making that decision. Consider questions like, ‘What do I want the future of my business to be?’ and ‘How much do I value personal control over business decisions versus legal protection for myself?’ If you see your business growing into a powerhouse, incorporation is probably the right move for you.
If your business is more of a passion project that you don’t mind keeping grassroots, then perhaps you want to be a sole proprietorship. There is no one-size-fits-all answer, but there are ways to better understand the risks and rewards involved in incorporating, and make the informed choice for your unique business.
