Incorporation 101: When and How You Should Incorporate

If you have been running your small business happily and without incident as a sole proprietorship, general partnership, or limited liability company (LLC), why would you want to incorporate? The answer could be that you do not want to incorporate, but there are valid reasons for you at least to consider the idea.

Protection of Assets – As a sole proprietor or general partner, liabilities against your business can consume your personal assets, and vice versa. Lawsuits or claims by creditors will apply to all of your assets, whether business or personal.

Incorporation divides these assets and protects one set of assets from claims on the other. Once incorporated, your business is a separate legal entity with its own liabilities and obligations.

Unlimited Life – Proprietorships and partnerships would end should an owner pass away or exit the business, but a corporation exists as a separate entity and can smoothly handle ownership and management changes – theoretically, in perpetuity.

Brand Protection – Incorporation prevents other businesses in different states from registering under the same name as you (although they may still use similar names).

An LLC can provide the same advantages as those above, but incorporation adds the following advantages.

Raising Capital – Corporations can issue stock to raise the funds needed for growth. Since stock is easily transferrable and there are no liability issues with stock ownership, corporations can raise money more easily than the other forms of governance.

Income Splitting – You may be able to lower your overall tax rate by splitting profits (and losses) between the corporation and personal distributions.

Profit from sole proprietorships, partnerships, or LLCs is taxed at the personal rate of the owners, while corporations can distribute any portion they choose to owners/shareholders and keep the rest in the business to be taxed at the 15% corporate rate.

If you are incorporating your small business, you will choose from one of two corporate formats.

C-Corporation – This is the standard form of incorporation. C-corporations do not have limits on the number of owners and may be owned by a business.

C-corporations suffer from double taxation – the corporate income is taxed first, and profits that are distributed to shareholders as dividends are also taxed at the personal level. This aspect of C-corporations led to the rise of the S-corporation.

S-Corporation – S-corporations avoid the double-taxation aspect of C-corporations by operating as a “pass-through” for the profits of the corporation. Taxation is similar to a partnership or sole proprietorship, where owners pay taxes based on their individual tax rates.

Income splitting is not allowed with S-corporations since they are pass-throughs. They have limitations on ownership that C-corporations do not have.

Once you have decided what type of corporation you want to form, you need to acquire information from the registering entity in your chosen state (typically the Secretary of State) on the necessary forms and requirements. Generally, this is your home state, but you have the option to incorporate in another state.

The incorporation paperwork must include the corporation’s name, purpose, names/addresses of incorporators, and stock parameters (such as amounts/types of stock and stockholder rights).

You do not have to have a lawyer to incorporate, but we recommend retaining one to make sure that you understand all of the corresponding requirements and obligations (as well as saving yourself the time and hassle of yet another round of documents).

Once you are incorporated, you have certain obligations that are associated with your new status, such as holding annual meetings and recording the minutes. Make sure that you follow through on these obligations or you may jeopardize your corporate status.

In summary, there are several good reasons to consider incorporating your business. If you consider the benefits and obligations of incorporation vs. LLCs and review how they apply to your situation, then you are likely to make the right choice.