There are many reasons to incorporate a business – the ability to limit the personal liability of the owners and shareholders, the availability of a body of law to guide owners and managers, the ease of raising capital through the sale of securities, the ease of transferring ownership and and certain tax benefits. While there are many advantages to incorporating, there are some disadvantages, such as the requirement that owners and directors hold annual meetings and observe certain formalities, that it has higher costs than setting up a partnership or a sole proprietorship and the requirement of filing documents.
Once you decide that it’s in your business’ best interest to incorporate, you have to choose what type you want to form. The top decision for many entrepreneurs is whether to form an ordinary corporation (“C Corporation”) or a Limited Liability Company (“LLC”) and whether or not to elect a subchapter S Corporation tax treatment.
Whether to form a corporation or an LLC is first of all a tax question. An ordinary corporation is subjected to double taxation, because the corporation pays tax on its income and its stockholders pay tax when the corporation pays dividends to them. On the other hand, LLCs are “pass through” entities for federal taxes, meaning that the LLC does not pay federal tax on its profits, nor does it get a deduction for its losses.
Instead, the tax profits and tax losses are passed through to the owners of the LLC and are paid directly by them on their tax returns. In the case of a company that expects to produce large amounts of income, LLCs eliminates the double taxation, which happens with a corporation.
While the tax treatment and fewer formal requirements make LLCs the entity of choice for businesses financed by a smaller number of individuals, C Corporations are the entity of choice for businesses planning to scale or raise several rounds of financing, especially since venture capitalists will not invest unless the business is incorporated as a corporation. Also, both LLCs and C Corporations can elect S Corporation tax treatment, which can be beneficial. However, S Corporations are limited to one class of stock and 100 U.S. stockholders, which will not work for businesses with investors who want preferred stock or foreign investors.
The next decision is where to incorporate. Most businesses incorporate in Delaware because it is business-friendly,, having a well developed and well understood body of corporate law. But it may be more cost effective to incorporate in the state where you are located, because you won’t have to bear the costs of qualifying your business in a foreign state, especially if it will mostly be controlled be one shareholder and will not seek venture capital backing.
To officially form your LLC or corporation with the state, you will need to fill out the required paperwork. Before getting started, contact the Secretary of State or the state office that is responsible for registering corporations to ask for instructions, forms and fee schedules.
If you want to file yourself, you’ll definitely save on attorney fees but you may miss small details that a lawyer can catch. Some states have downloadable pdf copies of the articles of incorporation that you or your attorney can prepare. Although different states may require different information, typically you’ll need to list basic information like the name of the corporation, mailing address, registered agent name and address, as well as the purpose of the corporation, and the names and addresses of directors and/or officers, or members and managers if you are forming an LLC.
Also, you’ll need to draft governing documents, such as corporate bylaws for corporations or operating agreements for LLCs. These governing documents will outline the details to how the corporation will be run. Finally, the secretary of state’s office will send you a certificate of incorporation once it is approved.
After you’ve incorporated, be sure to follow the rules of incorporation because a court deciding a lawsuit could make the owners personally liable for the business’s debts. Also, follow all the rules required by applicable law (wage and hour laws, etc.), and keep accurate financial records that are separate from the owner’s. If there are any other, more complex questions, consult an attorney for guidance. Kieu-Nhi Le, Rutgers School of Law Newark candidate for a JD degree in May 2016. She is the Managing Business Editor of the Rutgers Computer and Technology Law Journal collaborated with me on this blog.