Incorporating a business means turning your sole proprietorship or general partnership into a company formally recognized by your state of incorporation. When a company incorporates, it becomes its own legal business structure ─ set apart from the individuals who founded the business. Through incorporation, the company’s owner or owners create a separate legal entity to transact business. This new business entity ─ corporation or limited liability company (LLC) ─ transforms the way the business is seen through the eyes of the law and often has more credibility with potential customers, vendors and employees.
How does incorporation work?
Wondering how to incorporate a business as a C corporation or S corporation or how to form an LLC? Here are some of the steps included in the process:
- Determine where you want to incorporate.
- Decide which business type is best for your business and goals. Consult with an attorney or accountant.
- Determine who the directors of the corporation or who the members/managers of the LLC will be.
- Select a registered agent. Your registered agent must be listed on your Articles of Incorporation or Articles of Organization. The registered agent is appointed by you to receive important legal and tax documents on behalf of your business and forward them to you.
- Prepare and file the Articles of Incorporation or Articles of Organization per instructions from the Secretary of State’s office.
Why is incorporating a business important?
The primary benefit to business incorporation is limited liability. When you own a small business, you will invest a lot of money into not only getting it launched, but in keeping it running smoothly as well. As the owner you are responsible for any debts and losses your business may accumulate along the way. However, when you incorporate, you are typically only held responsible for the amount of money you personally invest. Your personal assets typically cannot be used to satisfy the debts and liabilities of your business.
Whether you’re just considering a new business idea or already act as a sole proprietorship or general partnership, you may wonder if incorporating your business is right for you. Discover why the benefits of incorporation can outweigh any downsides.
The pros
- Secure your assets, gain tax breaks. Corporation owners enjoy limited liability protection, and are typically not personally responsible for business debts. So creditors can’t pursue your home or car to pay business debts. Another plus: corporations often gain tax advantages, writing off such things as health insurance premiums, savings on self-employment taxes, and life insurance.
- Grow your corporation for now—and the future. Incorporating bolsters credibility, and may help you reach potential new customers and partners. And while you can’t live forever—your corporation can. Even if an owner dies or sells interest, the corporation still exists.
- Easy transfer and faster funds. Corporation ownership can be easily transferable (with some restrictions on S corporations). Capital can be raised more easily through the sale of stock. Another advantage is that many banks prefer handling loans with incorporated borrowers.
- Ready for retirement. Retirement funds and qualified plans, like a 401(k), can be easier to establish.
The cons
Corporations do have some potential disadvantages, including:
- Double taxation. C corporations are subject to double taxation of corporate profits when income is distributed as dividends. This can be avoided by electing S corporation tax status with the IRS.
- Ongoing fees. You must file articles of incorporation with the state, plus applicable fees. Many states impose ongoing fees—which are steeper for a corporation than for a sole proprietorship or general partnership.
- More record keeping. Corporations must follow initial and annual record-keeping requirements—which sole proprietorships, general partnerships and limited liability companies (LLCs) avoid.
Whether you are just starting your business or have been operating as a sole proprietorship or general partnership, you may be wondering about the benefits of incorporating your business as a limited liability company (LLC). Many business owners assume it will be too costly or time-consuming—but neither is the case.
LLC benefits
The benefits of creating an LLC typically outweigh any perceived disadvantages and are typically unavailable to sole proprietorships and general partnerships.
- Protected assets. LLCs provide limited liability protection to their owners (members), who are typically not personally responsible for the business debts and liabilities of the LLC. Creditors cannot pursue the personal assets (house, savings accounts, etc.) of the owners to pay business debts. Conversely, in a sole proprietorship or general partnership, owners and the business are legally considered the same—leaving personal assets vulnerable.
- Pass-through taxation. LLCs typically do not pay taxes at the business level. Any business income or loss is “passed-through” to owners and reported on their personal income tax returns. Any tax due is paid at the individual level.
- Heightened credibility. Forming an LLC may help a new business establish credibility with potential customers, employees, vendors and partners because they see you have made a formal commitment to your business.
- Limited compliance requirements. LLCs face fewer state-imposed annual requirements and ongoing formalities than S corporations and C corporations.
- Flexible management structure. LLCs are free to establish any organizational structure agreed upon by the company owners. LLCs can be managed by the owners (members) or by managers, unlike corporations which have a board of directors who oversee the major business decisions of the company and officers who manage the day-to-day affairs.
- Few restrictions. There are few restrictions on who can be an LLC owner or how many owners an LLC may have (unlike S corporations).
Potential LLC disadvantages
LLCs may have some potential disadvantages, including:
- Formation and ongoing expenses. To form an LLC, Articles of Organization must be filed with the state and the applicable state filing fees paid. Many states impose ongoing fees, such as annual report and/or franchise tax fees. While these fees often are not very expensive for small businesses, LLC formation is more expensive than that of a sole proprietorship or general partnership, both of which are not required to file formation documents with the state. A few states, such as New York and Arizona, also require LLC owners to publish notice of the LLC formation in local newspapers for several weeks. This can be costly.
- Transferable ownership. Ownership in an LLC is often harder to transfer than with a corporation. With corporations, shares of stock can be sold to increase ownership. Typically with LLCs, all owners must approve adding new owners or altering the ownership percentages of existing owners.
- Less precedent. Because the LLC is a newer type of business structure, there is not as much case law or legal precedent for LLCs as there is for corporations.
For specific questions on which corporation structure is best for your business, consider talking with an attorney or accountant.
