So you have an incredible idea for a business—or maybe you’ve already taken steps to start one. Do you need an “Inc.” in your company’s title? What does “incorporated” really mean, and is it right for your plans and dreams for your business? And if so, how do you incorporate your company?
In this article, we’ll walk you through what incorporation means, and what to consider as a startup founder when you decide to take this step.
Incorporation definition
First things first: What does incorporated mean? There are two ways to think about it. One definition is more broad, and one is the stricter legal definition of a corporation.
Broadly speaking, “incorporated” is used to mean that your business is registered with a state so that it becomes a separate legal entity.
Legally speaking, incorporated has a narrower definition: A business that registers as a “corporation” in a U.S. state is a specific type of legal entity that is owned by shareholders and run by a board of directors.
What is incorporation?
While colloquially called “incorporation,” formation is the proper term for setting up a business as its own legal entity by registering it with a state. Formation could mean you’re setting up one of several legal structures, like a limited liability company (LLC) or a corporation. Common types of corporations include C-corporations (C-corps) and S-corporations (S-corps), which have the same underlying legal entity type but are taxed differently. When you form an entity, you’ll have to pay fees to set it up, comply with all regulatory and tax requirements, and file reports.
A free, guided incorporation tool for founders.
Is incorporation necessary?
You don’t have to incorporate or form a legal entity to run a business. If you don’t, your business is a “sole proprietorship” by default, meaning that you’re signing contracts and doing business as a person.
As a sole proprietor, you’ll be personally liable for all contracts and debts you incur while doing business. If you are sued under a contract or for a personal injury, your personal assets unrelated to your business could be used to satisfy any claims. That’s a downside for you as the owner. The same goes for general partnerships if you bring on a partner without incorporating. You and your partners are each personally liable for all parts of the business. This means that you may be fully responsible for the decisions and actions of your business partners.
The administrative benefit of a sole proprietorship or general partnership is that they’re easy. There are little to no up-front registration or formation costs. You typically just start doing business (though you might also need to register your business name and/or get a business license first, depending on your state, your own business needs, and your legal requirements). You also don’t have to legally dissolve the business if you decide it’s not working out—in many cases, you can just stop your business activities. The owner of a sole proprietorship or general partnership will recognize any business income or loss on their personal tax returns.
Why should you incorporate?
So why would you form a legal entity for your business? Setting up a separate legal structure and complying with all your state’s requirements can come with a lot of upside, including liability protection, tax flexibility, and increased credibility.
Limited liability
This is usually a founder’s most important reason to form a separate legal entity to do business. Most types of formal legal entities protect you from personal liability by being legally separate from you as a person. This way, business entities can be considered separate from individuals when the business owns assets, earns income, incurs debts, sues and is sued, or goes into bankruptcy.
Typically, nobody can go after your personal assets if there’s a problem with your business. There are some exceptions, though. For example, lenders might require the owners of a business to personally guarantee a loan the business is taking out. And, courts may hold owners of an incorporated business personally liable if certain corporate formalities aren’t followed or if the owners have engaged in criminal or fraudulent activities—this is known as “piercing the corporate veil.”
“For US-based founders, protecting their liability is one of the most obvious reasons to incorporate,” says Mark Milastsivy, CEO and co-founder of Firstbase.io. “But there are other reasons. Fundraising is one of the main reasons why a company incorporates.”
Flexibility with taxes
Some entity types may be a fit if you prefer specific tax benefits. LLCs and S-corps allow for pass-through taxation, meaning that the owners of the business will recognize business income or loss on their personal tax return. LLCs may also choose to be taxed as a corporation (see below) if its members agree.
Income received by C-corps is subject to “double taxation.” First, the corporation itself pays taxes based on its taxable income or loss on the corporation’s own tax return. The shareholders of a C-corp are then also required to pay taxes on dividends they receive from the corporation or if they recognize capital gains from the sale of their shares. Though double taxation can seem costly, the corporate tax rate is lower than the personal income tax rate. Also, some types of C-corps may be eligible for other tax benefits, like the QSBS tax exclusion.
Added credibility
Legally becoming an LLC or corporation can help you establish more credibility as a business than remaining a sole proprietor. The business itself will also be able to establish its own credit rating.
Incorporating a business
If you’re ready to form your legal entity—whether as a corporation or an LLC—you have to choose a state to set it up in. You can set up within the U.S. state where you will do business or pick another state (like Delaware), as long as you properly qualify to do business with every state you’re actively operating in.
If you choose to form a corporation, you’ll file a Certificate of Incorporation (COI) or Articles of Incorporation (depending on the state). The vast majority of venture-backed companies are incorporated in Delaware, which requires a COI. If you choose to form an LLC, you’ll file a Certificate of Formation or Articles of Organization (the name of the actual document will vary depending on the state). In all cases, you’ll need to pay a fee and agree to comply with the state’s rules for regular ongoing filings and/or taxes (annually or biannually). The process for filing and the rules you’ll need to follow depend on which state you choose.
Where to incorporate
Because formation means registering the entity with a U.S. state and agreeing to abide by its rules and regulations, you may choose to incorporate in your home state. If you’re a small business planning to conduct physical operations solely in your state, this can be the simplest way to set up since you’ll only deal with one state.
But you might want to have your headquarters in one state but incorporate in a different state. For example, you could be doing business in more than one state, or you might want to take advantage of another state’s legal framework. If so, you’ll need to qualify the entity to do business in states other than where it was formed. (Doing so typically adds to your additional annual costs of doing business.)
Many venture capital firms (VCs) prefer—and often require—companies they invest in to be C-corps formed in Delaware. That’s because Delaware’s legal framework for corporations and its established patterns of how the state’s law treats businesses is seen as business-friendly. “There are obviously hundreds of different elements of business-friendliness,” Milastsivy says. “But in addition to that, Delaware also doesn’t require any state [income] taxes for companies that are registered there but aren’t physically located in the state.”
If you form your company in Delaware, it’s quick and fairly simple to set up, and the officers and shareholders don’t need to be residents of the state. Delaware’s Court of Chancery is a specialized business court with a lot of legal precedent around corporate cases, making litigation more predictable than in other states. Delaware is also a popular choice for forming LLCs for similar reasons.
Many of the benefits of forming in Delaware are more relevant to larger companies or companies that will be working with VCs. If you’re planning to stay small, you may not be able to take advantage of them.
How to form your business entity
Your state may vary in its requirements, and the process can get a little complicated. The general steps for filing for incorporation are as follows:
Before you incorporate
-
Decide you’re ready to incorporate.
-
Talk to a law firm. This isn’t technically required in all circumstances, but is always a good idea. The Carta Incorporation Resources tool can help steer you.
-
Choose a name. You’ll need to conduct a search with the secretary of state to confirm it’s unique and available.
-
Choose a state.
-
Name a registered agent. This is a person or company designated to accept official mail and legal documents for your business. Paperwork will go to this person. They have to have a physical office in the state. Most companies that incorporate in Delaware but aren’t physically located there will engage the services of a professional registered agent service.
-
Create a Certificate of Incorporation(for corps) or Certificate of Formation (for LLCs).These documents are different from one another, and the exact names may vary from state to state. For example, if you incorporate in California, you’d create Articles of Incorporation (for corps) or Articles of Organization (for LLCs). They both provide basic information about your company. A Certificate of Incorporation also authorizes the number and type of shares of stock that a corporation may issue.
-
File with the Secretary of State or relevant governmental body overseeing business entities and pay any required fees.
-
File any other documentation your state of incorporation requires.
-
Qualify the entity to do business in your home state(if you’re forming outside your home state or any other applicable state) and pay any fees required.
After you incorporate
-
Get an employee identification number(EIN)from the Internal Revenue Service (IRS). All corporations and any LLC with more than one member needs this tax document.
-
Open a bank account in the business’ name.
-
Set up your company’s organizational documents. If you’re a corporation, you should convene your first board meeting to adopt the bylaws that say how you’ll operate. If you’re an LLC, you’ll do something similar by having all members sign an operating agreement. These documents are internal and more specific than the charter you filed with the state. They are about setting yourself up with a roadmap for how you’ll run corporate matters, like board and stockholder meetings, voting, appointing officers, etc.
-
Be aware of the regulations you need to comply with.You’ll want to document your annual fees, tax obligations and schedule, and recordkeeping requirements.
-
Set up recordkeeping processes. Keep all your new documentation in one place so that you’re able to comply with all reporting and keep a clean corporate record to support your limited liability position, and stay on top of annual obligations with respect to your entity.
That’s a lot of steps, but the good news is that several online vendors provide quick and easy setup for Delaware C-corps—often within a week. Services can include obtaining an EIN and bank account. If you’re going that route, you could get started right this minute. But it’s always a good idea to talk to a law firm first, and in some cases, it’s required. For example, if you work in a highly regulated industry or if you’re already working with clients, you’ll need a law firm’s help. (You can find our recommendations for both in the Carta Incorporation Resources tool.)
“From what we see, many people are concerned with the entity being something they always need to manage, and think about,” says Milastsivy. “But with the number of tools that exist today, it’s becoming much easier to actually manage a company. High-level, when you have an idea, you can incorporate and still be safe—it doesn’t have to be such a huge deal.”
Once you’re incorporated, you’re ready to do business. Often, that means fundraising, hiring your first employees, and issuing equity to founders.
