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 some things to consider as a startup founder when you decide to take this step.
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 means 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?
Incorporation is setting up a business as its own legal entity by registering it with a state. Incorporating could mean you’re setting up one of several legal structures, like a limited liability company (LLC), C-corporation (C-corp), or an S-corporation. When you do incorporate, you’ll have to pay fees to set it up, comply with all regulatory and tax requirements, and file reports.
Is incorporation necessary?
You don’t have to incorporate 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. 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 agree to share personal liability for all parts of the business.
The upside 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 incorporate your business? Setting up a separate legal structure and complying with all your state’s requirements can come with a lot of upside.
Limiting your personal liability
This is usually a founder’s most important reason to incorporate. Most types of legal entities protect you from personal liability by being legally separate from you as a person. Once your business incorporates, the legal entity can enter into contracts on its own behalf, rather than you entering into contracts in your own name. Incorporated businesses can also own assets, earn income, incur debts, sue and be sued, and go 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 to the business. 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 at Firstbase.io. “But there are other reasons. Fundraising is one of the main reasons why a company incorporates.”
Getting some flexibility with taxes
Most forms of incorporation come with some 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—in effect, it’s like being a sole proprietor. (LLCs may also choose to be taxed as a corporation if their members agree to.)
Income received by C-corps can be subject to double taxation. First, the corporation itself pays taxes based on its profit or loss on the corporation’s own tax return. The shareholders of a C-corporation 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 be 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.
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.
What is a corporation?
A corporation is a separate legal entity owned by shareholders and run by a board of directors. Most corporations are designed to return a profit to company shareholders. They’re a popular way of setting up a business because they provide all of the advantages of incorporating, but with the advantage of issuing stock.
How corporations work
While “incorporating” in the broad sense can include setting up an LLC, a “corporation” is different from other structures. Aspects of a corporation include:
- Creation by filing a certificate of incorporation or articles of incorporation with a state.
- Profits and losses are taxable to the business instead of the shareholders. The corporation files its own tax return, just like individual people do.
- Perpetual existence. A corporation lives on until legally dissolved.
- Corporations issue stock in accordance with the state’s corporate law and the corporation’s governing documents.
- Corporate governance requirements, which generally include holding board and shareholder meetings and maintaining corporate records.
What is issuing equity?
Issuing equity means granting ownership of the corporation by selling stock or issuing stock options. Corporations can use equity to raise capital and incentivize employees to grow the value of the corporation. As the value of the corporation grows, the value of the equity each shareholder owns grows, too.
What are the different types of corporations?
The most common type of corporation is a C-corporation, or C-corp. This type of corporation is subject to double taxation, but allows for the issuance of stock options to employees and preferred stock to investors.
An S-corp is a type of corporation that allows for pass-through taxation. To become an S-corp, a business can only issue one type of stock, and only to a limited number of individual people and certain kinds of trusts and estates. Other corporations, partnerships, or non-resident aliens can’t be shareholders, and an LLC can only be a shareholder if it consists of a single member.
You may have also heard of a B-corp. A B-corp designation is an extra certification that a company is meeting high standards for social, environmental, and governance practices. But that’s not a structural or tax definition—a company can have a B-corp designation as an LLC, an S-corp, or a C-corp.
Founders who plan to scale quickly often choose a C-corp structure to allow more flexibility with the number of shareholders and the types of investors they can work with. (Since many VC firms are multi-member LLCs, this means that S-corps have a harder time raising venture capital funds.)
If you’re deciding between the two structures, try out the Carta Incorporation Resources tool, which was designed to help you choose the right way to set up your business. We also put together an explainer about the main differences between LLCs and C-corps.
Incorporating a business
If you’re ready to incorporate—whether as a corporation or an LLC, you have to set up within a U.S. state where you will do business. If you choose to form a corporation, you’ll file a certificate of incorporation or articles of incorporation (depending on the state). If you choose to form an LLC, you’ll file a certification of formation or articles of organization (depending on the state). In all cases, you’ll need to pay a fee and agree to comply with the state’s rules. The process of filing and rules you’ll need to follow depend on which state you choose.
Where to incorporate
Since incorporating is 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 planning to conduct physical business 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. You could be doing business in more than one state, for example. 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. (And you should note that doing so adds additional annual costs.)
Many VC firms prefer—and often require—companies they invest in to be C-corps formed in Delaware. That’s because Delaware’s legal framework for corporations 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 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 venture capitalists. If you’re planning to stay small, you may not be able to take advantage of them. If tax savings is a main goal for you, forming in a state that doesn’t collect income tax at all (like Wyoming or Nevada), might be a good choice, too.
How to file for incorporation
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 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 make sure 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.
- Create articles of incorporation (for corps) or articles of organization (for LLCs). These documents are different from each other. They both provide basic information about your company. Articles of incorporation also authorize the number and type of shares of stock that a corporation may issue.
- File this document with the secretary of state, paying any fees you need to.
- File any other documentation your state of incorporation requires.
- If you’re forming outside your home state, qualify the entity to do business in your home state and pay any fees your home state requires as well.
After you incorporate
- Get an employee identification number (EIN) from the IRS. All corporations and any LLC with more than one member needs this tax document.
- Open a bank account in the business’ name.
- Organize your company. 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 adopting an operating agreement. These documents are internal and more specific than the articles you filed with the state, and are about setting yourself up with a roadmap for how you’ll conduct your business in accordance with state law.
- Be aware of the regulations you need to comply with. You’ll want to document your annual fees, tax obligations and schedule, 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 refer to your bylaws easily, and stay on top of annual obligations with respect to your entity.
That’s a lot of steps, but the good news is that a number of 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, by the way.)
“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, thinking about hiring employees, and issuing equity to founders. Get started on all of those with our free platform for early-stage C-corp founders: Carta Launch.
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