What Is Incorporation?
Incorporation is the process of legally forming a company or corporate entity and separating it from the entity's owners. The result of the incorporation process is a corporation, a legal entity that separates a firm's income and assets from its investors and owners.
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There are three common corporate structures:
- C Corporation: C corps have no limit on the number of shareholders. You'll be taxed on shareholder dividends and corporate profits, and you need to hold annual meetings.
- S Corporation: These types of corporations give shareholders liability protection. Additionally, shareholders gain tax breaks that are not available with other business structures.
- Limited Liability Corporation: LLCs allow members to report profit or loss on individual tax returns. As a result, LLCs sidestep double taxation in terms of corporate profit.
Different Types of Corporate Structures
If you're incorporating your business, you should consider which type of corporation to choose.
S Corporations vs. C Corporations
S and C corporations vary in how they are taxed, how they are owned, and how shares work.
- They are taxed once, and only the shareholders pay taxes on profits received.
- They are limited to 100 shareholders, and these shareholders must be U.S. citizens or residents.
- They offer only common stock to owners, which comes with voting rights.
- They are taxed twice. The business pays taxes once at the corporate level, and shareholders pay taxes on income they receive.
- They do not have limits on how many people can own shares, nor do they place limitations on who can own the shares.
- They may provide owners with preferred stock. Preferred stock does not include voting rights but will give them priority of dividends before common shareholders.
LLCs vs. S and C Corporations
LLCs are similar to S and C corporations, but they offer more flexibility when it comes to taxation and management. They also don't usually have as many requirements in terms of recordkeeping. Instead of shareholders, LLC owners are known as members. Each member owns a percentage of the business, and restrictions almost always come into play when transferring these membership interests.
Here's an article to give you a better understanding of LLCs.
Corporations offer predictable structure and make transferring shares easy. These factors can be important for companies seeking outside investors.
How Does Incorporation Work?
Corporations are the most widely used method for business operations around the world. Legal details about how a corporation forms, as well as a corporation's organization, can differ between jurisdictions. However, most corporations have certain elements in common, including:
- Incorporation is the way a business is officially brought into existence and formally organized.
- They require articles of incorporation, a set of legal documents that enumerate the shareholders of a firm along with other important information.
- They have limited liability, which keeps a business's assets and cash flow separate from the assets and cash flow of owners and investors.
Incorporation offers a variety of benefits for a business and its owners, including:
- Achieving a lower tax rate than the rate on personal income
- Allowing for the easy transfer of ownership to another party
- Gaining the ability to raise capital through stock sales
- Protecting the assets of the business owner against company liabilities
- Receiving more lenient tax restrictions on loss
Advantages of Incorporation
Incorporation creates what is often called a corporate veil to protect a company's directors and shareholders. This corporate veil is essentially a protective bubble of limited liability, which allows businesses that incorporate to take risks that enable growth. Incorporated businesses can take these risks without exposing owners, directors, and shareholders to personal financial liability beyond their original investments into a company.
In order to limit the liability of shareholders, corporations must be properly formed, capitalized, and operated. This includes having the appropriate annual meetings for both directors and shareholders. With proper management, shareholders can only lose their investment in stock in situations where a corporation is unsuccessful or held liable for damages through a lawsuit. Shareholders cannot lose personal assets because of corporate liabilities.
Creating and Organizing Corporations
The process of incorporation includes drafting what is known as "articles of incorporation." These articles list:
- The primary purpose of a business
- A business's location
- The number of shares/class of stock issued, if any (a closed corporation does not issue stock)
Here is further reading about articles of incorporation.
Shareholders own companies. A small company might have just one shareholder, while a large, publicly traded company can have thousands of shareholders. Shareholders are only responsible for paying their own shares. As shareholders are owners, they are entitled to get the profits of a company. These profits usually come in the form of dividends.
Additionally, shareholders elect a company's directors. These directors deal with the daily activities of a company, and they must act in their company's best interests. Shareholders typically elect directors annually. A small company may have one director, while a larger company often has a board made of up of many directors. Directors do not have personal liability for a company's debts, except regarding specific tax statutes or in cases of fraud.
Steps to Incorporating a Business
If you are planning to incorporate a business as either a C corporation, S corporation, or LLC, you need to follow a few steps:
- Choose where you want to incorporate your business.
- Determine which type of structure fits best with your business goals. By consulting with an attorney or an accountant, you can make a more well-informed decision for you and other stakeholders.
- Decide who the directors of your corporation or who the members/managers of your LLC will be.
- Select your registered agent. A registered agent is appointed to receive important tax and legal documents on behalf of a business and must be listed on the articles of incorporation/articles of organization. Owners are often registered agents.
- Determine the business licenses that your corporation requires. For example, if you plan to hire employees, you need payroll tax registration, and if you plan to sell goods, you need sales tax registration.
- Prepare and then file the articles of incorporation/articles of organization, following instructions from the appropriate agency in your state.
Forms, Taxes, and Requirements
Corporations must file Form 1120 with the IRS. Corporations also have to pay their own taxes. While salaries paid to shareholders who are also employees are deductible, dividends paid to shareholders are not deductible. Therefore, these dividends do not reduce a company's tax liability.
A corporation must conclude its tax year on December 31 if income is derived primarily from personal services provided by shareholders, such as:
- Business consulting
- Dental care
- Legal consulting
Certain additional requirements may vary based on the size of a corporation:
Shareholders of a small corporation must prepare and sign a buy-sell agreement. This type of contract stipulates that stock must be offered first to surviving shareholders if a shareholder dies or wants to sell the stock. These contracts also often provide a method that determines the fair price for those shares. Life insurance generally funds the purchase of stock of a deceased shareholder.
If a corporation only has a few shareholders, the responsibilities of these shareholders can just be defined in corporate minutes.
A large corporation that sells shares to many shareholders may need to register with the U.S. Securities and Exchange Commission or with state regulatory bodies.
Work with a trusted lawyer when you're ready to take the next step and incorporate your business.