How Incorporation Works


For businesspeople just starting out, one of the most important choices they'll make is the best way to incorporate their venture.
For businesspeople just starting out, one of the most important choices they'll make is the best way to incorporate their venture.
iStockphoto/Thinkstock

Have you ever wondered what that "Inc." you see at the end of a company's name really means, or how that's different from the "LLC" you might find written after the name of some other company? Those ubiquitous strings of letters indicate how a business is structured. Whether it's a single mom-and-pop operation or a large-scale, national powerhouse, incorporating a business does a lot more than simply allowing someone to add "Inc." or "LLC" to the name of their business venture.

Selecting a business structure helps to determine how a business will operate and be taxed, and it takes other factors like liability into consideration. In order to choose the most suitable structure, a business owner must be aware of his or her own needs, as well as those of the business. This decision process isn't limited to just a few select individuals or organizations, either. In the year 2008 alone, nearly 30 million businesses were operating in the United States, most of which were small companies [source: U.S. Census Bureau]. At some point, the people behind each one of those enterprises had to assess their business and determine which type of structure worked best for them.

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Suppose you come up with the latest, greatest idea for a business that you just know everyone will love. It's going to be the next Google! How do you begin to bring your idea to life? What are your options?

The first step in understanding how businesses can be set up comes with knowing that, even though they may all seem similar from the outside, not all businesses are structured identically. Even within the same industry, some owners might opt for one setup while another owner will decide that a different type of arrangement is more suitable. It all depends on the individual needs, preferences and requirements of the potential business and the business owner. This article will give you a glimpse of the types of businesses that exist and weigh the pluses and minuses of each structure. Then, we'll show you how a corporation can spring into existence. Before we look at corporations, though, we'll explore some of the more common types of businesses.

Common Types of Businesses

A business can be structured in a few different ways. We'll cover the five most common: sole proprietorships, partnerships, limited-liability companies, corporations and S corporations. Each structure comes with its own set of requirements and procedures and will appeal to different types of business owners, depending on their needs and expectations.

Sole proprietorship: A sole proprietorship is a business that's owned by a single individual. These operations are often smaller in scale than other types of businesses. They're frequently the easiest to get off the ground because there tends to be less paperwork and associated fees involved. A sole proprietor operates a business that isn't incorporated.

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Partnership: A partnership is a business that is owned by two or more individuals. Several types of partnerships exist, but in the most basic form of partnership – known as a general partnership – all partners split everything evenly, both profits and losses. Members of a partnership also aren't incorporated.

Limited-liability company: A limited-liability company – or LLC – is more closely related to a corporation than the other business types. It offers greater liability protection than a sole proprietorship or a partnership, but doesn't have all of the requirements of a corporation. The owners of the LLC are referred to as members; and, as the name implies, an LLC limits the amount of liability that the owner can incur with regard to debt or other decisions made by the members.

Corporation: A corporation is a more complex business structure that, once established, is considered to be an entirely separate entity. The owners of a corporation are referred to as shareholders. They in turn elect a board of directors to run the company. Because a corporation is considered to be a separate entity, it can switch owners many times without causing the corporation to cease to exist.

S corporation: An S corporation is similar to a standard corporation, but lacks some of the requirements of a corporation. The main difference between the two is that while a corporation is taxed as a separate entity, the shareholders of an S corporation are taxed individually. With a standard corporation, the corporation is taxed and then the dividend earnings of the shareholders are taxed, a practice known as "double taxation." The creation of an S corporation eliminates this.

Corporation or Sole Proprietorship? You Decide

Corporations can take longer to set up than sole proprietorships, but offer more protections for the business owners.
Corporations can take longer to set up than sole proprietorships, but offer more protections for the business owners.
Nick White/Photodisc/Thinkstock

Like everything in life, each business structure has its own distinct set of perks and drawbacks. A sole proprietorship, for example, can be fast and easy to set up and operate. On the flip side, it offers fewer protections than other business structures. In a sole proprietorship, the owner assumes all liability for the business. If it loses money and goes into debt, the owner runs the risk of losing their personal property as a result.

Aside from the same liability issues that are inherent in a sole proprietorship, a partnership comes with some extra considerations. In its most basic form, everything is shared equally among the partners. Dividing the risks and obligations can provide a level of security for the partners, something that's absent in a sole proprietorship. All that division also applies to the profits and other resources, which can cause conflict in some instances. Disagreements of all types have the potential to arise among partners, which can cause the business to suffer as a result.

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With an LLC, the advantages and disadvantages take on a different form. One of the major advantages of an LLC is the limited liability that members experience. The fact that an LLC offers these protections while lacking the stricter requirements of a corporation can be attractive. The downside? The rules for operating an LLC vary from state to state. This can pose problems for members interested in expanding their business to other states.

Aside from the protections offered by a corporation, there are many other advantages provided by a corporation. It can sell shares of its company in order to raise capital, something than other business structures can't do. Corporations are also taxed at a rate that's generally lower than the individual tax rate. One of the major disadvantages of a corporation is the cost involved in starting it, the requirements that a corporation must meet, such as annual meetings and other formalities. Because of this, there are also greater administrative obligations related to maintaining a corporation.

The S corporation shares many of the same requirements that a corporation has and, as a result, has many of the same advantages. The S corporation has the added benefit of no double taxes, but also has the same disadvantages of a corporation. It also caps the number of shareholders that it can have. All shareholders in an S corporation must be U. S. citizens, which can deter noncitizens who wish to get involved in the business.

Now that we've run through the different business structures, we'll cover some other considerations for you to think about. After all, this is a big decision.

Other Considerations in Incorporation

Business owners usually dedicate a lot of time and research to determining which type of structure works best for them. Some of the factors that they might consider are:

  • Size: How big is the business? Size can influence structure. Someone who wants to start a small business in his or her basement, for example, might opt to create a sole proprietorship. That wouldn't work for someone who wanted to start a manufacturing plant.
  • Capital: How much money is available to invest in the business? The costs involved in starting a business can be a major factor in determining which business structure is most suitable. A sole proprietorship will require much less capital than a corporation, for example.
  • Time: How much time will be dedicated to the business? Here, too, if a person is running a part-time enterprise, something as complex as a corporation may not be necessary.
  • Personnel: Will the business have employees or other necessary staff? If so, having a corporation, S corporation or an LLC will make it easier to acquire employees.
  • Expected returns: How much money is the business expected to earn? If the expected profit is going to be small, a business won't need to make the same tax considerations that other businesses might.
  • Taxes: Which method of taxation best suits the needs of the business and the owners? Sole proprietors and members of a partnership each file taxes individually. Members of an LLC can file as a sole proprietorship, a partnership or a corporation, depending on how it is structured. Shareholders of S corporations file taxes individually as well.
  • Location: Where will the business be located? On the state level, laws can differ with regard to how businesses can function. The location of a business can affect taxation, how a business operates, and how it develops. In Washington, for example, low taxes make incorporating a business more desirable than in other states where taxes are higher. The same holds true for the state of Florida, where low tax rates make it a desirable destination for businesses.
  • Liability: Who is liable? Depending on the type of business being considered, there may be the chance that the business could run into serious financial trouble. Owners that intend to operate businesses where debt might be a major consideration might need to find a structure that offers greater personal asset protection than someone who starts a business that would not acquire much debt.

Next, let's look at the paperwork path of incorporation.

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Getting Your Corporation Started

As you launch your company, you have to decide what to call it, where you'll set up shop and other factors before you can fill out your incorporation paperwork.
As you launch your company, you have to decide what to call it, where you'll set up shop and other factors before you can fill out your incorporation paperwork.
Digital Vision/Photodisc/Thinkstock

While some future business owners might hire a lawyer to help guide them through the ins and outs of starting a corporation, others will employ the do-it-yourself method. In either instance, the steps needed to get a corporation off the ground don't necessarily require a law degree or a master of business administration (MBA).

The initial step in incorporating might seem like an obvious one -- picking a name. What's the corporation going to be called? Determining a name for a corporation allows it to be identified and sets it apart from other businesses.

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Next, you have to select a suitable location for the business. Will it be established in the home state? Will it be set up in a state that benefits the business in some way? Once a name has been decided upon, that name can be researched to ensure that it's not already in use and, if it is available, reserved in the chosen state for exclusive use.

After a name and location have been selected, the bulk of the paperwork can begin. This is the time when the articles of incorporation are created and filed with the state. The articles of incorporation establish the formation of the business and include information such as the name and location of the business, the name and location of the person or entity incorporating the business and the number of shares issued.

With the corporation moving closer to being a fully functioning entity, bylaws need to be created that establish how the business will operate. This is a document for use within the corporation that outlines procedures for how personnel will be selected, how meetings will be conducted, how stock will be handled, how records will be kept and maintained, how the business will be represented and other information that will be necessary for the company's smooth operation.

Finishing the Incorporation Process

With the bylaws established, all corporate records will need to be maintained. Like an official scrapbook, the corporate records contain all of the information that is vital to the business, such as copies of the articles of incorporation and the bylaws, along with meeting minutes and stock records.

Corporations must also file for an employer identification number (EIN) with the IRS, a number that identifies the corporation for tax purposes. If a company wishes to establish S corporation status, the incorporator can file with the Internal Revenue Service (IRS) to obtain this status. An S corporation must first be established in the same way that a standard corporation is established before applying to be recognized as an S corporation.

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Finally, it's time to fill some seats on the board by selecting directors and officers who will participate in the operation of the company. With all of the personnel in place, the first meeting can be conducted and, with that, the minutes of the board meeting can be recorded. The minutes of this meeting will then be placed in the corporate records book, along with the minutes of all subsequent meetings.

Now that the corporation has been established and is in operation, shares of stock can be issued to the shareholders. The corporation may also be able to issue shares of stock in order to raise capital at this point.

Some of the steps can be carried out in a different order, but some variation of them will need to be done in order to get a corporation up and running. In most cases, the procedures will be outlined by the state in which the business is incorporated. Suppose, for example, you wanted to be the next Colonel Sanders and start a business in Kentucky. Well, the recommended steps for incorporating in the state of Kentucky involve the following:

  • Speak to a knowledgeable advisor
  • Select a business name
  • File articles of incorporation
  • Acquire an EIN
  • Obtain the necessary licenses for running your business
  • Register the corporation with the Kentucky Revenue Cabinet

After you've followed those steps to completion, your corporation will be legally recognized by the state.

How Long Will Incorporation Take?

No matter how eager you might be to get your business off the ground, incorporating a business takes time. How long it takes can depend on factors that can include the location of the business or the desired type of business structure. In the United States there are generally up to six steps that are necessary in order to get most businesses started, a process that can be completed in a week or two. As you've read, potential business owners need to file forms on the state level that declare their intention to start a corporation and fill out federal forms that allow them to be identified for taxation, hire employees and offer insurance coverage. Each state has its own set of procedures and requirements for establishing a business, and requirements for forming different business structures can vary significantly by state. These factors will ultimately determine how long it takes to get a corporation started.

A great deal of research and planning is required before would-be entrepreneurs embark on a business venture. Otherwise, the two-week period it takes to incorporate could easily turn into two years or longer while the necessary planning is done. Understanding the ins and outs of starting a corporation and all of the available options can be tricky for those who are unfamiliar with the process. As a result, there are many organizations and agencies in existence, such as the Small Business Administration in the United States, that help fledgling business owners and incorporators to get started. Learning about corporations and business structure won't provide all of the necessary tools for a successful business, but it will help you to understand just what that "Inc." you might encounter on a business card actually means and the steps it took for it to get there.

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For more on business essentials, take stock in the links on the next page.

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More Great Links

Sources

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