Incorporation

Corporate ownership is one of three broad categories defining the legal ownership structure of a business. The other two broad categories are sole proprietorship and partnership. In a sole proprietorship, the owner is personally liable for his or her business's debts and losses, there is little distinction made between personal and business income, and the business terminates upon the death of the owner or the owner's decision to change the legal character of the firm (by relinquishing part or all of his or her ownership in the enterprise). A partnership is merely joint ownership, and in terms of personal liability, is similar to a sole proprietorship. Sole proprietorships and partnerships are categories of business ownership that may be entered into and dissolved fairly easily. Incorporation, on the other hand, is a more complex process. Incorporating involves the creation of a legal entity that serves as a sort of "person" who can enter into and dissolve contracts; incur debts; initiate or be the recipient of legal action; and own, acquire, and sell goods and property. A corporation, which must be chartered by a state or the federal government, is recognized as having rights, privileges, assets, and liabilities distinct from those of its owners.

In the 1990s, a new form of business structure became available to those operating businesses in many states. By the year 2002 this form, the limited liability company (LLC) or limited liability partnership (LLP), was available in all 50 states of the union and has become the business form of choice for newly formed businesses. These limited liability entities are the only forms of business structure other than the corporation in which the personal liability of the owners is limited. This feature accounts for their popularity. For the majority of small businesses, the relative simplicity and flexibility of the LLC makes it the better choice of business structure. However, there are situations in which incorporation may still be preferable. If a company wishes to do any of the following three things, incorporation is preferable to forming a limited liability company: 1) The company expects to have multiple investors or offer stock to the public; 2) The company wishes to offer extensive fringe benefits to owner-employees, and/or 3) The company hopes to use stock options or stock bonuses as part of an incentive program. In each of these three instances, IRS rules regulating corporations makes the desired activity either possible or more easily done than would be the case for limited liability companies.

Prospective entrepreneurs and established business-people operating sole proprietorships and partnerships are encouraged to weigh several factors when considering incorporating. Indeed, incorporation can have a fundamental impact on many aspects of business operation, from taxes and document keeping requirements to raising capital and owner liability.

ADVANTAGES OF INCORPORATION

• Raising Capital—Incorporation is generally regarded as an indication that the owners are serious about their business enterprise, and intend to devote time and resources to the venture for a significant period of time. This factor, as well as the reporting requirements of incorporation and—in some cases—the owners' more formidable financial resources—make corporations more attractive to some lending institutions. In addition, corporations have the option of raising capital by selling shares in their business to investors. Stockholders know that if the business they are investing in is a corporation, their personal assets are safe if the company gets into litigation or debt trouble.
• Ease of Ownership Transfer—Ownership of the company can be transferred fairly easily by simply selling stock (though some corporations attach restrictions in this regard).
• Tax Advantages—Some businesses enjoy lower tax rates under the incorporated designation than they would if they operated as a partnership or sole proprietorship. For instance, business owners can adjust the salaries they pay themselves in ways that impact the corporation's profits and, subsequently, its tax obligations. It can also be easier for a business to invest in pension plans and other fringe benefits as a corporation because the cost of these benefits can be counted as tax-deductible business expenses.
• Liability—This factor is often cited as far and away the most important advantage to incorporation. When a company incorporates, the shareholders or owners of the corporation are liable only up to the amount of money they contribute to the firm. Moreover, while a corporation can be targeted in legal actions such as lawsuits, the personal assets of the company's owners cannot be touched if a judgement is rendered against their establishment since it is recognized as a legal entity separate from the owners/shareholders.

Still, while incorporation provides business owners with far greater liability protection than they would enjoy if they operated as a standard partnership or sole proprietorship, business experts note that certain instances remain wherein the personal assets of business owners may be vulnerable:

• Many small business owners who approach banks to secure financing for a new corporation are asked to sign a personal guarantee that assures the lending institution that they will pay back the loan if the corporation is unable to do so. Banks sometimes require similar guarantees from entrepreneurs and small business owners seeking financial assistance to lease equipment or facilities. Owners are also held personally responsible for ensuring that the corporation makes its required tax payments.
• Protection from liability can also be compromised in situations in which legal action is brought against a director or officer who is alleged to have committed some transgression outside the parameters of his or her job description. In other words, a business owner or shareholder can still be sued for personal actions.
• In some cases, key personnel of a corporation—such as board members or officers—can be held personally liable if the establishment that they operate has been found criminally negligent or guilty of willful criminal acts.
• The personal assets of business owners operating a corporation can also be threatened if it is determined that the business has not been properly established and adequately maintained. In such instances, a plaintiff may claim that the corporation and the owner are one and the same, and therefore the owner's personal assets can be used to satisfy the judgement. This is called 'piercing the corporate veil.' There are several steps that business owners can take, however, to ensure that their corporation protection is maintained. These include: 1) Keeping up with taxes and regulatory requirements; 2) Staying in full compliance with guidelines regarding corporate minutes and various organizational bylaws; 3) Keeping personal and corporate accounts completely separated from one another; and 4) Showing proper capitalization by maintaining a satisfactory debt-to-equity ratio.

DISADVANTAGES OF INCORPORATION

• Regulatory and Record keeping Requirements—Corporate operations are governed by local, state, and federal regulations to a greater degree than are other businesses.
• Added Cost of Doing Business—Regulatory and record keeping guidelines and requirements often make it necessary for corporations to make additional investments (in accounting staffing, etc.) devoted to seeing that those legal requirements are met. In addition, there are fees associated with incorporating to which business partnerships and sole proprietorships are not subject.
• "Double" Taxation—People who are owners of a corporation, and who also work as an employee of the business, can receive financial compensation in two different ways. In addition to receiving a salary or wages for work performed, the owner may also receive a dividend or distribution on the stock that he or she owns. Any distribution of income to stockholders via dividends is taxable, however, if the corporation is organized as a "C corporation." This is sometimes called "double taxation" in recognition of the fact that such income has in reality been taxed twice, first when the corporation paid taxes on its profits, and secondly when the dividends were distributed. Companies that register as an "S corporation," however, are able to avoid this added tax.
• Separation of Finances—While incorporation provides significant protection of owners' personal assets from repercussions of business downturns, it also means that a business owner is not allowed to tap into the corporation's account for assistance in meeting personal debts.

S CORPORATIONS AND C CORPORATIONS

Small business owners can choose to incorporate as one of two basic types of corporations. The C corporation is the more traditional of the arrangements, and is more frequently employed by large companies. With a regular corporation, the business's profits or losses are absorbed directly into the company. With the alternative corporate arrangement—the S corporation (also sometimes known as the Subchapter S corporation)—profits and losses pass through to the company's shareholders.

The S corporation option was actually put together by the federal government in recognition of the fact that the operating challenges faced by small businesses and large businesses can often be quite different. Indeed, the S corporation was shaped specifically to accommodate small business owners. S corporations give their owners the limited liability protections provided by corporate status, while also providing them with a more advantageous tax environment. In fact, S corporation status puts companies in the same basic tax situation as partnerships and sole proprietorships. Whereas C corporations are subject to the above-mentioned double taxation, profits registered by an S corporation are taxed only once, when they reach the company's shareholders.

To qualify as an S corporation, a business must meet the following requirements: 1) It must be a U.S. corporation; 2) It can have only a limited number of shareholders (75 in 2006); 3) It may not offer more than one class of outstanding stock. In terms of the maximum number of shareholders, starting with taxable years beginning after December 31, 2004, a family may elect to have all the members of the family that hold stock directly or indirectly in an S corporation treated as one shareholder for purposes of the number-of-shareholders limitation. This election may be made by any family member and a "members of the family" is defined as individuals with a common ancestor, lineal descendants of the common ancestor, and the spouses (or former spouses) of such lineal descendants or common ancestor. These are the primary requirements for seekers of S corporation status, although the government has additional stipulations regarding the citizenship of owners/shareholders and affiliations with other business entities. Prospective S corporations must be in accordance with all these restrictions.

THE PROCESS OF INCORPORATION

The actual fees required to incorporate generally amount to several hundred dollars, although the total cost differs from state to state (corporations usually pay both an initial filing fee and an annual fee to the states in which they operate). Hiring an attorney to assist in the process can raise the cost, but several services are available on the Internet to assist businesses with the incorporation process. The Small Business Administration has noted that the owners of a business that is going to be incorporated must agree on several important issues, including the nature of the business; the total number of shares of stock the corporation will make available; the stock that the owners will be able to purchase; the amount of financial investment that each of the owners will make; the bylaws by which the corporation will operate; the management structure of the corporation; and the name under which the business will operate.

Indeed, it is a good idea to reserve the proposed name of the corporation with the state before filing articles of incorporation. The owners of the business must make sure that they have a clear right to that name, since only one corporation may possess any given name in each state. If a business owner files articles of incorporation using a name that already belongs to another corporation, the application will be rejected. The name of the business must also include either corporation, company, limited, or incorporated as part of its legal name; such terms serve notice to people and businesses outside the company that it is a legal entity unto itself and thus subject to different laws than other business types.

Since the corporation will be a legal entity separate from its owners, separate financial accounts and record keeping practices also need to be established. Once the shareholders have reached agreement on these issues, they must prepare and file articles of incorporation or a certificate of incorporation with the corporate office of the state in which they have decided to incorporate. Any corporation—with the exception of banks and insurance companies—can incorporate under Section 3 of the Model Business Corporation Act.

Business experts also counsel organizers of a corporation to put together a pre-incorporation agreement that specifies the various roles and responsibilities that each owner will take on in the corporation once it has come into being. Pre-incorporation agreements typically cover many of the above-mentioned issues, and can be supplemented with other legal documents governing various business operations, such as inventory purchases and lease agreements. Pre-incorporation agreements are also sometimes drawn up with third parties. Such contracts generally address: 1) Scope of potential liability; 2) Rights and obligations for both the corporation and its organizers once it has been formed; 3) Provisions to address business issues if incorporation never occurs for some reason; and 4) Provisions for declining the contract once the corporation has been formed.

Once a company has incorporated, stock can be distributed and the shareholders can elect a board of directors to take formal control of the business. Small corporations often institute buy-sell agreements for their shareholders. Under this agreement, stock that is given up by a shareholder—either because of death or a desire to sell—must first be made available to the business's other established shareholders. Stock issues and shareholder responsibilities are usually fairly straightforward in smaller companies, but larger corporations with large numbers of shareholders generally have to register with state regulatory agencies or the federal Securities and Exchange Commission (SEC).

In addition, incorporation requires the adoption of corporate bylaws. The bylaws, which are not public record, include more specific information about how the corporation will be run. These are the rules and regulations that govern the internal affairs of the corporation, although they may not conflict with the Articles of Incorporation or the corporate laws of your state. The bylaws are adopted by the board or the corporation's shareholders and may be amended or repealed at a later date. When preparing bylaws, it is sometimes easiest to start with the model bylaws that typically arrive with corporate kits or incorporation guides, although these may be altered. The bylaws should specify such information as:

• The location of corporate offices
• The names and powers of shareholders and directors
• The date and time for regular shareholders' and board of directors' meetings
• The content of such meetings
• The period of notice required before such meetings
• Voting eligibility
• Voting procedures
• Election procedures for seating directors and officers
• The names and duties of officers
• How financial transactions will be conducted
• The procedures for amending or repealing bylaws
• Stipulations as to whether powers or duties of board of directors may be relegated to ad hoc committees
• Procedures to be followed in the event of a merger with another company or the dissolution of the corporation itself

CORPORATE OWNERSHIP AND CONTROL

The owners of a corporation remain the ultimate controllers of that business's operations, but exercising that control is a more complicated process than it is for owners of partnerships or sole proprietorships. Control depends in part on whether the owners decide to make the corporation a public company—in which shares in the company are available to the general public—or a private or closely held corporation, where shares are concentrated in the hands of a few owners.

In most cases, small businesses have a modest number of shareholders or owners. When it comes to the day-to-day operations of the corporation, shareholders generally have very few powers. They are responsible for electing the board of directors and removing them from office. In smaller corporations, the shareholders can give themselves more operational powers by including provisions in the articles and bylaws of the corporation. In most cases, however, it is the shareholder-appointed board of directors that runs the company. Directors are responsible for all aspects of the company's operation, and it is the board that appoints the key personnel responsible for overseeing the business's daily operations. The officers (president, vice-president, treasurer, etc.), though appointed by the board of directors, often wield the greatest power in a corporation; indeed, in some corporations, officers are also members of the board of directors. Of course, in situations where only one person owns the incorporated company, he or she will bear many of the above responsibilities.

INCORPORATING IN DELAWARE AND NEVADA

Over the years, many companies have chosen to incorporate in Delaware or Nevada because of those states' business-friendly environment regarding taxation and liability issues. But some business experts caution small businesses from automatically casting their lots with these states. Small businesses with a small number of shareholder-employees should probably incorporate within their own state of operation. Although Delaware may offer some tax breaks and potentially more statutory protection from liability for corporate directors than most other states, for a small corporation the advantages are usually outweighed by the disadvantages. For instance, a company incorporated in Delaware but operating elsewhere must appoint someone in Delaware to be an agent for the corporation (there are companies in Delaware that do this). In addition, such a firm will have to pay an annual franchise (corporate) tax to the state of Delaware as well as file an application in its home state to do business as a foreign corporation. This designation will require them to pay a franchise fee in addition to their usual state income taxes.