Incorporating: The Basics
This is general information only and does not constitute legal advice. For questions about your specific situation you should contact an attorney.
- What is a corporate entity?
A corporate entity – whether a corporation, limited liability company, limited liability partnership, or otherwise – has its own distinct identity and conducts business independently from its owners. Just like a person, the entity can own property, accrue debt, enter into contracts, and open bank accounts, all in its own name. While individuals act on behalf of the company, they remain legally distinguishable from the entity itself. For example, the entity will have its own legal name, the equivalent of its own social security number (called a Federal Employer Identification Number or Tax Identification Number), and file its own tax returns.
Because the corporate entity exists apart from its owners, as a rule the people associated with the company (e.g. owners, shareholders, managers, members, etc.) are not personally responsible for its obligations. Thus, if a corporation borrows $50,000.00 in unguaranteed debt, the shareholders are not individually liable on that note. However, if the owners fail to honor the corporate form – for example, they commingle personal and business funds or property, fail to make required filings or maintain appropriate records, or undercapitalize the business – the “corporate veil” can be “pierced” by a court and the owners held personally liable for entity debt.
In addition, owners remain responsible for their own “bad acts”. For example, a physician with an ownership interest in an incorporated medical practice could still be individually liable for medical malpractice if her errors or omissions are the legal cause of an injury. The medical corporation may also have liability, but the other physicians would not have personal liability simply by virtue of joint corporate ownership.
- Should I create a corporate entity?
If properly managed, corporate entities are a very effective means of keeping the personal assets of owners from being used to satisfy corporate obligations. In most cases, they also keep owners from being sued personally on business debt.
From the perspective of the individual owner, a corporate entity should be created any time a third party can create a liability for which that owner could be legally responsible. For example, incorporation is recommended if the business has employees or contractors. If an employee driving a delivery truck negligently causes a car accident while traveling to a customer’s home or office, the business could be liable for damages. If the business is incorporated and employs the driver, in most circumstances the corporate entity but not the individual owners may be sued by the injured party. If there is no corporate entity, the individual owners of the business may be personally liable to the injured party.
A corporate entity should be created any time more than one person owns (or could reasonably be found by a court to own) a business. A general partnership, defined as two or more people in business for profit, exists as a matter of law regardless of whether the individuals intended to be partners or create a partnership. Each partner is personally liable for all partnership debts and liabilities whether or not that partner agreed to the accrual of the obligation or even knew of its existence. Thus, if Jack borrows $100,000.00 from James on the premise that the money will be used in a business Jack runs with Jill, Jill is personally liable to James for the entire $100,000.00 even if she didn’t agree to or know about the loan.
It is a widely-held belief that businesses should incorporate in certain “business friendly” states like Delaware or Nevada. However, except in unusual circumstances, it is generally cheapest and easiest to incorporate in the state in which the controlling or managing owner lives or where the business will have its principal office.
The benefits of incorporating in Delaware as opposed to the state of operation are minimal. State statutes governing corporate entities are generally uniform (with minor differences from jurisdiction to jurisdiction). The business will have to pay state taxes in the jurisdiction(s) in which it is physically located as well as certain Delaware taxes and administrative fees. Whatever small benefits accrue from incorporating in Delaware are usually offset by these additional expenses.
Nevada, Wyoming, and South Dakota are also popular states in which to form a corporation. As with Delaware, in most cases there is no real benefit to establishing the entity in one of those jurisdictions. Moreover, the Nevada legislature has been considering statutory amendments to increase the administrative costs to entities that do not have a principal place of business in the state. Some experts believe it is only a matter of time before that legislation becomes law.
- What kind of corporate entity should I create?
Accountants and lawyers have different opinions on whether a corporation or limited liability company is the optimal choice of entity. Functionally, they are the same. Properly created and managed, both corporations and LLCs protect owners from personal liability for business assets.
The tax consequences also tend to be the same, particularly at the start-up phase. To the extent possible, tax obligations should “pass through” the entity to the individual owners such that the entity pays no taxes. LLCs and corporations that qualify for subchapter S treatment (e.g. less than 100 shareholders, one class of stock, all owners are U.S. citizens or qualified residents) enjoy pass through status. Subchapter C corporations are theoretically taxed on both profits and dividends: However, in most cases the subchapter C corporation can avoid so-called “double taxation” with good accounting and management practices.
Limited liability companies tend to be slightly more expensive to form in terms of administrative costs (i.e. higher state filing fees) and have fewer structural and paperwork requirements than corporations (the latter are required to maintain a board of directors, keep meeting minutes, etc.). However, adhering to the corporation’s slightly more stringent paperwork requirements often provides a valuable source of evidence in the event a plaintiff sues the owner of a corporation alleging that he or she should be liable for its obligations. On the other hand, accounting rules with respect to limited liability companies tend to give the business more flexibility in terms of distributing money to owners.
State laws are also a factor to consider. For example, in New York, limited liability companies are required to publish notice of formation in a newspaper for six consecutive weeks within 120 days of organization. In New York City the publication cost is approximately $1,500.00 (the state filing fee for an LLC is $250.00). Because this is an administrative cost adding zero value to the entity itself, start-ups may opt to file a corporation instead.
You can also consider other corporate entities such as limited partnerships and limited liability partnerships. These generally have more specialized applications. Consult with an attorney for more information.
- How do I create a corporate entity and do I need a lawyer?
A corporate entity is created by filing an incorporating document – alternatively called a Certificate of Incorporation, Articles of Organization, Articles of Incorporation, or something else depending on the entity type and jurisdiction – with the appropriate state government office (usually but not always the state’s Secretary of State). Some states – including New York, Massachusetts, and Florida – offer online incorporation services. Others – including California and (surprisingly) Delaware – require the document to be mailed. The corporate entity is created upon acceptance of the incorporating document by the Secretary of State or other government office.
Each entity, including those with only one owner, should also have a governing document such as bylaws (for corporations) or an operating agreement (for limited liability companies). This document sets forth the rights and obligations of the owners. The bylaws or operating agreement should be crafted by an attorney so that it accurately reflects the understanding of the owners and sets forth basic operating procedures. The entity also has to make certain preliminary tax and other filings with federal and state governments. Finally, some internal organizational documents should be drafted, executed, and kept with the corporate records.
It is always advisable to use a lawyer to set up your corporation. A lawyer will help ensure that you realize the principal benefit of incorporation, protection of personal assets from business liabilities. A relatively small investment in legal services at the incorporation stage can save the business and its owners thousands of dollars in the future.
I STRONGLY ADVISE AGAINST USING LEGALZOOM OR SIMILAR SERVICES. THEY PROVIDE FORMS THAT YOU CAN OBTAIN ONLINE FOR FREE AND OTHERWISE ADD NO VALUE TO YOUR BUSINESS. A LAWYER WILL GUIDE YOU THROUGH THE PROCESS AND ADDRESS YOUR SPECIFIC CONCERNS.