In this 11-minute read:
- Sole proprietorship vs. incorporation
- Types of incorporations
- How to incorporate your small business
When you first start your business, a sole proprietorship makes sense, especially if you are your only employee. But at what point should you take the next step to incorporate your business?
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As your business starts to grow, there are several advantages that incorporating can offer you. There’s definitely a lot to think about as you’re considering taking that next step with your business, so we’ve provided a great starting point for your research with this article.
Sole proprietorship vs. corporation
First, let’s define sole proprietorship versus corporation.
A sole proprietorship is a business that is owned and run by one person. In this type of enterprise, the business and the owner have no legal distinction and are essentially the same entity.
An incorporated business (a corporation) is a company that is formally recognized as a separate entity in the eyes of the law. Once incorporated, the business is its own legal structure separate from the individuals who started it.
Advantages of a sole proprietorship
As you are starting your business, keeping it simple as a sole proprietorship can make a lot of sense. Some of the advantages of this include:
- You don’t have to file separate business taxes
- You have less paperwork because you aren’t required to separate financial statements for your business and yourself
- You get to keep all of your profits because you are the sole owner
Advantages of incorporating your small business
When you decide to incorporate your business, you are turning it into a legally separate entity. The business and the owner are no longer one and the same.
Because of this, some things may become a little more complicated, like taxes and financial records. But it provides several advantages that being a sole proprietor doesn’t offer.
- You can protect your personal assets from lawsuits and bankruptcies because your business and you are separate entities
- Establishing your business as a corporation gives your business more credibility with customers, vendors, and employees
- An incorporated business has the potential for better longevity. If you pass away as a sole proprietor, the business goes away with you, but an incorporated business can be passed along to another owner and the business can continue
- Better chance of securing a business loan
Types of corporations
As you are considering incorporating your business, it’s important to learn the types of corporations, the advantages of each, and the purposes they serve.
In simple terms, the main differences between each type of corporation are the ways that taxes are handled.
LLC
LLC is a limited liability company. Limited liability means that the owners of the company are not personally responsible for any debts or lawsuits that the business may incur. LLC members (another term for the owners) don’t have to put their personal assets on the line to cover lawsuit settlements.
That being said, there are some similarities between an LLC and a sole proprietorship to keep in mind. An LLC is kind of a stage in between a sole proprietorship and a full corporation. It combines some elements of both types of business structures.
Taxes are one such thing in an LLC that are more similar to the structure of a sole proprietorship. The LLC doesn’t pay its own income taxes; the owners list their business profits and losses on their personal tax returns.
With an LLC, you can choose to tax your business as a corporation, but there are some additional tax laws and filing requirements to consider (learn more under the S corporation section below).
There are some distinct differences between an LLC and a corporation that you should consider before deciding which direction to take:
- It only takes one business owner to form an LLC; you don’t need to have multiple members to get started
- If you run a business in the banking, trust, or insurance industry, you can’t form an LLC
- Some states prohibit additional types of businesses from forming an LLC, so learn what your state requirements are before pursuing this option
C corporation
A C corporation is owned by shareholders of the company and, as such, its profits are taxed differently from any other type of corporation. A C corporation is required to elect a board of directors to oversee policies and make business decisions for the company.
Major advantages that a C corporation has over other types of corporations:
- C corporations usually have a lower risk of being audited
- You can deduct the cost of benefits as a business expense (for example, you can write off the costs of health plans for your employees)
- The corporation’s profits are taxed, and then the profits can be split among the owners (usually saving money on taxes for the individual owners)
- C corporations can have an unlimited number of stockholders
- Foreign nationals can invest in C corporations
S corporation
An S corporation is not a type of business entity like an LLC or C corp. Rather, it is a way to designate how your business will be handling its taxes. The IRS only classifies businesses as one of the following when it comes to taxes:
- Sole proprietorship
- Partnership
- C corporation
- S corporation
“LLC” is not an option when determining how to handle your business taxes because in an LLC you have to choose whether to file taxes as a sole proprietorship, partnership, or corporation.
That’s where S corporation comes in. This is the designation you can choose on your taxes for your LLC business if you want to be taxed as a corporation.
The main difference between taxing your business as a sole proprietor and an S corp is the way Medicare and Social Security taxes are handled. Sometimes, LLC owners can save money here by choosing to file as an S corp.
Advantages to taxing your business as an S corp:
- The owner reports an individual salary which counts as an expense for the business on tax returns
- Medicare and social security taxes are only paid from each individual’s salary, not all business profits
How to incorporate your small business
You might already have a pretty good idea of which type of corporation will work best for your business. But no matter which way you choose to file, the following steps are important as you start the process of incorporating your business.
Consult an attorney
First, find a good attorney. Unless you are an expert business lawyer yourself, it’s likely that you’ll miss some things along the way, so protect yourself by consulting an attorney to help you hit all the right steps.
An attorney will be familiar with compliance, local licensing and zoning laws, and the proper paperwork for filing your incorporation.
Determine which type of corporation is right for you
Do your research on the purposes and advantages of each type of corporation. Which is the best for your business?
Are you a solo business owner and just want to keep your business and personal assets separate? Then an LLC could be a good route for you to take to protect yourself as an individual from any lawsuits that may come up related to your business.
Or, maybe you have multiple owners, several employees, and/or a number of people interested in becoming shareholders. Then a C corporation might make more sense for you.
Talk to your attorney about the tax implications of each type of corporation that you are considering and use that to help you decide which way to file your business.
Find a business name
When you file your business as a corporation, you need to have a unique business name. You won’t be allowed to choose a name that is already in use in your area because that will confuse consumers.
So, come up with several different options for a business name. Most secretary of state offices even have an online business name search where you can see which names are already registered. Use these resources to help you come up with something unique.
Name a registered agent
A registered agent is someone that can accept mail on behalf of your company. When your business becomes a corporation, you are required to have a registered agent. This can be the owner of the company, your business attorney, or another director or employee within your company so long as they reside in the same state as your business.
There are even online services that you can pay to act as your registered agent.
Write articles of incorporation
Every corporation has to write their “articles of incorporation.” This is typically a one to two-page document that includes the following information:
- Explanation of your corporation’s purpose
- Your business’s name and address
- Names and addresses of each member of your board of directors
- Names and addresses of each officer of the corporation
- The duration of your corporation (usually forever)
Your attorney should be familiar with this process and can help you draft up your articles of incorporation. There are also online legal sites that offer assistance with this for a small fee.
File articles of incorporation with your state
Once you have your articles of incorporation written, you need to file them with your state. There is a fee associated with this—usually anywhere between $100 and $500 depending on your state—so be prepared for that.
This document should be filed with your secretary of state, and you can usually do this through their website. Find your secretary of state’s website and follow their instructions for filling your articles of incorporation.
Obtain business permits and licenses
After your business is registered with the state, you need to obtain any and all business licenses and permits that are required for your particular business type (if you don’t already have these). Your attorney can help you determine what you need here.
Open a bank account for your business
Now that your business is a separate entity for you as an individual, you need to open a separate business bank account. This will help you keep accurate records of your business’s finances.
All of the steps leading up to this point should be sufficient for an LLC. If you are choosing to establish a C corporation, continue with the next three steps.
Write your corporate bylaws
Corporate bylaws lay out how your corporation is to be structured. They should have information about your shares, voting rights, how to replace board members, and other such details.
Types of information that you might include in your bylaws:
- Types of shares that can be issued by the corporation
- Information about shareholder and board meetings
- How loans, contracts, and other transactions will be approved by the corporation
- Procedures for financial audits and how often they should occur
- Information about the fiscal year
- Procedures for amending corporate bylaws
Your corporate bylaws help keep structure within the business and are typically much more detailed than your articles of incorporation. These will help board members and shareholders stay accountable to the business.
Keep a book of corporate records
As you incorporate your business, you should start keeping a “book” of corporate records. This is a record of all relevant documents for your corporation. This doesn’t need to be a physical book, but can (and probably should) be kept in your digital records for ease of access.
Items to keep in your corporate records:
- Articles of incorporation
- Corporate bylaws
- Minutes of shareholder and board meetings
- All stock transactions
- Annual reports
- Business loan documents
- Any contracts the business enters into
- Commercial real estate transactions
Hold a board meeting
Once you have all of your records in place and have registered your corporation with your state, you are almost there! The last step is to hold your first board meeting to make everything official.
Agenda for this first board meeting should include the following:
- Board member formally adopt the bylaws and articles of incorporation
- A corporate seal is decided on
- Issue shares of stocks to initial shareholders
- Elect your CEO, CFO, and other officers
Keep a record of the minutes of this board meeting and all future board meetings.
Complete any other state and federal requirements
No matter which type of corporation you are filing as, be sure you complete all state and federal requirements that apply to your business. Discuss these with your attorney.
Once this is done, your business is officially incorporated! This whole process can be completed within weeks if you enlist the right attorney and do your initial research to understand how everything works.
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