If you are a small business owner or considering starting a business, you have probably already had the thought in your mind to incorporate and you have a lot of questions. What are the advantages and disadvantages? Which entity should I choose? What do I need to start the process? We recently had the opportunity to work with one our On Call attorney’s Stuart Bronstein to answer the most common incorporation questions.
When should I incorporate?
A corporation can generally choose its fiscal year. So instead of accounting from January through December, it can account for income and pay taxes on a year from, for example, July 1 through June 30.
That can be important because (among other things) when you incorporate it could have an effect on your first-year taxes. For example, if you incorporate in November and use a calendar year for the tax year, you will pay state incorporation taxes and fees for that year, and then owe more for the following year only one month away.
When you incorporate could also have to do with the kind of corporation you will be using. An S-corporation is primarily (though not completely) a pass-through entity which doesn’t pay taxes itself. If you are going to spend more than you take in during the early years, using an S-corporation, or no corporation at all, will allow you to pass deductions to the business owners. If it’s a regular C-corporation, some or all of those deductions may be wasted, or at least put off until a future date.
What are the advantages of incorporating?
In the old days incorporating was useful because a corporation could put more money away into a pension plan for its owners than unincorporated businesses. That is no longer the case. But a corporation can still be of benefit because of certain employee benefits that are deductible to the corporation but are not taxed to the employee, such as health insurance. There are also other benefits in this category.
One traditional reason for incorporating is to limit your personal liability. So in case of disaster, you are likely only to lose your investment in the business, but not everything you own. Insurance is a much better selection if you have to choose. It can protect against your own actions, and prevent you from losing your investment.
Often investors will want a corporation rather than some other business form because it gives them certain rights that they feel will limit the risk of their investments.
What are the disadvantages of incorporating?
Corporations are more expensive than not having one. There are state fees and additional accounting expenses. Corporations also involve a lot of bureaucracy if you want to be able to benefit from the advantages of incorporating, through an LLC is much less formal than a corporation.
Which is better: An LLC or S-Corp?
It really depends on the specific situation. An LLC can elect to be taxed as a proprietorship/partnership, a C-corporation or an S-corporation, so it’s more flexible in that way. It’s also less formal without the same level of bureaucracy involved.
An LLC taxed as a proprietorship/partnership can be better than an S-corporation in some instances because some deductions (especially for highly-leveraged real estate) can be limited for an S-corporation while not for an LLC.
The best advice for anyone is to talk to his own tax preparation professional (CPA or Enrolled Agent).
What state should I incorporate in?
Some people think it’s best to incorporate in a state like Delaware or Nevada. However, if you are not locating your business in those states, there is almost no reason to do that, and good reasons not to.
The reason large corporations incorporate in Delaware (and a few other states) is that the laws give the corporate management more power and the shareholders less power than under traditional corporate law. If you get to the point that your corporation is so successful that you will have it go public, then moving to Delaware at that point might make sense. But it makes no sense to do it before that.
One of the reasons it makes no sense to set up in Delaware is that you also have to qualify your corporation to transact business in your home state. So you will be paying state fees and filing tax returns in two states instead of one. It’s more bureaucracy and more expense, without any real benefit.
Some states, like Nevada, have no corporate income tax. But that doesn’t help you either if your business is not located there. Because your home state will tax your corporation even if it’s incorporated in Nevada.
What happens if I move to another state?
There are a few different ways to deal with this. One is to keep the corporation you set up, and just qualify it to do business in the new state. This is the easiest and cheapest way to set it up. But it can be more expensive in the long run because you have to pay taxes to and comply with the rules of two states instead of one.
Another approach is to set up a new corporation in the new state and have it acquire all the stock of the current corporation. Then the current corporation is dissolved.
What do I need to incorporate a business?
The first thing I advise people to have when considering incorporating a business is the advice of a tax preparation professional (CPA or Enrolled Agent). The choice of business entity is quite individual and depends upon many factors. There really is no one-size-fits-all answer.
When setting up a corporation (or any business for that matter) you need to consider where your financing is going to come from, whether all financing will be equity or there will be loans. And if you need investors, where will they come from? The answers to these questions will have significant effects in several ways, not just financial or tax. But you could run afoul of the securities law, for example, if you are not careful.
A Business Plan is also extremely helpful. Studies show that people who have written business plans when they start a business are much more likely to be successful than those who haven’t. One reason is that writing a business plan forces you to think of all aspects of the business, including funding, marketing, and competition. If you deal with those in advance, you more likely create a roadmap for success.
Why do I need legal documents if I filed with the state?
Corporations require Bylaws and Corporate Minutes, and LLC’s require an Operating Agreement. If you don’t have them, and you get sued, you can easily lose the protection that these entities were set up to provide.
What is a Registered Agent and why do I need one?
Every corporation and LLC needs to have some person designated to receive official notices. That person has to be available to receive notices. And that is the function of a registered agent. It has to be a real person or a qualified corporation.
How do you pay yourself in an LLC?
How you pay yourself in an LLC will depend on how you elect to have the LLC taxed. If it’s taxed as a C-corporation, you pay yourself a salary and withhold the necessary taxes. As an S-corporation, you can take a mixture of a salary and other money not subject to the self-employment tax. But again, this is a highly individual decision based on many factors. The best person to talk to about how you should handle this in your case is your tax preparation professional.
Should I trademark my business name?
Whether or not you should trademark your business name is also highly individual and will depend on many factors. If you want to use an internet URL that is the name of your business, having a trademark can be helpful. If you want to do business outside your home state, a trademark can be helpful. And if you are selling unique goods and want the name to be a sign of, for example, particular quality.
This article contains general legal information and does not contain legal advice. Rocket Lawyer is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.