Incorporation: Definition, How It Works, and Advantages

What Is Incorporation?

Incorporation is the legal process used to form a corporate entity or company. A corporation is the resulting legal entity that separates the firm's assets and income from its owners and investors.

Corporations can be created in nearly all countries in the world and are usually identified as such by the use of terms such as "Inc." or "Corp." in their names. It is the process of legally declaring a corporate entity as separate from its owners.

Understanding Incorporation

Incorporation is the broad term to describe a business registered with a state to become a separate legal entity. That business entity often is owned by shareholders (even if it is a corporation with a single owner) that may also be overseen by a board of directors.

A company does not need to be incorporated to operate a business. Business owners may elect to operate as a sole proprietorship, partnership, or limited liability company (LLC) instead. These business structures treat company debt and taxes differently than compared to an incorporated entity.

Another primary difference between legal entities and one of the most important reasons a company may want to incorporate is for the advantage of issuing stock. When a company incorporates, it gains the ability to share ownership of the company by issues shares of stock. Whereas a sole proprietorship or partnership is usually only owned by those operating the company, incorporating allows a business owner to sell an ownership stake in part of the business.

If a business doesn't need to sell stock, an LLC can be a great option. It offers legal protection, but has pass-through taxation, meaning earnings are only taxed once.

The Creation and Organization of Corporations

Incorporation involves drafting "articles of incorporation," which lists the primary purpose of the business and its location, along with the number of shares and class of stock being issued if any. A close corporation, for instance, is held by a small number of shareholders and is not publicly traded. Companies are owned by their shareholders. Small companies can have a single shareholder, while very large and often publicly traded companies can have several thousand shareholders.

As a rule, the shareholders are only responsible for the payment of their own shares. As owners, the shareholders are entitled to receive the profits of the company, usually in the form of dividends. The shareholders also elect the directors of the company.

The directors of the company are responsible for day-to-day activities. They owe a duty of care to the company and must act in its best interest. They are usually elected annually. Smaller companies can have a single director, while larger ones often have a board comprised of a dozen or more directors. Except in cases of fraud or specific tax statutes, the directors do not have personal liability for the company's debts.

How to Incorporate a Business

There are many steps to incorporating a business, each with its own degree of importance. Below are the following decisions and actions a business owner must take to incorporate.

Decide Where to Operate and Comply With Local Laws

Prior to incorporating, a business should ensure it is adhering to local business licensing and zoning laws. This includes having the appropriate permits or licenses to operate, though not all businesses may require these.

By extension, this may have implications in to where you operate and ultimately decide to incorporate. It's sometimes best to incorporate in the state that the business is operating in as there are different types of applications and filing requirements to file elsewhere. For example, incorporating in a different state may require you to file a foreign corporation. On the other hand, filing in a different state may reduce the fees and reporting requirements needed to establish and maintain the corporation.

Decide if a Corporation Is the Best Option for You

One of the more fundamental, important decisions to make is to establish the business structure. The most common forms of business are a sole proprietorship, partnership, corporation, and S corporation. An LLC is also a common business structure allowed by state statute. While this article is focused on incorporation, the process of forming a corporation, readers should be aware of other entity types that may suit them better. Should you choose another entity, your entity formation process will differ from the incorporation process.

A business owner should choose the business structure that makes the most strategic and operational sense for the long-term. As mentioned above, corporations can issue stock, a very easy way for owners to sell part of the business for personal profit. There are also very considerable tax and liability considerations to be had based on the business structure chosen.

For those unaware of the best course of action, it's usually recommended to consult a business attorney to discuss business structure options. In this article, more of the specific benefits and advantages of incorporating a business are discussed below.

Select a Unique Name

To incorporate, your business name can not be the exact same name as another corporation in your local area. You also want a unique name to avoid trademark infringement and branding confusion. When selecting that unique name, consider that incorporated businesses often end in incorporation abbreviations (i.e. "Inc.").

There are online directories that can be used to search existing business names. These directories allow users to input intended names to see whether they are available. Some states may offer business owners going through the incorporation process the option to reserve an available name for a period between 60 and 120 days depending on the state.

Select Registered Agent

A registered agent is a person who has the right and ability to accept paperwork and mail on behalf of the company. States will require that a company name a local registered agent, as the state will need a contact of someone who will handle official business as items arise.

The registered agent does not need to be the business owner. For example, a company's business attorney can serve as a registered agent as long as they have an office within the state the business is being incorporated in. Should the registered agent move out of the state in which the business is incorporated in, the company will need to choose a new agent. There are also online legal services that can act as your registered agent (in return for a fee).

Draft and File the Articles of Incorporation

As discussed above, the articles of incorporation include many important aspects of a company including the business name, location, information on public or private shares, the information of the registered agent, and the name of the incorporator. Each state has its own filing requirements for the articles of incorporation. There will be a filing fee to submit the article of incorporation with the state; in most cases, this is several hundred dollars.

Draft Corporate Bylaws

In addition to drafting the articles of incorporation, companies must draft bylaws to outline how your compensation is structured, how shares are issued, what voting rights are, and how the board of directors operate.

The corporate bylaws are a more detailed set of instructions on how to operate a business. Very often, a company may refer back to its bylaws to better clarify the best course of action to take as it runs. Some states won't require a copy of these, but they may be required by other entities (i.e. financial institutions may require bylaws when setting up a bank account). In addition, bylaws may be revised to meet the adapting nature of a business.

Host Board Meetings

At the first initial board meeting, the board members will be tasked with performing an important series of actions. At that first meeting, the board members should formally vote to adopt the articles of incorporation and bylaws, authorize and issue shares of stock, elect officers, and make other operational decisions. It is also important that the meeting minutes are taken as certain entities may require a copy of notes as needed.

Complete Additional Requirements

There are other operational tasks a business owner should take as it becomes incorporated. Though independent of the actual incorporation process, companies should apply for an employer identification number, create a bank account, file federal taxes, announce the creation of your corporation (if applicable), and file annual reports as needed.

Advantages and Disadvantages of Incorporation

Pros of Incorporation

Incorporation effectively creates a protective bubble of limited liability, often called a corporate veil, around a company's shareholders and directors. As such, incorporated businesses can take the risks that make growth possible without exposing the shareholders, owners, and directors to personal financial liability outside of their original investments in the company.

Because an incorporated business can issue and trade shares, this allows for easy transfer of ownership to another party. Whereas a sole proprietorship must sell the entire company to financially profit from disposing of company equity, owners of a company can still retain primary ownership but sell part of their shares for personal profit. In addition, shares traded on public exchanges are much more liquid markets compared to other means of selling a business.

An incorporated business may achieve a lower tax rate than on personal income. Incorporated businesses often receive more lenient tax restrictions on loss carryforwards and may receive more favorable tax treatment for allowable deductions.

Cons of Incorporation

The primary drawback of an incorporated business is the operating constraints to maintain its incorporated status. Companies must adhere to their bylaws and must ensure it meets filing, reporting, and other ongoing requirements. An argument can be made that since an incorporated entity's tax filing is separate from any individual's, there is also an administrative burden angle when preparing multiple tax returns.

An incorporated business normally experiences double taxation. Consider an example of a corporation being assessed net income tax. Then, with after-tax proceeds, it makes a taxable distribution to a shareholder. This shareholder now has taxable income on funds that have already been assessed a tax liability.

Operating an incorporated may be more expensive based on the filing, reporting, and administrative fees. Companies must often meet public reporting requirements (such as getting their financial statements audited). There are also ongoing fees and regulatory charges to maintain their status on an exchange.

Last, an incorporated business may be considered less flexible in some ways compared to other forms of business. Once incorporated, a business must operate in accordance to its bylaws and articles of incorporation. In addition, it usually now has an entire board of individuals overseeing operations. It may be more difficult for the executives at an incorporated business to dramatically change business strategy or operational considerations.

The Bottom Line

For more complex companies looking to raise more capital, have the owners avoid personal liability, and gain certain tax incentives, companies can opt to incorporate and operate using a different operating structure. Though incorporating is more expensive and requires more time to handle administrative manners, there are long-term, strategic advantages to moving on from being a sole proprietor or partnership.