How to incorporate your business

Business Entity Essentials

Incorporating Your Business

In this series, we will go over the reasons why you may want to formally organize your business and discuss the pros and cons of each kind of organization (i.e., LLC, corporation, etc.).

For most small businesses, you will want to form either a corporation or a limited liability company.

Why incorporate? You usually incorporate to protect your personal assets from any liability the business incurs.

A corporation can also sue and be sued because it is considered a separate juridical entity under the law.

Also, forming a corporation can allow the owners to take advantage of certain tax and investment strategies.

When choosing between a corporation and an LLC, entrepreneurs should consider factors such as the need for investment, desired flexibility in management, tax implications, and the level of formality they are willing to maintain.

Each business structure has its own unique benefits and drawbacks, and the best choice depends on the specific goals and circumstances of the business.

I have personally formed LLCs and corporations, including Delaware corporations, and can share my own experiences in dealing with these different types of entities.

Should you form an LLC or a Corporation?

Corporation Attributes

1. 1. Limited Liability Protection

Shareholders have limited liability for the corporation’s debts and obligations, like LLC members.

2. 2. Ability to Raise Capital

Corporations can issue stocks (common or preferred shares) to raise funds, making it easier to attract investors.

3. 3. Perpetual Existence

Corporations continue to exist even if ownership or management changes, providing stability and longevity.

4. 4. Ownership Transferability

Shares in a corporation can be easily transferred or sold, facilitating changes in ownership.

5. 5. Potential Tax Benefits

C corporations are taxed separately from their owners, potentially leading to tax advantages in certain situations.

S corporations allow for pass-through taxation while retaining the benefits of the corporate structure.

6. 6. Credibility and Prestige

Corporations, particularly C corporations, are often perceived as more established and credible, which can be advantageous in business dealings.

7. 7. Employee Incentives

Corporations can offer stock options or other equity-based incentives to employees, which can be attractive in hiring and retaining talent.

Disadvantages of forming a corporation

1. 1. Double Taxation for C Corporations

C corporations face double taxation: the corporation pays taxes on its profits, and shareholders pay taxes on dividends.

2. 2. Complexity and Formalities

Corporations require adherence to strict formalities, such as holding annual meetings, maintaining detailed records, and following complex rules and regulations.

3. 3. Higher Costs

The cost of forming and maintaining a corporation is generally higher than for an LLC. This includes administrative, legal, and tax preparation fees.

4. 4. Rigid Management Structure

Corporations have a fixed management structure with directors, officers, and shareholders, which can be less flexible than the management structure of an LLC.

5. 5. Regulatory Scrutiny

Corporations, especially public ones, are subject to more regulatory scrutiny and disclosure requirements than LLCs.

6. 6. Less Tax Flexibility

Corporations have less flexibility in how they are taxed compared to LLCs. While S corporations offer pass-through taxation, they come with restrictions on the number and type of shareholders.

7. 7. Ownership Restrictions

S corporations have restrictions on the number and type of shareholders (cannot exceed 100 shareholders and must be U.S. citizens/residents).

Comparing Corporations with LLCs

1. 1. Tax Flexibility

LLCs have more tax options and are not subject to double taxation.

2. 2. Simplicity and Flexibility

LLCs are easier to form and operate with fewer formalities and a more flexible management structure.

3. 3. Ownership and Investment

LLCs may face challenges in raising capital due to the inability to issue stock and less appeal to certain types of investors.

There are pros and cons of each, and tax consequences of each so you will want to consider how each is treated by your state and by the IRS so you can make a wise decision on how to organize your business.

Forming Your Corporation

1. 1. Articles of Incorporation

Like the Articles of Organization for an LLC, but often require more detailed information, such as the number of authorized shares, the par value of the shares, and information about the initial directors.

2. 2. Shareholder’s Agreement

A shareholders’ agreement is a contract between the shareholders of a company. It outlines the rights, responsibilities, and obligations of the shareholders and governs the relationship between them.

The agreement typically covers issues such as:

Ownership and Share Transfer: It specifies the number of shares each shareholder owns and outlines the process for transferring shares.

Management and Decision Making: It defines how the company will be managed and how major decisions will be made. It may include provisions regarding board of directors, voting rights, and decision-making processes.

Rights and Obligations: It outlines the rights and obligations of the shareholders, including dividend entitlements, participation in management, and restrictions on competition.

Dispute Resolution: It sets out procedures for resolving disputes between shareholders, which may include mediation, arbitration, or other methods.

Confidentiality and Non-Compete: It may include provisions to protect the company’s confidential information and restrict shareholders from competing with the company.

Exit Strategy: It may outline procedures for the sale or transfer of shares, including buy-sell provisions, drag-along rights, and tag-along rights.

Miscellaneous: It may also include other provisions related to the operation and management of the company, such as insurance, indemnification, and amendment procedures.

Shareholders’ agreements are important for privately-held companies as they help prevent misunderstandings and disputes among shareholders and provide a framework for the efficient management and operation of the company.

Does my company need a shareholder’s agreement?

Whether your company needs a shareholders’ agreement depends on several factors, including the size of your company, the number of shareholders, and the nature of your business.

Here are some situations where having a shareholders’ agreement may be beneficial:

Multiple Shareholders: If your company has more than one shareholder, a shareholders’ agreement can help clarify the rights and obligations of each shareholder and establish a framework for decision-making.

Control and Management: If you want to specify how the company will be managed and how major decisions will be made, a shareholders’ agreement can provide clarity on these issues.

Exit Strategy: If you want to establish a mechanism for shareholders to exit the company, such as buy-sell provisions or drag-along rights, a shareholders’ agreement can help facilitate this process.

Dispute Resolution: If you want to establish procedures for resolving disputes among shareholders, a shareholders’ agreement can provide a mechanism for mediation, arbitration, or other methods of dispute resolution.

Confidentiality and Non-Compete: If you want to protect the company’s confidential information and restrict shareholders from competing with the company, a shareholders’ agreement can include provisions to address these issues.

Other Provisions: A shareholders’ agreement can also include other provisions related to the operation and management of the company, such as insurance, indemnification, and amendment procedures.

While not required by law for privately-held companies, having a shareholders’ agreement can help prevent misunderstandings and disputes among shareholders and provide a framework for the efficient management and operation of the company.

It is advisable to consult with legal counsel to determine whether a shareholders’ agreement is appropriate for your company.

3. 3. Bylaws

Corporations are typically required to adopt bylaws, which outline the corporation’s rules and procedures, including the governance structure, duties of officers and directors, and meeting protocols.

Bylaws are not the same as a shareholders’ agreement. Bylaws are a set of rules and procedures that govern the internal operations of a corporation.

They are typically adopted by the board of directors and outline how the corporation will be managed and how major decisions will be made.

Bylaws typically cover issues such as:

1. 1. The structure and composition of the board of directors.

1. 1. The procedures for holding meetings of the board of directors and shareholders.

1. 1. The duties and responsibilities of officers and directors.

1. 1. The procedures for amending the bylaws.

1. 1. Other administrative and procedural matters related to the operation of the corporation.

1. 1. Bylaws are legally required for corporations and are filed with the state in which the corporation is incorporated. They are binding on the corporation, its directors, officers, and shareholders, and they must be followed in the operation of the corporation.

In contrast, a shareholders’ agreement is a contract between the shareholders of a corporation that governs their relationship with each other and with the corporation.

While bylaws govern the internal operations of the corporation, a shareholders’ agreement governs the rights, obligations, and relationships of the shareholders themselves.

Board of Directors and Shareholder Meetings

Whether your company requires a board of directors depends on the legal structure of your company and the laws of the jurisdiction in which it is incorporated. Here are some general guidelines:

Corporations: In most jurisdictions, corporations are required to have a board of directors. The board is responsible for overseeing the management of the company and making major decisions on behalf of the shareholders.

Limited Liability Companies (LLCs): In many jurisdictions, LLCs are not required to have a board of directors. Instead, they are typically managed by their members or by managers appointed by the members.

Partnerships and Sole Proprietorships: Partnerships and sole proprietorships are generally not required to have a board of directors. The owners of these types of businesses are typically responsible for managing the business themselves.

It’s important to note that even if your company is not legally required to have a board of directors, having one can provide valuable oversight and governance, especially as the company grows.

A board of directors can also provide expertise and guidance to the management team, help make important decisions, and provide accountability to shareholders.

Corporations are required to hold regular meetings of the board of directors and shareholders. Minutes of these meetings must be recorded and maintained.

4. 4. Annual Reports and Fees

Corporations must file annual reports with the state and pay associated fees. These reports can be more detailed than those for LLCs.

5. 5. Stock Records

Corporations are required to keep detailed records of all stock issued, including a stock ledger documenting shareholders and share allocations.

6. 6. Compliance with Securities Laws

When issuing stock, corporations must comply with federal and state securities laws, which can be complex and require additional filings.

7. 7. Tax-Related Filings

Depending on their tax status, corporations may have more complex tax filing requirements, including separate corporate tax returns.

C Corporations (Regular Corporation)

1. 1. Taxation

C corporations are subject to double taxation. The corporation itself pays taxes on its profits at the corporate tax rate, and then shareholders pay taxes on dividends they receive at the individual tax rate.

2. 2. Ownership

There are no restrictions on the number or type of shareholders. C corporations can have an unlimited number of shareholders, including individuals, other corporations, and foreign entities.

3. 3. Stock Types

C corporations can issue multiple classes of stock, such as common and preferred stock, which allows for greater flexibility in raising capital and structuring ownership.

4. 4. Venture Capital and Investment

C corporations are typically more attractive to venture capitalists and investors, especially for large-scale investments or public offerings.

5. 5. Regulatory Requirements

Generally, C corporations face more stringent regulatory requirements and public disclosure obligations, particularly if they are publicly traded.

S Corporations

1. 1. Taxation

S corporations are pass-through entities for tax purposes. This means that the corporation itself does not pay income taxes. Instead, profits and losses are passed through to the shareholders, who report them on their individual tax returns, avoiding double taxation.

2. 2. Ownership Restrictions
      S corporations can have no more than 100 shareholders. Additionally, shareholders must be U.S. citizens or residents, and the corporation cannot have non-individual entities (like other corporations or partnerships) as shareholders.

2. 2. Stock Types

S corporations are limited to issuing only one class of stock, which can restrict the corporation’s ability to raise capital and structure different levels of ownership rights.

4. 4. Tax-Qualified Shareholders

Only certain trusts, estates, and tax-exempt organizations are eligible to be shareholders in an S corporation.

5. 5. Eligibility Requirements

To elect S corporation status, a corporation must file Form 2553 with the IRS and meet all the criteria. This election must be made by a certain deadline.

Choosing Between C Corporation and S Corporation

The decision to form a C corporation or an S corporation depends on various factors, including the desired tax treatment, ownership structure, capital raising needs, and the types of investors the business aims to attract.

While S-corporations offer the benefit of avoiding double taxation, they come with restrictions on ownership and stock types.

C-corporations provide more flexibility in these areas but are subject to double taxation on profits and dividends.

Businesses should carefully consider their long-term goals, financial strategies, and the implications of each corporate structure before deciding.

We recommend you consult with a knowledgeable lawyer and/or CPA for personal advice regarding your specific situation.

C-corps and S-corps — What’s the Difference?

The names “C-corp” and “S-corp” are derived from the specific subchapters of the Internal Revenue Code (IRC) that govern the taxation of these types of corporations. The IRC is the body of federal tax law in the United States, established by the U.S. Congress.

C-corporation:

This term refers to a corporation that is taxed under Subchapter C of the IRC. The “C” in C-corp stands for “Subchapter C.”

These corporations are subject to corporate income tax on their profits, and their shareholders are also taxed on dividends received, leading to the characteristic double taxation of C-corps.

S-corporation:

This designation comes from Subchapter S of the IRC. The “S” in S-corp stands for “Subchapter S.” S-corps are designed to avoid the double taxation that affects C-corps.

With S-corp status, the corporation’s income, losses, deductions, and credits pass through to shareholders’ personal tax returns, so the corporation itself is not taxed separately at the corporate level.

This pass-through taxation is subject to specific eligibility criteria outlined in Subchapter S.

These designations are primarily related to tax classification and do not impact the legal structure or formation of the corporation.

Both C-corps and S-corps are formed under state law and have similar legal and operational structures, but they differ significantly in their federal tax treatment.

It’s important to note that S-corp status is an elected status; a corporation must choose to be treated as an S-corp by filing Form 2553 with the Internal Revenue Service (IRS) and must meet and maintain certain eligibility requirements to qualify and continue as an S-corp. Otherwise, by default, corporations are treated as C-corps for tax purposes.

“C” Corporations Paperwork / Tax Filing

Here is a list of federal tax forms you may need if you operate as a “C-corporation.”

Form 1120 (U.S. Corporation Income Tax Return)

This is the primary tax form for C corporations. It’s used to report income, gains, losses, deductions, credits, and to calculate the corporation’s federal income tax liability.

Form 1125-A (Cost of Goods Sold)

Corporations that sell goods must complete this form as part of Form 1120 to report the cost of goods sold.

Form 1125-E (Compensation of Officers)

If a corporation pays compensation to its officers, it must file Form 1125-E with its Form 1120. This form reports the total compensation paid to all officers.

Form 1099-DIV (Dividends and Distributions)

Corporations issue Form 1099-DIV to shareholders to report dividends and distributions paid during the tax year.

Employment Tax Forms

Corporations with employees must file employment tax forms, including Form 941 (Employer’s Quarterly Federal Tax Return) for payroll taxes and Form 940 (Employer’s Annual Federal Unemployment (FUTA) Tax Return).

Form 1099-MISC or 1099-NEC

Used to report payments to non-employees, such as independent contractors, if the corporation pays them more than a certain threshold during the tax year.

S Corporations – Taxes and Paperwork

1. 1. Form 1120S (U.S. Income Tax Return for an S Corporation)

Similar to Form 1120 but used by S corporations. It includes income, losses, deductions, and credits, but the income is passed through to shareholders.

2. 2. Schedule K-1 (Shareholder’s Share of Income, Deductions, Credits, etc.)

Part of Form 1120S, Schedule K-1 is provided to each shareholder and reports their share of the corporation’s income, losses, deductions, and credits.

3. 3. Employment Tax Forms – W-2 to owner(s)

Similar to C corporations, S corporations must file Form 941 and Form 940 if they have employees.

S corp owners are also employees of the corporation, and must issue themselves a W-2 salary.

This salary needs to be “reasonable” to withstand IRS scrutiny.

4. 4. Form 1099-DIV, 1099-MISC, or 1099-NEC

As with C corporations, these forms are required for reporting dividends and payments to non-employees.

Additional Considerations for Corporations

Estimated Tax Payments

Both C and S corporations may need to make estimated tax payments if they expect to owe tax of $500 or more when their return is filed.

State Taxes

In addition to federal taxes, corporations may have state tax filing obligations, which vary by state.

Special Situations

Depending on the corporation’s activities, additional forms may be required (e.g., for foreign transactions, excise taxes).

Corporations should consult with a tax professional or accountant to ensure compliance with all federal tax filing requirements, as these can be complex and are subject to change.

Proper and timely filing of these tax documents is crucial to avoid penalties and maintain good standing with the IRS.

The primary differences between a regular corporation (often referred to as a C corporation) and an S corporation lie in their tax treatment and ownership restrictions.

Both are corporations in the legal sense, with similar structures and compliance requirements, but they are taxed differently and have different characteristics in terms of shareholders and stock.

Limited Liability Companies (LLCs) – Essentials
LLC — Definition and Basic Structure
An LLC (“Limited Liability Company”) is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation. An LLC is flexible and is usually simple to create and manage.

Often a single-member LLC can be formed with a few sheets of paper and for a few hundred dollars in filing fees with your state’s secretary of state. An LLC is also easy to manage because you do not need a board of directors. An LLC is a legal entity separate from its owners who are called “members.”

The IRS treats LLCs as “disregarded entities” meaning your income and expenses of the LLC will be picked up on your Schedule C which is part of your 1040 tax return.

If you the LLC has more than one member, however, it will be treated as a Partnership meaning you’ll have more tax forms to prepare (like Form 1065 and K-1) for the IRS and possibly additional tax forms with your state.

Advantages of an LLC

1. 1. Limited Liability Protection

Members are typically not personally responsible for business debts and liabilities.

2. 2. Tax Flexibility

LLCs benefit from pass-through taxation but also have other options for how they are taxed.

3. 3. Fewer Formalities

Less stringent requirements for meetings, record-keeping, and reporting compared to corporations.

4. 4. Management Flexibility

LLCs can be member-managed or manager-managed, providing flexibility in how the business is run.

Fiduciary Duties Owed to Members

Managing members can owe fiduciary duties to other members. If you have a multi-member LLC, always be aware of fiduciary duties regarding decisions you or other members make that affect the LLC or other members.

Keys to Protecting Your Personal Assets

Limited liability may not be absolute. While LLCs provide limited liability protection, this protection isn’t always guaranteed.

In cases of fraud, personal negligence, or failure to maintain a clear separation between personal and business finances (piercing the corporate veil), members may be held personally liable.

Self-Employment Taxes

Members of an LLC are typically considered self-employed and must pay self-employment taxes (Social Security and Medicare) on their share of the profits. This can be a significant expense, especially if the LLC is highly profitable.

Startup and Maintenance Costs

Forming an LLC often involves higher initial costs than sole proprietorships or partnerships. There are filing fees for the Articles of Organization and possibly other initial expenses. Additionally, LLCs may have ongoing fees, such as annual report fees or franchise taxes, depending on the state.

Varied State Laws

The rules and regulations governing LLCs can vary significantly from state to state, potentially complicating interstate business operations. Understanding and complying with different state requirements can be a challenge for LLCs operating in multiple states.

Transferability of Ownership

Transferring ownership in an LLC can be more complicated than in a corporation. In many cases, unless the Operating Agreement specifies otherwise, the approval of all members is required to bring in new members or change the ownership structure.

Limited Growth Potential

Since LLCs cannot issue stock, they may face limitations in raising capital compared to corporations. This can hinder growth potential, especially for businesses looking to scale quickly or attract certain types of investors.

Dissolution upon Member Departure

In some states and under certain circumstances, an LLC might be required to dissolve when a member leaves, unless the Operating Agreement specifies otherwise. This can lead to instability and uncertainty in the business structure.

Complexity in Taxation

While the pass-through taxation of an LLC is beneficial in many cases, it can also lead to complexity, especially when an LLC opts to be taxed as a corporation. Understanding and navigating these tax choices can require professional advice and incur additional costs.

Restricted Investment Opportunities

Some investors and venture capital firms prefer to invest in corporations rather than LLCs. The structure of an LLC may be seen as less favorable for certain types of investment strategies.

Reduced Perceived Prestige

In some industries or business circles, a corporation may be perceived as more established or legitimate than an LLC. This perception, whether accurate or not, could potentially affect business relationships and opportunities.

While LLCs are a popular and flexible business structure, it’s important for entrepreneurs to weigh these disadvantages against the advantages when deciding on the best entity type for their business.

Comparing corporations with Limited Liability Companies (LLCs) is important for entrepreneurs deciding on a business structure. Each has its own set of advantages and disadvantages.

LLC Formation Requirements

Articles of Organization

The primary document required to form an LLC. It includes basic information about the LLC, such as the name, address, and sometimes the members and management structure.

Operating Agreement

If you have more than one member, you will want to create an Operating Agreement that governs everything from buyouts, withdrawals, profit sharing and windup/dissolution.

While not always legally required, an Operating Agreement is highly recommended for LLCs. It outlines the ownership structure, member roles, profit distribution, management, and other operational details.

Annual Reports and Fees

Many states require LLCs to file annual or biennial reports and pay a filing fee. These reports are usually simpler than corporate filings and require basic information about the business.

State-Specific Requirements

Depending on the state you’re in, there may be additional requirements, such as publishing a notice of the LLC formation.

Tax-Related Filings

LLCs may need to make certain tax-related filings, depending on their chosen tax status (e.g., if taxed as a corporation).

Less Formal Record-Keeping

LLCs are not required to hold annual meetings, keep minutes of meetings, or adhere to many of the formalities required of corporations.

How do you incorporate? (using Texas as example)

Choose a Business Name

Your corporation’s name must be unique and not like any other registered business in Texas. You can check the availability of your desired name by searching the Texas Secretary of State’s business name database.

File a Certificate of Formation

You need to file a Certificate of Formation for a For-Profit Corporation (Form 201) with the Texas Secretary of State. This can be done online through the SOSDirect website, by mail, or in person. The form requires information like your corporation’s name, its purpose, the registered agent’s name and address, the number of shares the corporation is authorized to issue, and the incorporator’s name and address.

Appoint a Registered Agent

Every Texas corporation must have a registered agent in the state. This is an individual or business entity responsible for receiving important legal and tax documents on behalf of the corporation.

Create Corporate Bylaws

Although not filed with the state, bylaws are an internal document that outlines the corporation’s operating rules. They are essential for organizing your corporation’s internal affairs.

Obtain an Employer Identification Number (EIN)

This is necessary for tax purposes and is obtained from the IRS. You can apply for an EIN online, by mail, or by fax.

Hold an Initial Meeting

During this meeting, the board of directors should adopt the bylaws, appoint officers, and conduct any other initial business.

Register for State Taxes

Depending on the nature of your business, you may need to register with the Texas Comptroller of Public Accounts for state taxes, such as sales tax or franchise tax.

Comply with Federal and State Regulations

This includes obtaining any necessary business licenses and permits and understanding any regulations that may apply to your corporation, such as employment laws.

File Annual Reports

Texas requires corporations to file a periodic report with the Secretary of State, which includes updates on basic information about your corporation.

Maintain Good Standing

Ensure that your corporation stays in compliance with Texas laws and regulations, including keeping up with annual report filings and tax obligations.

Remember some of your corporate documents will likely need to be notarized.  We offer notary services in addition to our corporate legal services.