Start Your Business

What is Incorporation?

Forming a corporation offers important advantages for any business seeking outside investment and liability protection.

Deborah Sweeney

By Deborah Sweeney

You have a new business idea, so you have decided to start a business. But before you do, it is important to weigh the pros and cons of incorporation. Many new business owners don't understand what it means to incorporate or what benefits it actually provides, which can make the decision to do so difficult.

Incorporating your business provides tremendous advantages over operating a sole proprietorship for both the owners and the business itself. Let's first look at what it means to incorporate a business.

What does incorporation mean?

The term incorporation refers to the act of forming a new corporation. Basically, it is the process of turning a sole proprietorship or general partnership into a business legally recognized by the state.

You have likely heard of a C corporation, a nonprofit, or a professional corporation. The only thing you really need to know about these now is that each is a type of corporation, all providing a specific benefit. Depending on your business, each provides their own possible benefits. Before you decide which entity to choose, you'll first need to decide if forming a business is right for you.

Tip: Try our free entity choice tool. Answer a few simple multiple choice questions about your business, and our tool can recommend the entity type that best fits the needs of your business.

What are the benefits of incorporating a business?

There are 5 major advantages to consider when deciding whether or not forming a corporation is going to be the right choice for your business.

Personal asset protection

No matter which type of business you choose, incorporating designates your business as its own separate legal entity. This allows your business to do many things any person can do, like such as pay taxes or take out a small business loan. A business can also be sued, or file its own lawsuit. This is where the liability protection provided by incorporation becomes really important.

Forming a corporation creates legal separation between the business itself, and the owners/shareholders. This separation shields the personal assets of the shareholders from being used to pay the debts and obligations of the business.

As a practical example, let's imagine what could happen if someone files a lawsuit against your corporation. Without liability protection, you could be held financially responsible if you were to lose your case.

When an unincorporated business is unable to pay its debts, the creditor can attack the assets of the owners directly until that debt is satisfied.

In other words, your house, your car, and any other possessions you own could be exposed, and used to pay off the debts of the business.

However, a corporation provides protection against that scenario by creating legal separation between the owner(s) assets and those of the business. This protection is sometimes referred to as a 'corporate veil'. It is this protection that allows a business to make decisions without the risk of endangering the assets of its owners.

Risk is a necessary part of running a business, so the limited personal liability of an incorporated business in itself has a tremendous value to its owners. However, it is important to understand the limits of this protection.

The owners of a corporation are only fully protected by the business entity when the business is in good standing with the state.

For example, If a business is found engaging in illegal activities or fails to maintain the proper financial separation from its owners, a court can "pierce the corporate veil". This allows the owners of a business to be named as a party in a lawsuit, which nullifies the protections gained by incorporating the business. In other words, it is important that you meet your ongoing maintenance requirements to keep your business in good standing.

Tax Advantages

Depending on the specific details of your business, forming a corporation can provide major tax advantages over operating as a sole proprietorship. In many cases, corporations qualify for additional tax benefits and deductions that aren't available to individual taxpayers.

For example, when filing corporate tax returns, a corporation is able to deduct medical insurance paid to employees, as well as other fringe benefits provided to its employees. This also includes benefits such as retirement plans or tax deferred trusts. Corporations can also deduct real estate investments, employee salaries, bonuses, and more.

A corporation can also reinvest some of its income back into the business. This reinvested income comes directly out of net profits, essentially reducing the overall tax liability at the end of the year.

Obviously, the more tax deductions your corporation is qualified to claim, the lower it's taxable profit will be at the end of the year. This allows a greater amount of yearly earned income to be reinvested into the growth of the business.

Reduced Chance of Audit

Sole proprietors tend to be more likely to file incorrect returns (many are self-prepared), and tend to under report revenue or over report deductions. For these reasons, the IRS has audited a much higher percentage of sole proprietor tax filings than corporate filings in recent years. In tax year 2006, a Schedule C filer stood a 1 in 32 chance of being audited. For non-business filers, the odds were around 1 in 124. This means that sole proprietors are significantly more likely to be audited than corporations.

Added Credibility

Often times, a corporation will elect or may be forced to elect to use what is called a business indicator in the name of the business during formation. Adding INC. to your business name for example can really help prove your credibility to potential vendors and customers. It demonstrates that your business is operating as a legal entity, registered and approved by the state, which plans to operate under the legal limits of the law.

Depending on the industry in which your business operates, a formal business structure may be a prerequisite to win valuable contracts, and could be the difference between success or business failure.

In most states, it is a requirement that a business name be unique and not easily confused with another business name. This can provide an advantage as you build your brand, as forming your business provides local level protection of your brand / business name automatically.

Basically, this means that another business cannot attempt to register a name in your state which conflicts with your own, and in many cases for small local businesses, this is all the protection you will ever need. However, if you plan on operating your business on a larger scope, you may wish to trademark your business name.

Structure For Investment

With the ability to sell shares of stock, a corporation is an attractive option for owners who will seek outside investment. In fact, the structure of the corporation itself is designed to make distributing ownership simple.

Many investors maintain investment portfolios with dozens of companies. The well understood workings of a corporation makes their investment simple and more efficient. Plus from the perspective of investor, a c corporation is a tax wise investment.

Tip: If you are ready to form an LLC or start a corporation, we can help. Let us take the guesswork out of starting your business. Just answer a few simple questions, and our filing experts will handle the rest.

Does Incorporation offer any protections for the business?

Yes, in fact the concept illustrated above also works in reverse to protect the business, as well as protecting the business' owners from each other.

Let's now imagine a scenario where a partner or partial owner of your business files for personal bankruptcy. That could directly impact the business by opening up its assets to any creditors seeking to collect what they are owed from the owner.

By incorporating your business, you are separating the finances of the shareholders/owners and its employees as well. That means that the business would continue without disruption, it's finances would not be at risk.

This clear protection and separation is another one of the many benefits of choosing to form a corporation.

How does incorporation affect the ownership of a business?

As much as we believe that all the owners of a business will remain committed to the success of a business, that is not always the case. Regardless of the reasons for leaving a business, incorporation allows ownership to be more easily transferred among its owners.

If a partner decides to leave a partnership against the will of the other owners for instance, the business will be automatically dissolved. Incorporation removes this limitation by allowing the owners to transfer his/her interest without unanimous consent.

Who owns a corporation?

The ownership of a corporation is significantly different than the ownership of other entities. Partnerships or limited liability companies are owned by several individuals, who's ownership is often outlined during the formation process. A corporation on the other hand represents its ownership with shares, and often changes over time. Shares are units of ownership interest in a corporation, and an individual who owns those shares is called a shareholder.

A corporation may be owned by a single shareholder, or by thousands. Shareholders own a portion of a corporation represented by their ownership in shares, which is a percentage of the total shares issued by a business. An easily digestible example to illustrate this concept could be demonstrated by a hypothetical business that issues a total of 3 shares. The shareholder who owns two of those three shares would own two thirds of the business accordingly.

In terms of the rights of shareholders and their level of ownership, it can be broken down into the following:

  • A shareholder can receive a portion of the corporations revenue relative to their percentage of ownership.
  • A shareholder can vote on who will be members on the board of directors, the governing body of a corporation.
  • A shareholder has the right to access the records of the corporations operations.
  • A shareholder can sell their stock as they see fit.
  • A shareholder can receive dividends, which is the corporations way of distributing revenue back to its investors.

As a corporation sells its shares, they are commonly traded or sold, and that transfer of stocks is a transfer of ownership of the corporation. Even though the ability to freely transfer shares is a default rule, by no means is it mandatory. Small businesses may see the restrictions against transferring shares as a good thing, and may want to control how a shareholder can transfer his/her interest.

Incorporation allows this flexibility. Corporations have the option to place restrictions on the transfer of shares If it is seen as a detriment to a business. Incorporation lets the business decide whether or not to take advantage of this option. More importantly, unlike a partnership or llc, incorporation prevents the ability of a minority shareholder from dissolving a business without cause.

What is "double taxation"?

We already discussed the tax advantages of forming a corporation. But it is important to point out one of the most commonly misunderstood tax caveats associated with a corporation, double taxation.

A corporation's total income will ultimately be taxed at two different points. First, the income of the business is taxed as expected. Secondly, the dividends distributed to shareholders are again taxed as individual income. While this can be problematic for some businesses, the tax benefits of the corporation often outweigh the negatives.

If double taxation isn't a good fit for your business, there are ways to get around it. Corporations offer another choice in regards to how they choose to be taxed. By filing as an S Corporation for example, all business income will pass-through directly to the business owners, where the corporation itself does not pay any corporate tax at all.

This can provide major benefits depending on the individual variables of your business. This added flexibility can be a huge benefit for business owners both starting out and down the road. You can choose to elect a tax status at anytime during the business' existence as it grows and changes over time.

When in doubt, it's always valuable to seek the advice of a CPA or tax advisor to determine the benefits of your unique situation. You may pay upfront for the consultation, but could save thousands over time.