The Road to Incorporation

I'm starting a business with my son. Where can I find information on incorporating?

We can provide you with some basic information, but consider this the beginning of your journey. Whether or not you should incorporate — and which incorporation method you should use — depends on the type of business you want to start, the company's long-term goals, the number of owners and the assets involved. We'll discuss broad generalities only. Needless to say, you should find a good attorney before making a final decision.

The first thing a business owner must decide is whether to incorporate at all. Many small start-ups (such as side businesses) are simply sole proprietorships or general partnerships, which are not incorporated. A sole proprietorship is owned and operated by just one individual, while a partnership can have two or more owners. The founding process for both is simple and fast, but both business types share a major drawback — the lack of liability protection. If the company goes bankrupt or is sued, the owners are personally liable for all costs and charges.

For this reason, attorneys generally dislike partnerships and sole proprietorships. "I can't see a reason why you want to do it — unless it's a tiny business you're running part time out of your house that can't hurt anybody," says Jerry Goldman, a tax attorney with Philadelphia law firm Jerry S. Goldman & Associates. On the other hand, corporations (that is, C-corporations, S-corporations and limited liability companies, or LLCs) provide liability protection. Each model comes with pros and cons. Here's a quick tutorial.

The C-Corporation
To establish a C-corporation, owners file an article of incorporation in their home state. Once approved, the corporation becomes a separate legal entity owned by an unlimited number of shareholders.

The C-corporation isn't a universal solution. It's a good choice for those planning to take their company public, but it isn't the best choice for, say, a small mom-and-pop restaurant, says Dennis Cohen, a tax attorney with Cozen O'Conner in Philadelphia.

Why? First, there's the paperwork involved and all the corporate formalities that go with it. To retain the benefits of limited liability, a corporation (whether it's a C-corporation or an S-corporation, discussed below) has to appoint a board of directors and corporate officers, hold annual meetings, keep corporate minutes, issue shares and deal with a slew of red tape that might be a little too burdensome for a small family business.

Then, there's the issue of double taxation. In this case, any dividends paid out (if the business is successful enough to generate dividends) are taxed at the corporate level as well as the shareholder level, which in this case can often be the same folks. Take this example: At Mom and Pop's Diner, Aunt Helen's cookie recipe is popular and business is booming. The board of directors (Mom and Pop) decides to share the profits with the rest of the shareholders (Aunt Helen, Uncle Pete and a few other relatives) and start distributing dividends. First, the company pays corporate income tax on the profits. Then the shareholders pay personal income tax on the dividends they receive. And if someone were to buy the restaurant, the tax bill the shareholders would receive for the profit would be flat-out nasty.

That said, owners planning an IPO or seeking venture-capital financing are better off choosing C-corporation status, Cohen says. In fact, a venture-capital fund might demand it. That's because unlike regular folks, corporations (in this case, the venture-capital firm) can get handsome breaks on dividend taxes. (For more, read IRS publication 542).

Mom and Pop's Diner would be better off with a Subchapter S-corporation than a regular C-corporation. Why? S-corporations have almost all of the advantages of C-corporations, minus the problem of double-taxation. Plus, their structure is simpler.

So what's an S-corporation? It's a corporation that's taxed like a partnership or a sole proprietorship, which means the company's gains or losses appear on each shareholder's individual tax return. To qualify for this, the company must file Form 2553 with the IRS by March 15 of the current year.

Needless to say, if the owners of a company expect to incur start-up losses, they should file for S-corporation status and take advantage of the tax deductions. S-corporations can also do tax-free mergers or stock exchanges — good to know for small-business owners hoping to sell to a larger corporation eventually.

But the tax benefits of S-corporations come at the price of structural flexibility. S-corporations cannot have more than 75 shareholders, or any shareholders who are resident aliens. They are permitted to issue only one class of stock. And the IRS can terminate a company's S-corporation status if its income from passive investments is more than 25% of its total income for more than three years in a row. (This makes it an unattractive option for real-estate businesses).

Moreover, that preferred tax status can become a drawback for company owners who plan to reinvest most of their profit. Don't forget that the owners pay income tax on all of the company's profits, so even if they take out minuscule salaries, in a good year their income tax bill will likely be outrageous.

The LLC offers some of the best attributes found in S- and C-corporations. Tax attorney Goldman strongly recommends this designation for small family businesses. "If two people come into my office right now and say they want to set up a business, the first thing that comes into my head is an LLC, and then I have to think of a reason why not," he says.

The owners of an LLC enjoy limited liability protection and the preferred tax treatment of S-corporations. Unlike S-corporations, LLCs may issue several classes of stock with different priorities of ownership, without the formalities that have to be observed by C-corporations. There also are no limits to the number and nature of the shareholders of an LLC. LLC shareholders can be individuals, corporations, partnerships and even nonresident aliens. Tax-wise, LLCs with only one member are automatically treated as a sole proprietorship, and those with two members are considered partnerships (which means a heftier tax bill for the owners in some states), unless they elect to be treated as a corporation with IRS Form 1120.

So what's not to like about an LLC? It's a relatively young form. "They've been around for only 10 to 15 years, and people are worried they don't provide the same limited liability that the corporation does, because there've been no court cases about it," Cohen says. But Cohen believes the benefits of LLCs far outweigh the legal uncertainty.

For more on starting a business, we recommend MyCorporation Business Services, which provides a wealth of resources, including online incorporation packages for small and midsized businesses. The U.S. Chamber of Commerce has a section on forming a corporation, and the Small Business Administration has a tool kit on getting started as well.