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The Basics of Small Business Incorporation

Starting a new business is exciting, but there's much to consider. One big decision is choosing a business structure for your business. This can be a sole proprietorship, a limited liability company, or one of several types of corporations. This choice will impact how you pay business tax and how much liability protection you have. It also determines how you report to the federal government and the Internal Revenue Service (IRS).

As many small business owners know, forming a corporation may provide you with limited personal liability. This means you are personally not responsible for any debts that your business owes. However, incorporating a small business and maintaining it as a corporation is not as easy as it may seem. Along with filing the necessary papers and fees, you will also need to keep very accurate and detailed business records. Read on to learn about the basics of small business incorporation.

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Small Business Incorporation and Limited Personal Liability

When you start a new business, you might first consider becoming a sole proprietor. As a sole proprietor, you and your business are one. If you incorporate, your business becomes its own business entity. At this point, it becomes separate from you. A popular choice is the limited liability company (LLC). This type of business provides liability protection. This means personal assets, like your home or car, are often safe if your business owes money.

Another option is the C corporation (C-corp), which sells shares of stock to raise money. One of the biggest considerations of incorporation includes limited personal liability. Corporations protect the owners' personal assets and property from creditors. It also protects owners from others making claims against the corporation.

For example, suppose a court finds your corporation owes a creditor $20,000. The creditor cannot take that court judgment and charge your personal assets. Personal assets include things like your personal bank account or home. Instead, the creditor must take the claim against the corporation. This is because the corporation is a stand-alone legal entity. Corporate assets pay corporate debts. By choosing small business incorporation, you only stand to lose the money or property you already invested.

Exceptions to Limited Personal Liability

In most situations, limited personal liability laws shield corporation owners. However, there are some situations in which this limited liability will not protect the owners of a corporation. If the board of directors does something illegal or dishonest, they can still face personal consequences. Not keeping business and personal funds separate can also affect your personal tax returns.

An owner of a corporation can be personally liable for corporate debts or obligations if the owner:

  • Personally guarantees (puts up personal assets) a bank loan or business loan that the corporation fails to pay off
  • Does not deposit the taxes that are withheld from employee paychecks
  • Personally and directly causes injury to someone
  • Performs an intentional act that is fraudulent or illegal and that causes the corporation, or someone else, harm
  • Behaves as if the corporation is an extension of his or her personal affairs rather than its own, separate legal entity

The last exception to limited personal liability is sometimes called the "alter ego" theory. This theory categorizes when courts find corporations did not exist on their own. In these situations, the corporation is an extension of the owners and so the owners should be personally liable. Courts look for these factors to see if a corporation is only an extension of the owner/alter ego:

  • The corporation is under-capitalized (under-funded)
  • The corporation never formally issued stock to the initial shareholders
  • The shareholders and directors of the corporation do not hold regular meetings 
  • The owners of the corporation do not keep records showing that their personal transactions are separate and personal transactions and the corporation's transactions commingle

Liability Insurance

Once you have formed your corporation, be sure to invest in corporate liability insurance. This helps cover costs if your business faces a lawsuit. For instance, if someone gets hurt using a product you sell, insurance can help. Sole proprietorships and partnerships, like general partnerships or limited partnerships, especially need this. This is because they do not have the same protections as corporations.

Corporate liability insurance protects the assets of your corporation. For instance, suppose your incorporated small business is a shopping mall. You should invest in liability insurance, which can help you pay off a claim if someone falls while riding down an escalator.

Besides protecting your corporation's assets, liability insurance can also protect your personal assets. It can help if you are personally liable for something. Suppose you are in a car accident while driving a corporate car. In this car accident, you harmed someone. In this instance, you and the corporation can be liable for the damages.

Corporate liability insurance would normally cover this situation. Corporate liability insurance will generally not help if your corporation fails to pay its bills. If a creditor comes after your corporation for an unpaid debt, no amount of liability insurance will cover you in that situation.

Corporate Income Tax

A big thing to think about with a C corp is corporate tax rates. Unlike an LLC or partnership, which has pass-through taxation, a C corp pays its own business taxes. When owners or shareholders receive company profits, they face taxes again on their personal tax returns. This is "double taxation." In contrast, for self-employment income you pay social security and employment taxes directly.

A corporation is its own legal entity. You are not responsible for paying personal income taxes on the profits that the corporation makes. Instead, if you own a corporation, you may take a yearly salary and bonuses from the corporation in exchange for your services. This is your personal income, and you must pay income taxes on it.

The corporation handles paying corporate income tax on any profits left to the corporation. After paying out all salaries, bonuses, and overhead expenses, profits are paid out. The corporation must file a corporate income tax return with the IRS and pay taxes at a special corporate rate.

Some corporations choose classification as an S corporation. The owners divide the corporation's profits, much like a partnership. You and all other owners must pay personal income taxes on your respective shares.

Corporate Formation

Starting a corporation or LLC involves paperwork. You might need a registered agent, someone to receive official notices for your company. You'll file articles of organization for LLCs or articles of incorporation for corporations. These are filed with the secretary of state's office. This form normally requires the name, address, and contact information of your business. In addition, some states require that the names and addresses of all the owners of the corporation be provided as well.

You may also need to pay a filing fee. If you use a business name different from your own, you might need a DBA (Doing Business As) with local governments. An operating agreement or partnership agreement outlines how the business runs and who's in charge.

Additionally, when you file your articles of incorporation, you should also create corporate bylaws. These bylaws are very important for a corporation as they govern the day-to-day running of the corporation. Bylaws normally set out rules that dictate when shareholder meetings will occur, as well as the voting rights of shareholders, directors, and owners. Lastly, when you decide to incorporate your business, you will need to issue stock to all of the initial shareholders (the owners) of the corporation.

Retaining Corporate Status

To keep the corporate status of your business once incorporated, you must be sure to follow certain formalities. More specifically, corporations must:

  • Hold annual meetings for shareholders and the board of directors
  • Record the minutes for major decisions by shareholders and directors
  • Ensure that directors sign any important documents in the name of the corporation
  • Keep the corporate funds separate from private funds
  • Keep detailed records of finances
  • Submit an annual report
  • Get an employer identification number (EIN) from the IRS. The EIN helps to handle business taxes and hire employees
  • File a separate tax return for the corporation

If a corporation does not take these steps, it risks having its corporate status revoked.

Get Professional Legal Help With Incorporation

The world of business can be complicated. There are rules from the federal government, state agencies, and local governments. To make sure you choose the right business structure and follow all the rules, it's wise to get legal advice.

Entrepreneurs should visit the IRS website for some resources but also consider hiring a lawyer. Lawyers can help, especially when starting up your business. They can help you incorporate your business, which can be quite complicated.

Find a business organization attorney near you to get started.

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