Incorporation is the term used to explain how a corporation is brought into existence. Unlike a sole proprietorship or even a partnership, a corporation is a business entity that exists outside its owners and deemed is its own separate and distinct entity. This means that the people who own the business—the shareholders—have limited personal liability.
There are many decisions that must be made and steps that must be taken prior to incorporation of a new business. This article will explain the incorporation process and what steps need to be taken prior to complete incorporation. While is more than one corporate structure to be considered when incorporating a business, which we discuss below, all corporate structures generally must engage in the same steps discuss to be incorporated. However, it is important to keep in mind that state laws predominantly regulate the incorporation process, so in this respect, incorporation regulations will vary some between states. Let’s start with the basics:
While most businesses will be incorporated in the state in which the owners/operators live and where the business will conduct their business dealings, this is not always the case. Many times, businesses are incorporated in where their owners live, but not where the business is operated; where the business is operated, but not where the owners live, etc. However, generally, it is reasonable to incorporate where the business is operated.
Many businesses strategically incorporate in states such as Delaware, where they are likely to have more advantages—particularly, tax advantages. Corporations that are registered in Delaware, but do not do business within Delaware’s borders, do not pay corporate income taxes. In addition, Delaware does not impose sales taxes, investment taxes, inheritance taxes, or personal property taxes on corporation. However, Delaware is an exception when it comes to states not imposing corporate income taxes and other taxes on businesses incorporated under the state’s laws even when they are not engaging in business activities within the state’s borders. Generally, incorporation under the state’s laws alone is enough to impose corporate income tax against a business.
The initial step in creating a business in incorporating a business is deciding on a business name. You cannot pick a name that is already in use, so it is necessary to do some research and determine which names are already in use within the state you’ll be incorporating the business in. Every state will have their own requirements and regulations that a business must adhere to in selecting a name. For example, some states prohibit some terminology used in business names. It is also important to make sure your business has the correct ending, such as Inc., Corp., or LLC. The name chosen should be descriptive and speak to what the business is being created to do, so that investors, customers, and others can recognize the corporation.
A registered agent is the “contact person” representing the corporation. The registered agent is the person who will receive notices, legal documents, and will be served with process in a representative capacity when the corporation is sued. Each state requires every business, even unincorporated business entities, to designate a registered agent as to prevent any claim by a business that they didn’t receive certain documentation, particularly important legal documental. Generally, this must be done prior to the business conducting any business activity within the state.
There are multiple ways to incorporate a business, and each way has advantages and disadvantages. Generally, corporations are established as: (1) a limited liability company (“LLC”); (2) an S-Corporation (“S-Corp”); and (3) a C-Corporation (“C-Corp”). Each structure has its own unique advantages and disadvantages and will vary in how they are owned, how they are taxed, and how their shares work.
Limited Liability Companies (LLCs)
An LLC is a business entity created under state statutes, and depending on certain elections made by the LLC, can either be treated as a partnership, a corporation, or as a disregarded entity (meaning the LLC’s taxes are paid via the owner’s personal income tax, such as with a sole proprietorship). Interestingly, some LLCs are inherently categorized as LLCs based on certain characteristics, such as Joint Stock Associations, business entities whose banking deposits and/or activities are ensured by the FDIC, a business entity owned by a political organization, acting as an actual insurance company, and many more inherent ways the business operates.
S-Corporations vs. C-Corporations
S-Corps and C-Corps vary in key ways: (1) how they are managed; and (2) how they are taxed. C-Corporations are usually larger, publicly traded businesses. Although shareholders own a corporation, as discussed below, C-Corps are usually governed by directors who manage the day-to-day operations.
On the other hand, an S-Corp structure is generally utilized by smaller businesses, as S-Corp can have as little as one shareholder and no more than 100 shareholders and is generally operated by its owners rather than designated directors. Regarding taxation, C-Corps are double taxed: once at the corporate level and again at the shareholder level. An S-Corp, on the other hand, has more options. An S-Corp can choose to be taxed regularly, or, in the alternative, they can choose to pay their business’ taxes through the shareholder’s personal income tax. This is known as pass-through taxation.
A corporation cannot be incorporated without stock being issued. Corporations must issue stock to raise money to start and operate their business. For “stock” to be issued, there must be shareholders. Shareholders own the corporation and can be an individual, institution, or even a company. Who the shareholders are will largely depend on the corporate structure chosen. Being a shareholder and owning stock in a corporation endows upon the shareholder with certain rights and responsibilities, including the right to vote at shareholders meetings on directors, the right to receive dividends, and to sell shares to other shareholders or potential shareholders.
It is important to keep in mind that C-Corps are generally much larger, publicly traded companies and can have unlimited stock issued. Whether or not a corporation has to register their stock with the Securities and Exchange Commission (“SEC”) depends on how many shareholders there are. In addition, stock is broken down into "types", which will not discuss here, unlike an S-Corp.
Unlike C-Corp Stock, S-Corp issuing stock has many more conditions. To issue shares and be a shareholder in a S-Corp entity, the shareholder must be a U.S. Citizen, the shareholder must be individuals or be an estate, such as a domestic trust or tax-exempt organization, and other similar regulations. Strict regulations have been imposed by the Federal government regarding shares issued in S-Corp’s because the S-Corp was designed to be used by small businesses, and the Federal government has discovered potential abuse by businesses more appropriately deemed as C-Corps. Accordingly, when an S-Corp issues shares to individuals or entities not within the required guidelines, the S-Corp could be altogether revoked and lose its advantageous tax status and risk additional consequences and penalties.
Authorized Stock vs. Issued Stock
When incorporating a business, it is important to understand the relationship between authorized shares and issued shares, because the Articles submitted to the state, which will bring a corporation into being will necessarily need to contain all the relevant parameters and data regarding the business, including stock to be issued. Whenever a corporation wants to increase its authorized stock, it must amend its incorporation Articles. For this reason, a corporation may be well-advised to have more authorized stock than it needs at the time it is incorporated to allow growth and investment opportunities.
Issued Stock v. Outstanding Stock
Based on the paragraph above, issued stock are the maximum shares available as outlined in the corporation’s incorporating documents submitted to the state. On the other hand, outstanding stock is the stock already belonging to the shareholder(s). In essence, the outstanding stock is simply the stock issued, minus the stock presently owned by the corporation, which is known as "treasury stock." Unlike outstanding stock, which gives the shareholders the right to vote, treasury stock does not endow the corporation additional voting rights.
A Note on Promoters
In business and/or corporate law, a promoter is the person who does the groundwork to create a new business or venture. A corporation cannot be incorporated on its own—it requires a person or entity doing the preliminary work necessary to incorporate the business, including raising capital to get the business started, entering pre-incorporation contracts, and soliciting investors. Despite the pre-incorporation phase being crucial to the potential return on the corporation and its overall existence, promoters have wide latitude to make choices and decisions to get the corporation moving.
Although "promoter" is a generalized label, and generally endows a promoter with authority to handle various tasks necessary to get a business incorporated, there are also "stock promoters" which are particularly tasked with raising capital through various marketing strategies to get a business going. A business looking to incorporate will likely need to hire a promoter, who may be paid in shares in proportion to the capital the promoter is able to raise.
The corporation’s Articles, or “charter” is a document or document(s) that must be submitted and approved by the State in the state in which the business is incorporated in. The Articles are the documents that bring a corporation into being. Without the Articles, the corporation does not exist. The incorporator will need to review their state's laws regarding the incorporation process and what items need to be included in the Article. However, an incorporator in any state can expect to see items consistent with the steps explained above, such as:
As you can see, the incorporation process is not something to rush and will take some consideration and planning prior to the initial steps in the incorporation process being taken. While these are the basic steps a business can generally expect to comply with when planning to incorporate their business, the incorporator should consult the state's regulations in the state in which they plan to incorporate to get a more complete understanding regarding their state's incorporation documents.
In addition, it would be well-advised to consult with an attorney that can assist the incorporator with the incorporation process, and the requisite steps, to ensure everything is done correctly and to give the corporation its best chance at early and continued success. Attorneys experienced in business and/or corporate law can provide sound advice on not only how to handle the incorporation process correctly, but how to make strategic decisions that will be advantageous to the corporation and its shareholders.