This article focuses on incorporation. The first thing that you need to think about when you are starting a business is whether or not you need to incorporate or not.
The answer is often “yes,” but not always. Sometimes you don’t need to incorporate. It might be too expensive, and too much of a hassle.
If your business is a single owner entity, and you obtain sufficient insurance coverage to insure against most risks, and your revenue is modest, then you might be just fine to operate as a sole proprietorship rather than as a corporate entity.
So, what is a sole proprietorship?
A sole proprietorship means a business is operated by an individual person without a corporate entity, but with a “business name,” or as it is often called, a “fictitious” name. You’ve probably heard of a fictitious name, it is also known as a DBA (or “doing business as”). A DBA is simply a way to call your business something “business-ish” but still operate as simply an individual person. For example, my first business was Cricket Lawn Care, a fictitious name for “Dana Robinson.” There was no corporate entity. But, I didn’t want my customers to think of the business as “Dana Robinson” so I filed a fictitious business name to say that I was “Dana Robinson doing business as (DBA) Cricket Lawn Care” to hold myself out as that business name rather than my personal name.
With my business name, I could then open a bank account in the name of the DBA and take checks from customers in the name of the business. However, at bottom, the business was the same as if I had been just “Dana Robinson.” The DBA simply means Dana Robinson = Cricket Lawn Care.
There is a downside to operating as a sole proprietor. A sole proprietor is personally liable for the risks of the business. This includes financial risks, as well as injuries and other liabilities that arise in the course of the business. This is why so many small business owners incorporate, rather than operating as a sole proprietor. Incorporation separates you as the owner from the business, providing a shield against personal liability.
Insurance can also provide a way to protect the owner’s personal assets. For Cricket Lawn Care, I acquired a commercial general liability insurance policy (“CGL”) to cover business risks and to avoid liabilities that may have created risk to us personally. Thus, while I had some personal risks, I used an insurance policy to insure against the biggest risks. A typical sole proprietorship can avoid incorporating, do business under a “business” name, and use insurance to avoid major liabilities. That was the approach I took in my first business, and it is often the most economical path for newer small businesses.
I probably should have incorporated as an LLC or corporation. Had I incorporated, I would have been shielded personally from many of the company’s liabilities. A corporate entity places some additional protection between the conduct of the business and the assets of the owner. But, at the time, the cost of incorporating was substantial, and the annual renewal costs were more than the cost of my insurance. In California, the initial cost of incorporating is about $100, but there is an annual renewal of $25, plus an annual corporate tax of $800. In addition to these costs, a corporation or LLC will have to file its own tax return, costing another $400 or more per year. Even without an attorney involved, the annual maintenance on a corporation is many states ranges from $400-900, not including the cost of your CPA for filing your annual tax return.
This is a substantial cost for a small business that may only make $30,000 per year. In my case, back in 1990, I simply could not afford to incorporate my first business venture. In addition, I did not have any personal assets. At the time, I was so young that I really had no assets, no savings, and no investments. If a major liability occurred that was not covered by my insurance, I had nothing to lose. It was not very smart of me to run my risky business without a corporate entity, but at the time, I really had nothing to protect, and the cost of forming and managing an entity was more than I could afford. In many cases, a small business simply cannot justify operating as a corporate entity because the owner/operator does not make enough profit to pay the incorporation costs and the ongoing annual renewal and tax filing costs.
Many businesses start as a sole proprietorship, but eventually “incorporate.” A “corporation” is a legal entity that exists separate from its owners. As a business grows, the owner tends to realize that she needs to separate herself personally from the risks of the business.
Let me talk about incorporation.
Early corporations were used by merchants who would raise money to find new trade routes, bring spices and products to Europe from Africa and Asia, and to undertake other risky ventures. The business owner and his investors would not take such large risks if they all had personal liability for the liabilities of the business, such as a ship that sinks in a storm.
Prior to the rise of the corporation, business owners were personally liable for the risks of the venture. Many business owners would have been fine with taking the personal risk of their business, as long as they were the ones in control of their business. But, what if the business owner was not in control. What if the business owner was a passive investor? Prior to the creation of corporate law, even a passive investor was personally liable for the risks of the business. This presented a major problem. If you want to encourage economic expansion, you need to incentivize investment in business ventures. If you tell an investor that he is personally liable for the liabilities of the company, he is not very likely to put his money in because he would be taking a double risk: First the risk that he loses his whole investment and second that he loses even more than his investment if he gets sued because the company has unpaid debts, or if someone is injured.
An early corporation might have been headed by an explorer who needed to finance a ship, a crew and all of the supplies to make a trek to India. If every investor was personally liable for every injury to the crew, no one would invest. The investors needed a way to invest money and only risk that, they only risked their investment, which they might lose entirely. But, at least they were not liable beyond their investment. This allowed a promoter to obtain financing from various wealthy individuals.
The first corporations were created by the crown; a king or queen would authorize the charter of a corporation, and then investors could own shares in the corporation. The investors would take a risk of loss, but only to the extent of the money the put in, and not more.
There were, and still are, two key purposes in forming a corporation: 1) joint ownership; 2) limited liability.
In the 17th Century, if you were a single merchant trying to find a better source for rare spices, you would have to make a tremendous investment. The odds of success were slim, but the payoff for success was massive. Only a few people had the wealth to single-handedly undertake the risk of losing that much of their money. Thus, the formation of a corporation allowed a business person to share ownership with other investors. The effect was to share the financial risks as well as the rewards (we call this issue joint ownership).
No investor would invest in a risky venture if they had to assume the risk of losing more than their investment. Yes, the investor puts their entire investment at risk, but if they face the risk of also paying personally for a sunken ship and injured sailors, they would never invest. They would only invest if their entire downside was their investment and no more (we call this limited liability).
Joint ownership and Limited Liability: This system, once it was adopted, proved to be beneficial for the whole society. If a corporation was successful it brought greater access to goods, more competition, and lower prices for goods. The corporation encouraged economic expansion through investment in ventures. Corporations provided a means of connecting passive wealth from one type of person with the expert management and hard work of another type of person.
Now, in thinking of a modern-day corporation, we should always start with these two historic purposes that incorporation addresses: joint ownership and limited liability. Before you incorporate, you should focus on these questions.
We covered the issue of limited liability a little already. Essentially, a corporate entity separates the risks of the business from the owners of the business. If you are a shareholder of IBM stock, you do not have personal liability for the conduct of IBM. The same is true of owning small company stock. If you own all of the stock in your company, you, as a shareholder, do not have personal liability for the company’s debts, obligations or risks. You may still face liability for what you do as an officer or employee of the company. But, as a shareholder, your personal assets are not at risk. For most companies, this is the primary reason for forming a corporation or LLC.
In evaluating the issue of joint ownership, the question is whether you will have more than one owner. Will you have partners? If you will not have active partners, are there any investors? If you will not have investors now, will you need investors down the road? If the answer is no to all of these, then you may not need a corporate entity.
If you are operating your business as a single-owner, or husband and wife, and don’t have shareholders or investors, you can simply be a sole proprietor.
If you are going to have co-owners, partners, shareholders, or investors involved, then you will need to form a corporate entity. You may eventually need an attorney, especially if you plan to sell stock to passive investors. But, in the beginning, you at least know that you are going to need a corporation or LLC.
LLC or Corporation
Now, if you’ve come to the conclusion that you need an entity because you want limited liability and/or you have multiple owners, the next step is to determine if you want to form an LLC or a corporation.
Typically small partnerships and solo businesses are formed as limited liability companies (or “LLC’s”).
Businesses that intend to take investors, or have passive shareholders that aren’t involved in the day-to-day operations are often formed as corporations.
A limited liability company (“LLC”) is a fairly new innovation that provides a business owner the ability to have a “corporate shield” in the nature of a corporation. However, the LLC uses “partnership” operational structure, rather than the formalities that a corporation must observe. The LLC allows an individual to operate the company without the annual meetings and other formalities required of corporations. The LLC also allows the owner to have partners in the business that function as “partners” with shared control. If two partners form a traditional corporation, then they always face the question: who is president? If three partners form a traditional corporation, then two can often “oust” the third from management. The LLC is different in that both or all three (or more) of the “partners” can share control and both be active in the management of the entity.
The LLC has become the preferred entity structure for small businesses. Most new small businesses are advised to form as a limited liability company.
As a result, today the most popular entity type is an LLC, and the vast majority of these business entities are owned and operated by one person. This is so common that the IRS has created a special category of LLC tax status for “single member” LLC’s that is known as a “disregarded entity.” This means that there are so many single-owner LLC’s that the IRS makes it easy: you don’t even have to file a corporate or partnership tax return. You just file the same “schedule C” with your 1040 that a sole proprietor would file.
So, if your business is entirely owned by you, then the LLC is probably right for you. If you are a small operation with two or three owners who are all involved in management, the LLC is probably appropriate as well. If you have a silent partner, a rich uncle, or a small investment backing your venture, then the LLC is still probably the ideal type of entity for you.
To form an LLC, most states have a simple one-page form that you fill out, or submit online. Once you have done that, you then only need one additional document, called the Operating Agreement. This is an agreement that says how the LLC operates. I have included a sample operating agreement for a manager managed LLC in the legal forms bundle. This will help you understand the way that an LLC is managed. Again, the legal forms are not for you to simply sign and use; but for you to read through as a way of learning about how to operate your company. Reading the LLC operating agreement will help you see the inner workings of the LLC.
If you are likely to raise money by selling stock, then a corporation might be a better fit for you, even if you do not have a diverse shareholder base in the beginning.
A corporation is the classic, historical “business organization.” The corporation is an entity that issues stock to its owners, and then hires management to operate the entity on behalf of the shareholder-owners. Because this type of organization evolved from the need for multiple owners that hire a manager to run the business, the corporation is a bit of an awkward fit for a single-owner business. What makes it awkward is that a single-owner corporation has one shareholder who elects one person to the board of directors, and the one-person board of directors hires one person to act as president, secretary and treasurer. The single-owner of a corporation has a lot of titles, and has annual “meetings” with him or herself. It’s fun, of course, and lets you feed your ego. “I’m chairman of the Board …well, and I’m CEO … well, I’m also the corporate treasurer …” In my annual meeting, I can stand up as the shareholder and say, “I vote for ME to be on the Board of Directors.” Then as a board member, I’ll say how great I would be as the president, and then move to vote for myself as president. I can tell myself in that meeting that I will be the best president that this company has ever had. It’s pretty cool. However, these “corporate formalities” are some hassles that come along with being a corporation.
It may seem odd to operate a corporation that has only one shareholder, one board member and one officer, but there are millions of one-owner corporations in the United States. However, these one-owner corporations still need to “act like” corporations. To “act like a corporation” the owner must have bylaws that govern the company’s activities and management. The owner must have annual meetings of the shareholders and vote for who will be on the board of directors. The owner must then have a board meeting and elect the officers. These “annual meetings” are considered the “corporate formalities” that must be observed if the owner is going to be successful at maintaining the shield of liability that the corporation provides. If the owner fails to observe these formalities, then the owner risks having the corporate “veil” set aside, or “pierced,” thereby putting his or her personal assets at risk.
But, many corporations are formed by one person in the beginning because they want to sell stock later. Remember those original corporations? They were created to allow a promoter to put together a risky venture and then bring passive investors. Many start-ups need financing that the first owner doesn’t have. In the case of a start-up that needs funding, we say that such companies will be “fundraising.” This means that the company will ask people to buy stock in the company.
It may sound very interesting to hear that you can form a corporation and then sell stock. While it is true that you can do this, there is a very large body of regulatory law that governs the sale of stock. If you plan to sell stock, then you will definitely need an attorney before you start. But, you don’t necessarily need an attorney to form your corporation. You can form the corporation now, with just yourself as the shareholder, and then hire a securities attorney later to help you comply with the law when you sell stock.
Forming a Corporation or LLC
A corporation is formed by filing Articles of Incorporation with the secretary of state for the particular state that you want to use to form your entity. This can be done online in many states for $100 or less. Most states also have pre-filled forms that are very easy to complete.
Once the Articles of Incorporation are filed, then the corporation has a “meeting” of its incorporator(s) and appoints directors, who then issue shares and adopt bylaws, and then the shareholders have a “meeting” to ratify the organization, bylaws, Articles and appoint directors to serve for the ensuing year. This process is known as “incorporation.” The initial meetings are often referred to as the “initial minutes” of the company. The “minutes” themselves are normally NOT really the actual minutes of any actual meeting; they are “forms” that are followed in order to observe corporate formalities. These forms are part of your Start-up Kit, including sample bylaws.
In corporate law, “formalities” are important. The theory is that the corporation is a “separate” entity with its own existence. Therefore, it needs to act as if it is separate, and act like a corporation. Even if you are the sole shareholder, sole director, and sole officer, the company needs to act like a company. At a minimum this means having initial minutes, and holding an annual meeting of shareholders and of directors. You must also keep the corporate finances separate from your own. Open a checking account for the company and run all financial transactions through that account and do not intermingle with your personal finances.
Forming an LLC is accomplished by filing a simple Articles of Organization with the Secretary of State. As with corporations, most states have pre-formatted articles of organization that are easy to complete and submit either online or by mail.
After the Articles are returned to you from the Secretary of State with an approval stamp, the members of the LLC must agree upon how the company will be managed in what is known as an “Operating Agreement.” A sample operating agreement is included in the legal forms bundle.
Can I file my own Corporation or LLC?
Yes! There are several ways to file your own corporation or LLC. In some states, like California, you cannot “file online” with the Secretary of State. In other states, such as Nevada and Colorado, you can file online. There are many private companies that will allow you to file your information with them “online” and they, in turn, file the necessary paperwork for you with the Secretary of State. But, with the help of the Start-up Kit, you should be able to do this on your own.
The Articles of Incorporation or articles or organization are the easiest part of forming an entity. The Articles are somewhat simple in many states because the states have tried to streamline the form that you fill out to submit to the state as the Articles of Incorporation. Many states actually provide a form online in PDF format that can be used to file Articles on a single page with only a few blanks to fill in. I have provided links to the forms in the New Business Quick Start Guide that is part of the Start-up Kit. To begin the incorporation process, you simply fill in the blanks on most state forms, and mail it to the secretary of state with the appropriate fee. In many states, the process can take well in excess of a month. Thus, if you need to get going in less than a month, you will need to request expedited service, and pay the expedite fee, which is often more than the original filing fee.
The secretary of state processes the Articles of Incorporation by checking the form to ensure that it complies with the standard requirements. They also check the name of the corporation to ensure it is not already being used by another corporation that has been filed in that state. To avoid causing delay, it is wise to check a state’s database online to ensure that you have not selected a name that’s identical to the name of a prior registered company.
Many states allow “name reservations.” This allows you to pay a small fee to “reserve” the name prior to making your final filing. As an attorney, I have never reserved a name when forming an entity for a client. The likelihood of conflict is rare, especially if you check the state’s database of prior company names first.
Once you file for a business entity, what’s next?
Once you have received your Articles of Organization (LLC) or Articles of Incorporation (Corporation) back from the State with a stamp from the Secretary of State you are almost done! But, you need to take a few additional steps before you can head to the bank to open a business checking account.
Bylaws/Minutes (Corporation only)
If you have formed a Corporation, you will need Bylaws. Bylaws are often considered “forms” (meaning just a pre-formatted document that is the same for every company) but bylaws can be, and often are, customized to the particular needs of the corporation. Bylaws are the governing document for your corporation. The bylaws cover how your company will actually be governed. How can shares be sold? Who is in charge, and what are their powers? How is the company dissolved? When are meetings? How are matters voted on? These and many other questions should be answered in the bylaws. Most critical issues are addressed in “form” bylaws that can be found on Web sites that sell or give away legal forms. Of course, we include a template for you to use as a starting point for your Bylaws as part of the Start-up Kit.
Annually, a corporation must produce (but not file with any government entity) minutes of its meeting of shareholders, and minutes of its meeting of the board of directors. These are often minimal, but if not observed, can lead to a “piercing of the corporate veil.”
Also, annually most states require a statement of some kind. In California it is called the Statement of Information, filed each year with a fee of $20. In Nevada, it is called the Annual List of Officers and Directors, and requires a fee of $125. In Arizona, there is no annual renewal for LLC’s, but there is for corporations.
Note that almost all entities will receive “junk mail” from companies that are not government agencies, but look very formal. These companies try to get business owners to unwittingly pay them to file the annual renewal for the particular state. The typical non-governmental company that uses junk mail to solicit annual “corporate compliance” often charge between $150 and $300. You don’t need to pay these companies or pay these high fees.
Operating Agreement (LLC only)
If you’ve formed an LLC, the LLC isn’t quite “done” when you get your file stamped Articles of Organization back from the Secretary of State. To complete the process of forming your LLC, you must create an Operating Agreement that is signed by all members of the organization. The Operating Agreement is similar to bylaws of a corporation, except that bylaws are only for corporations. The Operating Agreement is the governing document for LLC’s. While we include a form Operating Agreement as a starting point for you, there is no set way in which an LLC operating agreement should be drafted. Thus, if you need anything unique about the company, you must address it in your Operating Agreement.
Tax filings with IRS
There are several required filings with the IRS. The federal tax identification (also known as the “Tax ID” or “Federal Tax ID” or “TIN”) will be required in order to open a bank account and file taxes.
How do I get a “Tax ID” number?
A vital document that you will need in order to complete your “incorporation” (or LLC formation) and have legal existence is a federal tax identification number. A bank will not open a corporate account until the tax identification is filed and a tax ID number has been issued. This can be done online in a matter of minutes at the IRS website online application. The website is listed in the New Business Quick Start Guide or can be found by googling “tax ID”. Once complete, the company has its very own tax identification number (the equivalent to its own “social security” number) and can open bank accounts and transact business in its own name, and even build credit in its own name under its own tax ID number.
The IRS and the “S” Election (“S” vs. “C” Corporations)
There is a lot of confusion about the difference between C and S corporations. Let me set the record straight: a corporation is a corporation … period! There is no “structural” difference between a “C” and an “S” corporation. You don’t “form a C corporation” or “form an S corporation.” The “C” and “S” designations are tax identifications. The corporation is filed only ONE way with the secretary of state. The choice of “how to be taxed” is a choice that you can make after the corporation is formed. The choice of “S” or “C” status is made when first when you file your application for a tax ID, not when you incorporate. So, first you file articles of incorporation, and then you file a tax ID application, where you choose S or C tax status, and third, you file an IRS form called the Form 2553 to finalize the status as an S corporation. For a C status, there is nothing else to do after filing the tax ID application.
The “election” to be treated under Subchapter S of the IRC (Internal Revenue Code) is only permitted for an entity with fewer than 100 shareholders that are all natural persons (no corporate shareholders, trusts, or foreign nationals without legal residency) and US citizens or residents. The election gives the corporation “partnership” tax treatment, allowing it to pass all profits and losses directly to the members without paying “corporate” income tax. The C Corporation pays taxes on its profits and then the shareholder pays taxes again when the corporation passes its profits to the shareholder (this is commonly referred to as “double taxation”). As such, most small businesses elect S treatment. If you want S treatment don’t forget to file the Form 2553, included in your legal forms bundle.
Most states have some sort of tax regime for corporations and LLC’s. Some states only require a business license, such as Nevada. Other states, notably California, charge $800 per year as a minimum tax on any entity in the state. Most state tax authorities send you appropriate information after you have filed your incorporation papers. Typical taxes, licenses and filings include the following: state tax; sales tax; use tax; business license; and registration for regulated specialties requiring licenses (attorney, doctor, barber, etc.). As mentioned previously, most states require an annual renewal filing for the corporate entity and a fee ranging from $20 to $200 in order to maintain the “active” status of the entity. Failure to file this and pay the fee normally creates a large penalty that must be paid for late filing.
Each city has the right to require that businesses register for a “business license” or permit for doing business within the city’s boundaries. Thus most cities issue business licenses to businesses in its borders. The business license is simply a way for cities to collect a small tax from local businesses.
San Diego, as an example, charges $34 for businesses with fewer than 12 employees and $125 for larger ones. Whatever the city you are in, you need to fill out that city’s “business license” form (normally a simple form) and pay the requisite fee. The “license” is simply the right to operate in the city, and does not grant any special “licensing” for what you are doing. If your field requires some form of special licensing (hair salon, accounting, etc) then you must comply with additional licensing by the state before you enter business. Such special licensing is beyond the scope of this booklet.
So, you’ve started a business … and it is my hope that you will have success in your new venture. It is a wonderful thing to operate a small business. It is also a big responsibility. The first time you start a business, you will feel overwhelmed with all of the requirements.
Let me encourage you with this: take the time to comply with all of these formalities now, even though you feel too busy and too overwhelmed to bother. Do it now and try to start on the right foot. You can conquer these tedious things, and then move on into your business venture without feeling that you have unfinished tasks. Take just one full day without interruption, and complete the forms, create files, and take care of your corporate compliance. Do this at the beginning of your incorporation, and then do it once each year, every year.
I have attempted to address the essential issues that confront every new business and make them a bit simpler. The reality is that all of the requirements of businesses in any state are manageable. You can do them without a lawyer or an accountant if you take a little extra time to read the forms. This Start-up Kit is intended to give you an easy launch pad, and set you in the right direction, by providing you with the “starting point” as well as forms, links and resources.
I’m big on small businesses. I wish I had the Start-up Kit when I first started by business. I hope that this gives you a “leg up” as you get out there and stake your claim. My greatest wish for new entrepreneurs is that they find the strength to pursue their vision until they see it through. Remember that you can do whatever you set your mind to do.