April 24, 2018
As an entrepreneur, you probably have a general understanding that it is important to incorporate your business. But that bit of received wisdom hides layers of more complicated considerations. In this article, we walk you through why incorporation can be essential for your business, and the options that are available to you.
The information below is not offered or intended as legal advice, but rather as an overview to get you started in thinking through the issues. As you'll see, depending on your goals and business needs, it may be necessary for you to retain a lawyer to help you out.
What is a "Corporate Form"?
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Let's start with the basics. When we speak about "incorporating", we mean the process of holding and operating your business in a "corporate form". Generally speaking, a "corporate form" is any entity in which there is a legally-defined separation between the business's liabilities and the personal liabilities of its owners and investors.
In the absence of a corporate form, a business owned by a single person is a "sole proprietorship", and a business owned by two or more people is a "general partnership". In sole proprietorships and general partnerships, the owners are personally liable for the business's debts. By law, these entities spring into existence when you begin operating a business for profit. Nothing else is needed (although it is common for partnerships, especially, to be governed by an agreement among the partners).
The Purpose of Incorporation
Fundamentally, the purpose of incorporating a business is to make it easier to raise capital by limiting investors' liability for business debts to the size of their investment. After all, investors are more likely to put money behind a project when do not need to worry that business debts could cause them to lose their house and their life savings.
Over time, laws have evolved to create significant other benefits to holding and operating a business in a corporate form. According to the Internal Revenue Service1, one benefit currently available under United States law is that the income business owners receive as distributions from certain corporate forms is taxed at a lower rate than "ordinary" income from a sole proprietorship or general partnership.
In addition, state laws authorizing corporate forms supply detailed rules for, among other things, how corporate forms can be operated, when they can be held liable for certain obligations, and what information must be disclosed about their owners and operations. These rules have the benefit of making the operation and management of a corporate form predictable and relatively transparent for owners, investors, and anyone who does business with them, which in turn fosters efficiency, stability, and long-term growth. As a result, corporate forms have become an essential tool for creating and protecting personal wealth in the United States.
So, if raising capital, protecting your personal assets, taking advantage of favorable tax rates, and fostering stability, growth, and personal wealth are important to your business plans, incorporation is likely a good step to take.
Common Corporate Forms
Though all corporate forms share the basic characteristics above, they can vary widely in their specific features. According to the Small Business Administration2, three common corporate forms in the United States are corporations, limited partnerships, and limited liability companies. Here is an overview of each.
- A corporation (also sometimes called a "stock corporation") is a legal entity governed by a board of directors in which ownership is evidenced by "shares" issued by the corporation. State law supplies highly detailed and often rigid rules for the operation, management, and disposition of shares of corporations. The most fundamental of these are the fiduciary duties of care and loyalty that managers and directors of a corporation owe to its shareholders and the unfettered transferability of corporate shares. It is sometimes useful to think of a corporation as the most inflexible corporate form, but also the most protective of investors in terms of limiting their liability. You can tell a business is a corporation by its name, which always contains the words "corporation" or "incorporated", or the abbreviation "Inc." or "Corp.".
- A limited partnership is a legal entity comprising two or more partners, at least one of whom is a "general partner" who is personally liable for the business's debts, and the rest of whom can be "limited partners" whose liability is limited to their investment. In a limited partnership, the terms of the relationship between general and limited partners are set forth in a "limited partnership agreement" covering everything from management to operation to distributions to the disposition of partnership interests. Partners in a limited partnership can agree to limit their fiduciary obligations to each other, create mandatory contribution obligations, and limit each other's right to sell or transfer their interests. It is sometimes useful to think of a limited partnership as the most flexible corporate form, but also the least protective of the personal assets of at least one "general" partner. You can tell a business is a limited partnership by its name, which always contains the words "limited" or "limited partnership", or the abbreviation "L.P.".
- A limited liability company (or "limited liability corporation") is something of a hybrid between a corporation and a limited partnership. On one hand, its owners (usually called "members") enjoy absolute limitation of liability similar to shareholders in a corporation. On the other hand, its operation and governance are the subjects of an agreement (called a "company agreement" or "operating agreement") that can be as flexible as the agreement in a limited partnership. This "best of both worlds" approach has made limited liability companies very popular. You can tell a business is a limited liability company by its name, which will always include "limited liability company" or the abbreviation "LLC".
Be aware that the same corporate form can have different characteristics depending on the state in which it is formed and under whose laws it is governed. The technical differences between corporate forms state-by-state are beyond the scope of this article but can have important implications for your business. Before choosing a corporate form and the state in which to incorporate it, it may be useful for you to consult with an experienced business attorney to understand those implications.
Considerations and Pitfalls
When choosing the appropriate corporate form for your business, it's important to evaluate which characteristics suit your goals. The certainty and predictability of laws governing corporations, and the unfettered transferability of shares, can make corporations very useful for raising capital but also expensive and cumbersome to operate. The personal liability component of limited partnerships makes them popular when investors and lenders want to ensure that managers, in particular, keep "skin in the game" as general partners, such as in the real estate development industry. And, the flexibility of LLCs can make them well-suited to operating a smaller, more nimble enterprise, but the terms of their operating agreements must be carefully thought out so as not to scare off investors. Finally, state laws sometimes require that some businesses, like insurance companies and banks, can only be held in specific kinds of corporate forms.
Conclusions
There are significant benefits to incorporating your business, namely capital raising, liability protection, and certainty. In selecting an appropriate corporate form, is important to understand which corporate features you need to achieve your business goals.
At Lorman Education Services, we provide training to help entrepreneurs navigate all manner of business decisions. To learn more, contact us today.
1 "Business Structures" (https://www.irs.gov/businesses/small-businesses-self-employed/business-structures)
2 "Choose a Business Structure" (https://www.sba.gov/business-guide/launch-your-business/choose-business-structure)