Many new online business owners aren't sure if they should incorporate, what their business structure options are, what incorporation might mean for the business, or even what they need to do to form a company.
This guide is a 'company formation 101' and will explain the benefits and disadvantages of incorporating when you're starting a business, lay out the various options you have to officially form a business in the United States, and give you a few easy first steps.
What is business incorporation?
Incorporation describes the process of creating a new business structure where that business becomes a recognized entity or person under the law. Once created, this new legal entity can be treated separately from its founders or shareholders, potentially reducing liability for its shareholders and gaining other benefits that could help the business grow and thrive long term.
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In the United States, corporations must pay a fee between $25 and $1,000 depending on which state, and choose an operating name. A 'corporate name' must have a legal ending, like “Inc.,” “Corp.,” or "Ltd." which stand for “incorporated,” “corporation,” and "limited" respectively. The process of registering your company as one of the business structures that we're going to outline below is different in each state.
Benefits of incorporation
There are plenty of benefits to incorporating your business. Here are the most important you should be aware of:
- Protection of personal assets
- Transferable ownership
- Pay fewer taxes
- Increased durability
- Separate credit rating regardless of an owners personal score
- Easier to create retirement plans
Each of the 6 primary business structures come with different benefits, and we'll outline them in more detail after going over a few of the disadvantages of incorporation.
Disadvantages of incorporation
Of course there are disadvantages of incorporation as well - especially to small business owners. Here are a few you should consider:
- Tons of paperwork!
- You'll have to pay fees
- Liability protection isn't guaranteed
Now that you know the pros and cons of incorporating your business, lets go over your options.
6 possible business structures
There are six primary business models or structures that a company may choose in the United States. These include a sole proprietorship, a limited liability company (LLC), a partnership, a cooperative, a corporation, or an S corporation. Here's a rundown on all of your options:
What is sole proprietorship?
This is by far the most common and popular form of business in the United States - mostly because it's easy to start and manage. Simply put, a sole proprietorship is an unincorporated business where there is no legal distinction between the company and the individual who owns it and runs it. This is the business model most ecommerce merchants are using.
This business type is especially good for new ecommerce companies that have a low risk of liability. The company does not need to file taxes, startup costs are very low, and the owner has complete control over the business. Get a business license your local state or county, perhaps register a name, and the business is up and running. The sole proprietorship can evolve into another business type later, but is the fastest and easiest way to start.
Note though, that taxes do need to be filed under the individual owning the sole proprietorship. The risk here is that because there is no difference between the individual and the company, the individual is personally liable for everything the company does. Thus, the individual's personal assets are on the line. Also, once the business grows to more than one person, it can no longer be a sole proprietorship.
What is LLC? (Limited Liability Company)
A lot of people don't know what an LLC is, or how to get an LLC. Now it's important to note that LLCs can differ from one state to another, but generally speaking they are a hybrid business structure, combining the ease of a partnership with the liability protection found in corporations. Owners, frequently called members, pay taxes on the LLCs profits directly and the LLC itself does not file taxes as a separate legal entity.
LLCs require a lot less record keeping than corporations do, provide some protection for the member’s personal property, and are burdened with fewer profit sharing requirements than corporations. Conversely, LLC members will have to file additional forms for both federal and state taxes depending on the number of members, local laws, or even the LLC’s articles of organization. Often the members of an LLC pay payroll tax too.
Depending on the state, LLCs may also have a limited lifetime. In some jurisdictions when a member leaves the LLC, that LLC is dissolved. Starting an LLC requires significantly more effort than forming a partnership and a business will probably want to employ a lawyer or at least consult a certified public accountant.
What is a partnership?
Partnerships are single businesses that have two or more owners. Each of these owners or partners contributes to the business either with funding, property, labor, skill, or similar.
A general partnership assumes that the business is evenly divided or that specific percentages of ownership are documented if there is a partnership agreement. A limited partnership can limit both control and liability for specified partners.
Partnerships will require registration, but are still relatively easy to set up. Partners share responsibility and profits. Each state will have slightly different requirements for forming a partnership, but in many, if not most cases, it is a matter of filling out a form and paying a small fee.
What is a cooperative?
It would be somewhat unusual to find an ecommerce store merchant organized as a cooperative, but it's not impossible. Cooperatives are businesses created to service and benefit the owners. Put another way, its customers are its owners.
One possible example would be a labor union that operated an online uniform store, so that the union members could purchase work clothing at or near wholesale.
What is a corporation?
The corporation is a legal entity separate from any “natural” person, meaning that its owners are generally free from personal liability - which can save your butt if things go awry.
Each state has particular rules for corporations, but in general you'll need to register a company to be considered a corporation. Once you're registered, corporations will need to pay local, state, and federal taxes that are filed separately from its shareholders. It will need to acquire a particular tax ID number, and abide by all applicable rules, regulations, and laws for its industry.
The primary benefit of forming a corporation is that regarding the corporation’s assets or debts, a shareholder’s personal property is protected.
Example: If a customer sued a retail corporation, and won, the corporation could be forced to pay, but if the corporation ran out of money, the shareholders would not have to make up the difference.
Corporations are also more easily transferred compared to other business structures, may sell shares to raise capital, and may be more attractive to employees, who can be compensated — in part — with shares in the corporation.
Corporations are relatively more difficult to form and maintain than the other options. If the corporation’s records are not properly maintained, it is possible to lose the limited liability. When attorneys sue corporations and demonstrate that the corporate records were not maintained and that the corporation was not, in fact, acting like a separate legal entity, they have “pierced the corporate veil”, and the protection for personal property is lost.
Corporations may or may not pay lower taxes than individuals. This differs state by state, so it is a good idea to compare individual tax rates, which would apply for sole proprietorships, partnerships, or LLCs, with corporate tax rates. In many cases, the corporation will pay less.
In some cases, shareholders of small companies may get taxed twice. Specifically, the corporation will pay taxes on its profits, and then the shareholders will pay taxes on their share of the profits in the form of personal income.
What is an S Corporation?
An S corporation is formed through a special U.S. Internal Revenue Service (IRS) tax election and is specifically built to avoid the double tax problem mentioned above. The owners of an S Corporation still have limited liability, although not to the same extent as with a regular corporation, but pay taxes just once.
The S corporation has the same or similar record keeping and regulatory restrictions of a corporation, which can be a burden for some small retailers.
Which business structure is best for me?
Unfortunately, there isn't an easy answer or formula that every new business can follow when selecting a business structure as part of the business planning process. Most online retailers start as sole proprietorships or partnerships, and only go on to incorporate when the company’s potential liability makes protecting personal assets attractive or when being able to sell shares of the business would help it grow.
Right now, over 70% of US businesses are owned by sole proprietors and operate successfully without incorporating. Knowing that, it's safe to say that most ecommerce merchants won't need to go through the hassles of incorporation. But if you're more than a couple people strong, and you're growing in size, then you should start weighing your options now - and contacting an attorney will be the safest way to decide which business structure is best for you and your company.
How do I incorporate my business?
Each state has a different process to get your business incorporated. Search and apply for your state license here.
If you're not in the US, we'll be publishing a similar guide for other countries in the coming weeks, and the Canadian guide to incorporation is now live. Let me know in the comments if you have anything specific you want me to address.