INCORPORATION

Corporate ownership is one of three broad categories of legal ownership of a business, along with sole proprietorship and partnership. In a sole proprietorship, the owner is personally liable for his or her business's debts and losses, there is little distinction made between personal and business income, and the business terminates upon the death of the owner or the owner's decision to change the legal character of the firm (by relinquishing part or all of his or her ownership in the enterprise). A partnership is merely joint ownership, and in terms of personal liability, is similar to a sole proprietorship. Both of these categories of business ownership are simple arrangements that can be entered into and dissolved fairly easily. Incorporation, on the other hand, is a more complex process for it involves the creation of a legal entity that serves as a sort of "person" that can enter into and dissolve contracts; incur debts; initiate or be the recipient of legal action; and own, acquire, and sell goods and property. A corporation, which must be chartered by a state or the federal government, is recognized as having rights, privileges, assets, and liabilities distinct from those of its owners.

Prospective entrepreneurs and established businesspeople operating sole proprietorships and partnerships are encouraged to weigh several factors when considering incorporating. Indeed, incorporation can have a fundamental impact on many aspects of business operation, from taxes to raising capital to owner liability.

ADVANTAGES OF INCORPORATION

* Raising Capital—Incorporation is generally regarded as an indication that the owners are serious about their business enterprise, and intend to devote time and resources to the venture for a significant period of time. This factor, as well as the reporting requirements of incorporation and—in some cases—the owners' more formidable financial resources—make corporations more attractive to some lending institutions. In addition, corporations have the option of raising capital by selling shares in their business to investors. Stockholders know that if the business they are investing in is a corporation, their personal assets are safe if the company gets into litigation or debt trouble.
* Ease of Ownership Transfer—Ownership of the company can be transferred fairly easily by simply selling stock (though some corporations attach restrictions in this regard).
* Tax Advantages—Some businesses enjoy lower tax rates under the incorporated designation than they would if they operated as a partnership or sole proprietorship. For instance, business owners can adjust the salaries they pay themselves in ways that impact on the corporation's profits and, subsequently, its tax obligations. It can also be easier for a business to invest in pension plans and other fringe benefits as a corporation because the cost of these benefits can be counted as tax-deductible business expenses.
* Liability—This factor is often cited as far and away the most important advantage to incorporation. When a company incorporates, "the shareholders, the owners of a corporation, are liable only up to the amount of money they contribute to the firm, basically equal to their shares of stock," wrote Todd Buchholz in From Here to Economy: A Shortcut to Economic Literacy. "In contrast, partners are legally liable for all debts and unpaid bills of the partnership. Because investors in a corporation do not risk their personal assets if the firm goes belly-up, the corporate system encourages people to invest." Moreover, while a corporation can be targeted in legal actions such as lawsuits, the personal assets of the company's owners cannot be touched if a judgement is rendered against their establishment since it is recognized as a legal entity separate from the owners/shareholders.

Still, while incorporation provides business owners with far greater liability protection than they would enjoy if they operated as a partnership or sole proprietorship, business experts note that certain instances remain wherein the personal assets of business owners may be vulnerable:

* Many small business owners who approach banks to secure financing for a new corporation are asked to sign a personal guarantee that assures the lending institution that they will pay back the loan if the corporation is unable to do so. Banks sometimes require similar guarantees from entrepreneurs and small business owners seeking financial assistance to lease equipment or facilities. Owners are also held personally responsible for ensuring that the corporation makes its required tax payments.
* Protection from liability can also be compromised in situations in which legal action is brought against a director or officer who is alleged to have committed some transgression outside the parameters of his or her job description. In other words, a business owner or shareholder can still be sued for personal actions.
* In some cases, key personnel of a corporation—such as board members or officers—can be held personally liable if the establishment that they operate has been found criminally negligent or guilty of willful criminal acts.
* The personal assets of business owners operating a corporation can also be threatened if it is determined that the business has not been properly established and adequately maintained. In such instances, noted the Entrepreneur Magazine Small Business Advisor, "a plaintiff may claim that the corporation and you [the owner] are one and the same, and therefore your personal assets can be used to satisfy the judgement. This is called 'piercing the corporate veil.' " The Small Business Advisor added, however, that there are several steps that business owners can take to ensure that their corporation protection is maintained. These include:1) Keeping up with taxes and regulatory requirements; 2) Staying in full compliance with guidelines regarding corporate minutes and various organizational bylaws; 3) Keeping personal and corporate accounts completely separated from one another; and 4) Showing proper capitalization by maintaining a satisfactory debt-to-equity ratio.

DISADVANTAGES OF INCORPORATION

* Regulatory and Record keeping Requirements—Corporate operations are governed by local, state, and federal regulations to a greater degree than are other businesses.
* Added Cost of Doing Business—Regulatory and record keeping guidelines and requirements often make it necessary for corporations to make additional investments (in accounting staffing, etc.) devoted to seeing that those legal requirements are met. In addition, there are fees associated with incorporating that business partnerships and sole proprietorships are not subject to.
* "Double" Taxation—People who are owners of a corporation, and who also work as an employee of the business, can receive financial compensation in two different ways. In addition to receiving a salary or wages for work performed, the owner may also receive a dividend or distribution on the stock that he or she owns. Any distribution of income to stockholders via dividends is taxable, however, if the corporation is organized as a "C corporation." This is sometimes called "double taxation" in recognition of the fact that such income has in reality been taxed twice, first when the corporation paid taxes on its profits, and secondly when the dividends were distributed. Companies that register as an "S corporation," however, are able to avoid this added tax.
* Separation of Finances—While incorporation provides significant protection of owners' personal assets from repercussions of business downturns, it also means that a business owner is not allowed to tap into the corporation's account for assistance in meeting personal debts.

S CORPORATIONS AND C CORPORATIONS

Small business owners can choose from two basic types of corporations. The C corporation is the more traditional of the arrangements, and is more frequently employed by large companies. With a regular corporation, the business's profits or losses are absorbed directly into the company. With the alternative corporate arrangement—the S corporation (also sometimes known as the Subchapter S corporation)—profits and losses pass through to the company's shareholders.

The S corporation option was actually put together by the federal government in recognition of the fact that the operating challenges faced by small businesses and large businesses can often be quite different. Indeed, the S corporation was shaped specifically to accommodate small business owners. S corporations give their owners the limited liability protections provided by corporate status, while also providing them with a more advantageous tax environment. In fact, S corporation status puts companies in the same basic tax situation as partnerships and sole proprietorships. Whereas C corporations are subject to the above-mentioned double taxation, profits registered by an S corporation are taxed only once, when they reach the company's shareholders.

To qualify as an S corporation, a business must meet the following requirements: 1) It must be a U.S. corporation; 2) It can have only a limited number of shareholders (35 in the mid-1990s); 3) It may not offer more than one class of outstanding stock. Seekers of S corporation status should also be aware that the government has additional stipulations regarding the citizenship of owners/shareholders and affiliations with other business entities. Prospective S corporations must be in accordance with all these restrictions.

THE PROCESS OF INCORPORATION

The actual fees required to incorporate generally amount to several hundred dollars, although the total cost differs from state to state (corporations usually pay both an initial filing fee and an annual fee to the states in which they operate). Hiring an attorney to assist in the process can raise the cost, but several services are available on the Internet to assist businesses with the incorporation process. The Small Business Administration has noted that the owners of a business that is going to be incorporated must agree on several important issues, including the nature of the business; the total number of shares of stock the corporation will make available; the stock that the owners will be able to purchase; the amount of financial investment that each of the owners will make; the bylaws by which the corporation will operate; the management structure of the corporation; and the name under which the business will operate.

Indeed, it is a good idea to reserve the proposed name of the corporation with the state before filing articles of incorporation. The owners of the business must make sure that they have a clear right to that name, since only one corporation may possess any given name in each state. If a business owner files articles of incorporation using a name that already belongs to another corporation, the application will be rejected. The name of the business must also include either corporation, company, limited, or incorporated as part of its legal name; such terms serve notice to people and businesses outside the company that it is a legal entity unto itself and thus subject to different laws than other business types.

Since the corporation will be a legal entity separate from its owners, separate financial accounts and record keeping practices also need to be established. Once the shareholders have reached agreement on these issues, they must prepare and file articles of incorporation or a certificate of incorporation with the corporate office of the state in which they have decided to incorporate. Any corporation—with the exception of banks and insurance companies—can incorporate under Section 3 of the Model Business Corporation Act.

Business experts also counsel organizers of a corporation to put together a preincorporation agreement that specifies the various roles and responsibilities that each owner will take on in the corporation once it has come into being. Preincorporation agreements typically cover many of the above-mentioned issues, and can be supplemented with other legal documents governing various business operations, such as inventory purchases and lease agreements. Preincorporation agreements are also sometimes drawn up with third parties. The editors of The Entrepreneur Magazine Small Business Advisor noted that such contracts generally address: 1) Scope of potential liability; 2) Rights and obligations for both the corporation and its organizers once it has been formed; 3) Provisions to address business issues if incorporation never occurs for some reason; and 4) Provisions for declining the contract once the corporation has been formed. The services of an attorney should be employed when putting together such a contract.

Once a company has incorporated, stock can be distributed and the shareholders can elect a board of directors to take formal control of the business. Small corporations often institute buy-sell agreements for its shareholders. Under this agreement, stock that is given up by a shareholder—either because of death or a desire to sell—must first be made available to the business's other established shareholders. Stock issues and shareholder responsibilities are, generally speaking, fairly straightforward in smaller companies, but larger corporations with large numbers of shareholders generally have to register with state regulatory agencies or the federal Securities and Exchange Commission (SEC).

In addition, incorporation requires the adoption of corporate bylaws. The bylaws, which are not public record, include more specific information about how the corporation will be run. These are the rules and regulations that govern the internal affairs of the corporation, although they may not conflict with the Articles of Incorporation or the corporate laws of your state. The bylaws are adopted by the board or the corporation's shareholders and may be amended or repealed at a later date. When preparing bylaws, it is sometimes easiest to start with the model bylaws that typically arrive with corporate kits or incorporation guides, although these may be altered. The bylaws should specify such information as:

* The location of corporate offices
* The names and powers of shareholders and directors
* The date and time for regular shareholders' and board of directors' meetings
* The content of such meetings
* The period of notice required before such meetings
* Voting eligibility
* Voting procedures
* Election procedures for seating directors and officers
* The names and duties of officers
* How financial transactions will be conducted
* The procedures for amending or repealing bylaws
* Stipulations as to whether powers or duties of board of directors may be relegated to ad hoc committees
* Procedures to be followed in the event of a merger with another company or the dissolution of the corporation itself

CORPORATE OWNERSHIP AND CONTROL

The owners of a corporation remain the ultimate controllers of that business's operations, but exercising that control is a more complicated process than it is for owners of partnerships or sole proprietorships. Control depends in part on whether the owners decide to make the corporation a public company—in which shares in the company are available to the general public—or a private or closely held corporation, where shares are concentrated in the hands of a few owners.

In most cases, small businesses have a modest number of shareholders or owners. As noted in The Small Business Advisor, "the shareholders generally have very few powers in regard to the day-to-day operations of the corporation but are responsible for electing the board of directors and removing them from office. In smaller corporations, the shareholders can give themselves more operational powers by including provisions in the articles and bylaws of the corporation." In most cases, however, it is the shareholder-appointed board of directors that runs the company. Directors are responsible for all aspects of the company's operation, and it is the board that appoints the key personnel responsible for overseeing the business's daily operations. The officers (president, vice-president, treasurer, etc.), though appointed by the board of directors, often wield the greatest power in a corporation; indeed, in some corporations, officers are also members of the board of directors. Of course, in situations where only one person owns the incorporated company, he or she will bear many of the above responsibilities. As Janet Attard, author of The Home Office and Small Business Answer Book, commented, "If you are the only stockholder, you might appoint yourself director, then, as director, appoint yourself, or whoever else you choose, to each of the corporate officer positions required by law in your state … unless your state requires different people hold those positions or requires corporations to have more than one director."

INCORPORATING IN DELAWARE AND NEVADA

Over the years, many companies have chosen to incorporate in Delaware or Nevada because of those states' business-friendly environment regarding taxation and liability issues. But some business experts caution small businesses from automatically casting their lots with these states. As Attard noted, small businesses with a small number of shareholder-employees should probably incorporate within their own state of operation: "Although Delaware may offer some tax breaks and potentially more statutory protection from liability for corporate directors than your own state, for a small corporation the advantages are likely to be outweighed by the disadvantages. For instance, you will have to appoint someone in Delaware to be an agent for your corporation (there are companies in Delaware that do this) [and] you will have to pay an annual franchise (corporate) tax to the state of Delaware. Finally, Attard pointed out that companies that incorporate in Delaware but do business in another state have to file an application in its home state to do business as a foreign corporation. This designation will require them to pay a franchise fee in addition to their usual state income taxes.

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