So you’ve decided to start a company—congratulations! But now you’re trying to navigate the quagmire of whether and how to incorporate as a business. Welcome to the sometimes head-scratching world of entrepreneurship.
I know that frustration all too well—I struggled through it myself when I was first figuring out whether I should incorporate my own freelance copywriting business. Then when I did decide to form an LLC (limited liability company), I was shocked at the amount of misinformation online when it comes to this topic.
To ensure I was doing it right, I sought the advice of many tax and legal professionals, including tax attorney Braden Drake of Braden Drake Law. So when Foundr decided to write an authoritative, no-nonsense article on incorporating a business, I immediately turned to Braden, asking if I could interview him on some of the common questions that arise when tackling this challenge. I also reached out to Casey Handy-Smith of C. Handy Law, which specializes in entertainment and digital media law, to have her weigh in on these same topics.
Before we begin, a necessary disclaimer: This blog post is not legal or tax advice. When dealing with matters as complicated as business formation, always seek advice from an attorney or CPA who can advise you based on your unique situation. The way a company is set up differs greatly depending on your particular business, the state you’re operating in, and other factors that a qualified professional will be able to take into account.
Even so, I hope this article gives you helpful information on how to incorporate a business, as we hack away at some of the misconceptions and provide much needed clarity. Let’s demystify this process!
What Does It Mean to Incorporate a Business?
There seems to be a lot of confusion even around the term “incorporate.” Technically speaking, to incorporate means to start a corporation, which you do by filing Articles of Incorporation. However, it seems that people also use the word “incorporate” to mean “form an LLC,” which you do by filing Articles of Organization. Below, we’ll go over both LLCs (limited liability companies) and corporations.
Common Types of Business Structures
When deciding which business structure to opt for, there are two main categories of benefits to consider: legal and tax. There are also many different kinds of business structures, but below, I’ll go over the most common ones among freelancers, consultants, and small businesses.
This is the most basic business structure and the easiest to set up. That’s because you don’t have to do anything! There is no paperwork you have to file to become a sole proprietorship. The second you start earning money for your business, you’re a sole proprietor. Congratulations.
Most freelance businesses start out as sole proprietorships. When you opt for this structure, your business income tax is paid through your personal tax return, and you’ll report business income and loss on a Schedule C as part of that return. Essentially, you and your business are one and the same.
While many solopreneurs enjoy the ease of being a sole proprietor, there is a significant downside: Sole proprietorships offer no liability protection. This means that if your business were to be sued, your personal assets would be up for grabs. For this reason, it’s a good idea to obtain business insurance if you operate as a sole proprietor.
If you want to start a sole proprietorship, here’s a checklist of some basic tasks you’ll need to accomplish:
- Open a bank account that you will use only for business income and expenses. This is not required by law; it just makes bookkeeping much simpler, and come tax time, it’s easier to see how much your business made and how much it spent.
- If you will be operating under a name other than your own, obtain a fictitious business name certificate. Depending on which state you live in, this might be filed at the county level or state level. For example, California requires that you register fictitious business names with the county, while Florida has you register an FBN with the state.
- Obtain any necessary licenses and permits. Check to see if you require any federal, state, county, or city licenses or permits for your type of business. For example, CPAs (Certified Public Accountants) are licensed at the state level.
Limited Liability Company (LLC)
A limited liability company provides you with liability protection. This is the biggest advantage of forming an LLC. If someone were to sue your business, they would sue the LLC—not you personally. That means if a judgment is made against you, the court cannot go after your personal checking account, car, house, etc.
Will forming an LLC provide tax benefits? It depends. LLCs can choose how they are taxed, and that affects whether there will be any potential savings. There are a lot of nuances here, so definitely speak to an accountant to see if you could save money on taxes for your specific situation.
Maybe you, like many entrepreneurs, are operating as a sole proprietorship and wondering if it’s time to upgrade to an LLC. When’s the best time to do that?
“As soon as possible,” says attorney Casey Handy-Smith. “Forming an LLC, or any type of legal entity, provides a shield of protection from liability against you personally. It’s best to separate the affairs of your business from your personal life as early as you can. The last thing you want is for your family (and personal assets) to be negatively impacted by the things going on in your business.”
Tax attorney Braden Drake agrees. “The way I look at it is pretty much everyone should have an LLC for liability protection. The question just is ‘how necessary is it?’”
He likens it to insurance, which is a good thing to have, but its necessity depends on your level of risk. For example, for a 70-year-old, health insurance may be an absolute necessity, whereas for a 20-year-old, their risk isn’t as high.
And in case you think you don’t need liability protection because you’ve “got nothing to lose,” consider this: “If you get a judgment against you,” Drake says, “that judgment’s going to follow you until you do have assets.”
How long a creditor (the person who is owed money) can enforce a judgment varies by state, and for some states, it’s 20 years. That means even if you don’t have assets to protect now, you probably will in the future.
An LLC’s liability protection comes with some major caveats, though:
- If a court finds that you are guilty of fraud, your LLC doesn’t protect your personal assets. So for example, if you took out a loan in your LLC’s name knowing that you could not pay it back, that might be deemed a fraudulent act, and the liability protection you thought you had will disappear.
- If the court finds that there is no real separation between you and your LLC, then the plaintiff can “pierce the corporate veil” and go after your personal assets. A common reason this may happen is if you commingle personal and business finances. To avoid this mistake, you need to have separate bank accounts and credit cards for your personal use and business use. And you should never receive business income into your personal bank account nor use your personal bank account to pay for business expenses.
Common ways LLCs are taxed include:
- Disregarded entity. If you’re a single-member LLC, you’ll be taxed as a disregarded entity by default; you don’t need to file anything to achieve this. A disregarded entity is a “pass-through entity,” meaning you’ll file your taxes the same as a sole proprietor, with a 1040 and Schedule C.
- Partnership. If you’re a multi-member LLC, by default, you’ll be taxed as a partnership. As such, you’ll use IRS Form 1065, and a Schedule K-1 must be issued to each member.
- S corp. Some LLCs decide to elect to be taxed as an S corporation. Doing so can provide some tax benefits, depending on your income, because you’ll avoid paying self-employment tax on profits and your S corp can deduct the payroll taxes and wages it pays to you as an employee as a business expense. The math gets complicated, so check out this detailed post from Gusto on how an S corp could save you money.According to Drake, becoming an S corp doesn’t provide you with much financial benefit until you’re netting at least $60,000 a year. Whether or not you’ll benefit from forming an S corp depends on many factors, such as your business model, the industry you’re in, your geographic area, and your expertise. So for his clients in Southern California, he advises them to wait until they’re netting around $80,000 a year before they elect to be taxed as an S corp. A lot of this is because, if you’re an S corp, the IRS requires you to pay yourself a “reasonable compensation.” Just what would be deemed “reasonable” gets tricky, though, so in that case, you may want to enlist the help of a tax attorney.
If you want to form an LLC, here’s a basic checklist of the steps to take:
- Pick a name. When coming up with a business name, be sure to do your due diligence: search the USPTO’s trademark database, conduct Google searches, and check the LLC database of your state (just type “ LLC search” in Google). You don’t want to accidentally infringe on someone’s trademark by registering a name that’s too similar.
- Get a registered agent. A registered agent is someone who has a physical presence in the state where you form your LLC, is available during regular business hours, and can receive legal documents on your behalf. For example, if you get sued, this is the address where a summons would be served. The registered agent must then notify you of the lawsuit. You can also be your own registered agent, though there are some reasons why you may not want to do that. Your attorney, if you have one, can be your registered agent—and sometimes, even your CPA—but the most cost-effective route is probably to subscribe to registered agent services online. Simply Google, “registered agent service ,” and you’ll find a bunch of options, some for as low as $40 or $50 a year.
- File your Articles of Organization with your state. For most states, you can do this online, usually through the Secretary of State website.
- Get an EIN from the IRS. An EIN (employee identification number) is the tax ID the IRS assigns to your LLC. You can easily apply for an EIN on the IRS website for free.
- Open a business bank account with the EIN. To keep your business separate from your personal life, you’ll need to open up a business bank account for your LLC. Different banks require different documents to do this, but typically, you’ll need your EIN (it’s best to bring the EIN letter you got from the IRS), your Articles of Organization (some banks can look this up online at the state’s appropriate website), and maybe even your operating agreement (I cover what that is below). Check with your bank ahead of time to confirm which documents you’ll need to bring.
- Obtain any necessary federal, state, and local licenses and permits. Most commonly, businesses need a business license from their city and/or county government. Depending on your location, a business license may be called by another name, such as “business tax receipt.”
- Maintain your “corporate veil.” The biggest thing is to make sure you never commingle personal finances with business finances. Also, make sure you sign contracts and legal documents as your LLC, not as yourself personally. There are many considerations here though, and the most exhaustive list I’ve ever found on how to prevent the piercing of your corporate veil is from BizFilings.
- Create an operating agreement. In most states, an LLC operating agreement is not required by law, but even if you form your LLC in one of these states, it is still a good idea to have an operating agreement. Why? A few reasons:
- Some banks may require an operating agreement to open a business bank account.
- It helps maintain your corporate veil. Having an operating agreement in place adds legitimacy to your business and can be proof that you were truly running your LLC as a business separate from yourself.
- It helps clarify things if you have multiple members. As a single-member LLC, you probably won’t run into misunderstandings with yourself. But if you have other members, you want to be sure to clearly outline what each member is and is not allowed to do. An operating agreement can help resolve, or prevent, any disputes.
- File your annual report. Most states require that LLCs file an annual report to remain in good standing. Some states even require extra fees, such as California’s $800 annual franchise tax. For more information, check out LLC University’s LLC filing fees by state.
- Optional: Elect to be taxed as an S corp. If you have an LLC and want it to be taxed as an S corporation, fill out IRS Form 8832.
For most new entrepreneurs, knowing how to start a corporation isn’t necessary, because it’s a business structure you probably don’t need anyway. And even if you do, the process is complicated enough to warrant hiring an attorney. According to Handy-Smith:
A lot of entrepreneurs think that forming a corporation is the “next step” in business, but it may never make sense to incorporate for your business. I think the confusion here comes in when the business is making more money and the conversation regarding S corporation status comes up. Unlike an LLC or a C Corporation, an S Corporation is not a type of business entity. Instead, it’s a tax election under the Internal Revenue Code. Thus, the business could still be an LLC and elect to be taxed as an S Corporation to take advantage of the tax benefits.
There are two major reasons you may want to start a corporation:
- You plan to issue stock. If you plan to go public, you’ll want to become a corporation so you can sell shares.
- You plan to raise capital. While it’s not required in order to do any fundraising, being a corporation definitely helps to attract investors.
Bottom line: Corporations are best for startups that plan to raise money and/or go public.
How to Start a Corporation
Keep in mind that setting up a corporation is much more complicated (and expensive) than the previous business structures we went over, so below, I’ll just share some of the basics.
- Pick a name.
- Get a registered agent.
- File your Articles of Incorporation with the state.
- Get an EIN from the IRS.
- Open a business bank account with the EIN.
- Obtain any necessary federal, state, and local licenses and permits.
- Create corporate bylaws. Most states do not require LLCs to have operating agreements, but most states do require corporations to have bylaws.
- Follow corporate formalities. As a corporation, you are expected to follow strict formalities, including holding regular meetings, holding special meetings for major decisions, and keeping records of things like meeting minutes. There are many more guidelines, so check out this helpful corporate formalities checklist.
- File your annual report. Most states require that corporations file an annual report. Here’s a list of corporate annual report requirements by state.
- Optional: File IRS Form 2553 to elect to be taxed as an S corporation. Just as LLCs can elect to be taxed as an S corp, so can corporations in order to bypass “double taxation.” You can opt to be taxed as an S corp if you meet certain guidelines. One requirement is that you must have no more than 100 shareholders.
In Which State Should You Incorporate?
If you’ve spent any amount of time Googling how to incorporate your business or how to form an LLC, you’ve likely seen websites touting Delaware as the best state in which to set up a company due to its tax-friendly nature. I’m sorry to break it to you, but it turns out much of that information is wrong, or at least, probably doesn’t apply to you.
Those tax benefits you read about probably only apply to publicly traded or multi-state corporations. So if you’re an LLC, there’s no real reason to form in Delaware—unless, of course, you live in and operate your business in Delaware.
Why? Because if you live in California and form your LLC in Delaware thinking you’ll save taxes, you’ll be disappointed. If you’re physically in California operating your business, even if you form an LLC in Delaware, you’ll still have to register a foreign LLC in California—and you’ll still owe income taxes to California. In short, for most people, it’s best to form an LLC only in the state in which you operate your business.
Should You Hire an Attorney to Help You Incorporate?
Hiring an attorney to incorporate a business is not required, but it is strongly recommended. In particular, if you’re concerned about tax benefits and protecting your personal assets, you’ll want to consult an attorney or CPA. You could even consult a tax attorney who can advise you on both legal and tax ramifications.
The process of registering your business as an LLC is pretty straightforward: You usually just file a short document (Articles of Organization) with your state. The complicated parts really come after: compliance.
For Drake’s law firm, many of his clients file the Articles of Organization themselves and then schedule a consultation with him for a compliance check, where he’ll go over things like getting their business license, obtaining an EIN, and ensuring they’re properly separating business and personal finances. They may also hire him to create their operating agreement.
The process of incorporating a business (becoming a corporation) is more complicated than forming an LLC, so hiring an experienced attorney is in your best interest.
So if you decide to hire a lawyer to help with your business formation, what should you look for? Drake recommends asking for a referral and finding someone you like who’s transparent about their process and rates. To save money, ideally, you’ll hire an attorney who will advise you on how to do the LLC formation yourself—but Drake says that’s uncommon. Instead, you’ll typically find law firms with flat-rate packages, such as an LLC formation package, or law firms that charge an hourly rate and don’t necessarily give an estimate of how many hours they expect to take. And as he points out, if you’re only making $30,000 a year, hiring a lawyer who’s going to charge you $2,000 probably isn’t a good deal for you.
When I was looking for a lawyer who understood creative online businesses, I found Braden Drake Law by searching my Facebook business groups for recommendations. So if you’re having a hard time finding an attorney who’s the right fit for you, try asking an entrepreneur in your industry who they’d recommend.
Which Business Structure Will You Choose?
Now that you’ve gotten more information about business structures and how to incorporate a business, which route will you take?
A sole proprietorship is undoubtedly the easiest to set up, as it doesn’t require any paperwork, but it lacks liability protection. An LLC requires filing Articles of Organization with the state, but will protect your personal assets should you get sued (as long as you maintain your corporate veil). And a corporation demands the most paperwork and formalities of all the structures, but it is practically essential if you want to attract investors or go public.
At the end of the day, here’s Drake’s take on business formation: “It’s funny because there are all these different issues and people get really carried away Googling it, but 95% of the time, the advice is going to be ‘form an LLC in your home state,’ and then once you’re making enough money, elect for your LLC to be taxed as an S corporation.”
Regardless of which business structure you choose, there are some commonalities:
- When coming up with a business name, make sure someone else doesn’t already have that name or something too similar to it, as you don’t want to infringe on an existing trademark.
- You should keep personal and business finances separate. Even if you’re a sole proprietor and there’s nothing illegal about commingling funds, it becomes a headache if you do that and then need to clean up your books come tax time.
- If you are operating your business under a name that is not your legal name or is not the name of your LLC or corporation, you’ll likely need to register your fictitious business name. Some states don’t require this. Here’s a list of DBA (doing business as) requirements by state.
- You’ll probably need to obtain licenses and/or permits at the city, county, state, or even federal level. Even if you’re a freelance graphic designer operating as a sole proprietorship, your city or county may want you to obtain a business license.
Alright, I know you didn’t start your business because you love all the legal and tax considerations involved in setting up a company, but hey, that’s part of being an entrepreneur. The great news is you don’t have to figure out how to incorporate a business all on your own. Finding an experienced attorney to advise you is worth its weight in gold!
Which business structure do you operate under, and why did you choose it?