Incorporation

Incorporation is a legal method that business owners can use to separate their business from their personal finances and liabilities. By incorporating, business owners can reduce their personal liability for activities the business engages in and any business debts or financial hardships the business experiences.

There are several ways to incorporate and register a business as a proper and separate business entity. This includes the following:

1. Nonprofit corporation. For companies operating as charities, educational organizations, and other similar sectors, nonprofit formations can give them additional tax breaks. However, the company must meet strict qualification requirements, and profits can’t be distributed to organization members or directors.
2. For-profit corporation. For-profit organizations are those that exist to earn a profit by offering products or services. This structure provides some liability protection for the owners and establishes a separate legal entity that can enter into contracts and distribute dividends to shareholders.
3. Professional corporation. These corporations are designed for licensed professionals like doctors, lawyers, accountants, and engineers. Under this type of corporation, the owners of the company are usually both shareholders and employees of the organization.
4. Public benefit corporation. Sometimes referred to as benefit corporations, these businesses strive to generate profits while still making a difference in their communities. They agree to operate in a responsible way and typically have a clear environmental or societal mission, similar to a nonprofit.

How incorporation works

A corporation forms when its organizers file formal documents with a state agency, typically the Secretary of State’s office. The foundational document is the articles of incorporation (also called a certificate of incorporation or corporate charter), which establishes the corporation's legal existence.

The general process follows these steps:

1. Choose a state of incorporation. Corporations can form in any state, regardless of where they operate.
2. Select a corporate name. The name must be distinguishable from other registered entities and typically must include a designator such as “Inc.,” “Corp.,” or “Corporation.”
3. File articles of incorporation. This document includes the corporation’s name, registered agent, and number of authorized shares. Filing fees vary by state and the type of corporation being formed.
4. Appoint a registered agent. Every corporation must designate an individual or entity authorized to receive legal and official documents on its behalf.
5. Create corporate bylaws. Bylaws govern internal management, including shareholder meetings, board elections, and officer roles.
6. Issue stock and hold an organizational meeting. The board adopts bylaws, elects officers, and issues shares to initial shareholders.

Why incorporation matters

Incorporation provides a formal legal structure for operating and growing a business.

One of its main benefits is limited liability protection. Shareholders generally aren’t personally responsible for corporate debts or legal judgments solely because they own shares. However, this protection isn’t absolute.

Corporations also generally continue to exist when shareholders sell their shares, leave the business, or die. This continuity can make it easier to transfer ownership, raise capital, and plan for the business’s future.

Common uses

Business owners may choose incorporation for several reasons:

1. Startups seeking investment. Venture capital firms typically prefer C corporations for their established framework for issuing multiple classes of stock.
2. Business owners separating personal and business liability. A contractor or consultant who incorporates limits personal liability exposure if a client files a lawsuit.
3. Businesses operating across multiple states. A corporation formed in one state can register as a foreign corporation in other states where it conducts business.

Key limitations

Incorporation does not guarantee unlimited liability protection. Courts can pierce the corporate veil, holding shareholders personally liable, if the corporation fails to maintain separation between personal and business finances, neglects required formalities, or is used to commit fraud.

C corporations are also subject to double taxation: the corporation pays income tax on profits, and shareholders pay tax again on dividends. Eligible corporations may elect S corporation tax status to avoid double taxation, subject to IRS eligibility requirements.

Corporations carry ongoing compliance obligations, including annual reports and shareholder meetings. Failing to meet these requirements can result in loss of good standing or administrative dissolution.

Related terms

The following documents and processes commonly relate to incorporation:

1. Articles of incorporation: The formation document filed with the state to create a corporation.
2. Corporate bylaws: The internal rules that govern the corporation’s operations and decision-making.
3. Foreign qualification: The process of registering a corporation to conduct business outside its state of incorporation.
4. Dissolution: The formal process of ending a corporation’s legal existence.
5. Reinstatement: The process of restoring a corporation or other business’ status after an administrative dissolution or loss of good standing.

FAQs about incorporation

What is the difference between a corporation and incorporation?

A corporation is the legal entity itself. Incorporation is the process of creating it.

What are the main disadvantages of incorporation?

Incorporation may involve higher formation costs, additional record-keeping, and ongoing state compliance requirements. C corporations may also face taxation at both the corporate level and the shareholder level when they distribute dividends.

Does incorporation automatically protect a business owner's personal assets?

Not unconditionally. Courts can pierce the corporate veil if the corporation does not operate as a genuinely separate entity, which requires keeping finances distinct, maintaining corporate formalities, and avoiding fraud.

Can I incorporate in a different state from where my business operates?

Yes. However, the corporation may need to register as a foreign corporation in each additional state where its activities count as doing business. It may also have filing, tax, registered agent, and annual reporting obligations in multiple states.