Determining when to incorporate a company is an important milestone in the life of a business venture. In fact, it is the nature of the business and its stage of development that drives the decision of when to incorporate. Below we discuss the common types of entity form; the attributes relevant to a particular business entity; and the drivers for incorporating the business entity.
Types of business entity
The most common forms of business entity are general partnerships, limited liability companies, and corporations. Generally, these entities represent the lifecycle of a growing business entity. When more than one individual begins working together with the purpose of generating profits (or loses) and share those profits, it results in a general partnership. There is no filing or other requirements to form the general partnership. Once the individuals become more organized, they generally form a limited liability company (LLC) to provide personal liability protection to the owners. The LLC also provides options for a management structure while maintaining many of the operational and financial characteristics of a partnership. The business entity generally becomes a corporation when some financial or operational need drives the decision. Below we explain the major characteristics of the corporation and the primary factors driving the decision to become a corporation.
Business Entity Characteristics
What are the primary identifiable characteristics of a corporation.
Formation – Individuals must file articles of organization with the state government to form a corporation. The articles of organization lay out the ownership structure of the company, such as classes of shares and the number of authorized shares.
Maintenance – The state will require annual filings, record keeping, and other corporate governance requirements of the corporation. The corporate governance procedures are normally lined out in the corporate bylaws.
Continuity – A corporation remains in tact when shareholders sell their shares back to the entity. This allows shareholders the ability to leave the company without disrupting the company’s operations.
Ownership & Control – The ownership and control functions in a corporation are separate. While shareholders own the corporation, directors and officers manage the company. This ownership and control structure is more sophisticated that other entities, such as a limited liability company or general partnership. This structure seeks to separate the roles or owner and manager.
Personal Liability – Shareholders are protected from personal liability for the debts and obligation of the corporation. This adds security for shareholders who are actively involved in company operations and wish to avoid personal liability resulting from the torts or contracts of company employees.
Compensation & Taxes – Shareholders may serve as employees and owners of the corporation. The shareholder will receive a salary for services rendered to the company. She will receive dividends from the corporation as owner compensation. The corporate entity form may allow for certain tax advantages, such as a lower tax rate and avoidance of Federal Insurance Contribution Act (FICA) taxes.
Business Characteristics Driving the Decision to Incorporate
The characteristics driving the decision to become a corporation are primarily related to the stage of the business, specific funding transactions, compensation methods, or tax benefits.
Structure – A company may grow to the point that it requires the division of roles between owners and managers. As discussed, the corporate organizational structure allows shareholders to elect the board of directors. The board of directors appoints officers to run the company. Separating the high-level decision making from the role of company officers can be beneficial to high-level decision making. Also, having a knowledgeable board of directors made up of insiders and outsider of the corporation can add diversity of thought and leadership.
Funding – Investors in early-stage, non-public companies generally seek preferred shares in return for their investments. The preferred shares offer numerous special right to shareholders beyond those of the common shareholders. The specific type of preferred shares must be authorized under the articles of incorporation. Also, the nature of the rights afforded the preferred shareholders is expanded upon in the corporate bylaws. As such, each time that a company goes through an equity funding round, the company must generally be reorganized and the articles of incorporation restated. If the company lists as a public company and sells on an exchange, most exchanges require the company have only one class of stock. As such, the company will reorganize and restate the articles of incorporation to clean up the equity structure by authorizing a single class of shares. In any event, a company seeking equity funding from outside investors or seeking to go public must generally assume the corporate entity form.
Compensation & Taxes – The corporate tax structure may offer a number of compensation and taxation advantages to owners. For example, owners of a corporation can also receive a salary for services provided to the company. This is not the case for partnership-taxed entities, which provide a draw on profits to owners. As such, the owners who participate in the business can receive compensation from company profits in the form of dividends. The dividends may be taxed at a lower tax rate and may not be subject to FICA taxes. While a partnership or LLC may choose to be taxed as a corporation, the company will often align its organizational and operational structure with its corporate tax structure.
LawTrades Knows Incorporation
When you need help in determine when and how to incorporate, look to the services offered by the legal professionals at LawTrades. Our experts will provide you expert advise or handle the incorporation process for you.