As a business owner, you face many decisions when it comes to starting, running, and growing your business. Our guide illustrates your options and can help you decide what structure your business will take. It explains the advantages and disadvantages of incorporation, what the incorporation process entails, and your post-incorporation requirements — such as filing annual statements with your state of incorporation.
About the term "incorporation": Technically, the term “incorporation” means creating a corporation while the term “formation” or “organization” means creating any kind of business entity. However, in this guide we will use all three terms interchangeably.
The following section on business types is for general information purposes only. For more help regarding your particular business, talk with an attorney or accountant.
This guide covers
- Business entity types: Advantages and disadvantages
- Sole proprietorship
- General partnership
- Limited partnership
- Limited liability partnership
- C corporation
- S corporation
- Nonprofit corporation
- Limited liability company
- Professional corporation
- Professional limited liability company
- Where to incorporate
- The incorporation process
- Post-incorporation and ongoing compliance requirements
- Using an incorporation service provider
Business entity types: Advantages and disadvantages
Sole proprietorship
The sole proprietorship is the simplest business form and not a legal entity. It is the easiest type of business to establish — no state filing or agreement with other owners is required. It is simply an enterprise owned and operated by an individual.
By default, once an individual starts selling goods or services, he or she has created a sole proprietorship. A sole proprietorship is not legally separate from its owner. The law does not distinguish between the owner’s personal assets and the business’ obligations. In fact, a sole proprietor’s assets can be (and often are) used to satisfy the debts and liabilities of the business. Remember: businesses end all the time. If they end with debts and liabilities, it can become a nightmare for a business owner who operates as a sole proprietor.
Advantages
- The owner can establish a sole proprietorship instantly, easily, and inexpensively.
- No state paperwork is required for creation.
- No separate tax filing is required. Profits or losses are reported on the owner’s tax return.
- A sole proprietor need not pay unemployment tax on himself or herself (but must pay employee unemployment tax).
- Few, if any, ongoing formalities.
Disadvantages
- The owner is subject to unlimited personal liability for business debts, losses, and liabilities.
- Obtaining capital, such as a bank loan, can be more difficult. Lenders often require a more formal entity structure.
- Sole proprietorships rarely survive an owner’s death or incapacity, so they do not retain value.
- Sole proprietorships by definition can only have one owner.
General partnership
A general partnership is the simplest type of partnership and is created automatically when two or more persons engage in a business enterprise for profit.
By default, a business that begins with a verbal agreement or handshake is considered a general partnership. All partners share in both the day-to-day management and business profits. A formal, written partnership agreement that sets forth all the partners’ rights and responsibilities is highly recommended; oral agreements are fertile ground for disputes.
A general partnership offers owners no liability protection — partners are all liable for business debts and obligations, and their personal assets can be used to satisfy those debts.
Advantages
- Owners can start partnerships relatively easily and inexpensively.
- No state paperwork is required for creation.
- Most states do not impose a fee for the privilege of existing.
Disadvantages
- All owners are subject to unlimited personal liability for business debts, losses, and liabilities.
- Individual partners bear responsibility for the actions of other partners.
- Obtaining capital, such as a bank loan, can be more difficult, as lenders often require a more formal entity structure.
- Poorly organized partnerships and oral partnerships can lead to disputes among owners.
Limited partnership
A limited partnership (LP) is owned by two classes of partners: general and limited. General partners manage the enterprise and are personally liable for its debts. Limited partners contribute capital and share profits, but typically do not participate in management. Limited partners also incur no personal liability for partnership debts beyond their capital contributions. At least one partner must be a general partner with unlimited liability, and one must be a limited partner whose liability is limited to the amount of his or her investment. Limited partners enjoy liability protection much like a corporation’s shareholders or an LLC’s members.
An LP allows for pass-through taxation, as income is not taxed at the business level. An informational tax return is filed, but profits or losses are reported on the partners’ personal tax returns and any tax due is paid at the individual level. LPs are especially appealing to businesses focused on a single, limited-term project (such as real estate or the film industry). LPs can be used as a form of estate planning in that parents can retain control of their business while transferring shares to their children.
An LP is a statutory entity. To form an LP, a formation document (typically called a Certificate of Limited Partnership) must be filed with the home state’s business entity filing office (Secretary of State or similar office) along with the filing fee. They are also required to appoint and continually maintain a registered agent (agent for service of process).
Advantages
- LPs enjoy pass-through taxation.
- Limited partners are not held personally responsible for business debts and liabilities.
- General partner(s) have full control over all business decisions.
- General partners have flexibility in how they manage the partnership with few formal requirements and annual paperwork.
- Some states authorize limited liability limited partnerships (LLLPs) which are limited partnerships in which the general partners have limited liability.
Disadvantages
- The general partner(s) face unlimited liability.
- Limited partners are prohibited from participating in business management.
- Ongoing compliance requirements of the state LP law, such as having to file annual reports.
- If the LP transacts business in states other than the formation state, it will have to qualify to do business in those “foreign” states.
Limited liability partnership
A limited liability partnership (LLP) is a special kind of general partnership. LLP partners participate in the management of the business, as in regular general partnerships, but the personal assets of the partners typically cannot be used to satisfy business debts and liabilities. LLP partners may also enjoy personal liability protection from the acts of other partners (but each partner remains liable for his or her own actions). State laws may require LLPs to maintain insurance policies or cash reserves to pay claims brought against the LLP.
The LLP is appealing to licensed professionals — such as accountants, attorneys, and architects — who are accustomed to operating as partnerships. In fact, in some states only licensed professionals can form LLPs. It’s also an option when professionals are prohibited from operating under other business forms, such as LLCs. An LLP also allows for pass-through taxation, as its income is not taxed at the entity level. An informational tax return is filed, but profits or losses are reported on the partners’ personal tax returns and any tax due is paid at the individual level.
To form an LLP, a document (referred to, among other names, as a Statement of LLP Registration) is filed with the home state’s business entity filing office (Secretary of State or similar office) along with the filing fee. An LLP is also required to appoint and continually maintain a registered agent (agent for service of process).
Advantages
- LLPs enjoy pass-through taxation.
- All partners are not held personally responsible for business debts and liabilities.
- Partners have flexibility in how they manage the company with few formal requirements and annual paperwork.
- The LLP form may be the only choice for a professional services business that wishes to have pass-through taxation in states that do not allow limited liability companies to be formed to perform professional services.
Disadvantages
- Ongoing compliance requirements, such as the need to file annual reports.
- If the LLP transacts business in states other than the state in which it is registered, it will have to qualify to do business in those “foreign” states.
C corporation
The corporation is the oldest form of statutory business structure. Although more LLCs are formed these days than corporations, corporations are still popular.
A corporation is a separate legal entity owned by its shareholders, thereby protecting owners from personal liability for corporate debts and obligations. The corporation is liable for its own debts and obligations.
Management of a corporation is governed by the state of incorporation’s corporation law, as well as the corporation’s Articles of Incorporation and bylaws. The statute will require the corporation’s management to observe particular formalities in its operation and administration. For example, management decisions must often be made by formal vote and recorded in corporate minutes. Director and shareholder meetings must be properly noticed and documented.
Corporations must also meet annual reporting requirements and pay ongoing fees in their state of incorporation and in foreign states where they are registered to transact business. They are also required to appoint and continually maintain a registered agent (agent for service of process).
Taxation is a significant consideration when choosing a business entity type. For income tax purposes (and income tax purposes only) there are two types of corporations — C corporations and S corporations. A C corporation (so named because it is taxed under Subchapter C of the Internal Revenue Code) is taxed as a separate legal entity (i.e., no pass-through taxation as with a partnership). A corporate income tax return is filed and taxes are paid on the corporation’s profits. If the corporation distributes profits to the shareholders in the form of dividends, shareholders pay income tax on those distributions. This creates a double taxation of corporate profits.
You don’t create a C corporation. You create a corporation. As with any business entity type that offers liability protection to owners, a corporation must be created by filing a formation document with the state’s business entity filing office, such as the Secretary of State or similar office. Articles of Incorporation (sometimes called a Certificate of Incorporation) in the appropriate state must be filed and filing fees paid. By default, all corporations are taxed as C corporations. So nothing has to be filed with the IRS for a corporation to be taxed as a C corporation.
Advantages
- Shareholders (owners) are not personally responsible for business debts and liabilities.
- C corporations can have an unlimited number of shareholders (as opposed to S corporations).
- Ownership is easily transferable through the sale of stock.
- Corporations have unlimited life, extending beyond owner illness or death.
- Some business expenses may be tax deductible.
- Additional capital can be raised by selling shares of corporate stock.
Disadvantages
- C corporations incur double taxation on corporate profits.
- Corporations are more expensive to form than sole proprietorships and partnerships.
- Corporations face ongoing state-imposed filing requirements and fees.
- Corporations face ongoing formalities, such as holding and properly documenting annual meetings of directors and shareholders.
- If the corporation does business in states other than the state of incorporation it will have to qualify to do business in those “foreign” states.
S corporation
The other type of corporation for income tax purposes is an S corporation (so-called because it is taxed under Subchapter S of the Internal Revenue Code). S corporations have pass-through taxation — thereby sidestepping the double taxation of corporate profits borne by C corporations.
Income taxation is the only distinction between C and S corporations. They are identical under state corporation laws. All corporations, whether taxed as C corporations or S corporations are subject to the same statutory requirements regarding management formalities and ongoing compliance requirements.
S corporations file an informational tax return (much like a partnership) but pay no tax at the business entity level. Corporate profit or loss is reported on the shareholders’ personal tax returns, and any tax due is paid at the individual level.
You don’t create an S corporation. You create a corporation, which is done by filing a document generally called Articles of Incorporation (sometimes called a Certificate of Incorporation) in the appropriate state. Then, in order to be taxed as an S corporation you must file Form 2553 with the IRS to elect S corporation status.
Advantages
- S corporations enjoy pass-through taxation.
- Shareholders are not personally responsible for business debts and liabilities.
- S corporations have unlimited life extending beyond owner illness or death.
- Additional capital can be raised by selling shares of the corporation’s stock. (However, there are restrictions imposed by the IRS on who can be a shareholder and on how many shareholders an S corporation can have.)
Disadvantages
- The IRS imposes restrictions on S corporation shareholders. They must number 100 or fewer; be individuals, estates, or certain qualified trusts; and cannot be non-resident aliens.
- Another IRS restriction is that S corporations can have only one class of stock (disregarding voting rights).
- The IRS also requires that all shareholders must consent in writing to the S corporation election.
- Corporations are more expensive to form than sole proprietorships and general partnerships, and face ongoing, state-imposed filing requirements, and fees.
- A few states’ tax laws require a state-level filing with the state’s tax department for the entity’s S corporation status to be recognized.
- Corporations face ongoing corporate formalities, such as holding and properly documenting annual director and shareholder meetings.
- Corporations face ongoing compliance requirements like filing annual reports and paying franchise taxes.
- If the corporation does business in states other than the state of incorporation it will have to qualify to do business in those “foreign” states.
Nonprofit corporation
A nonprofit corporation is a corporation formed for a purpose other than earning a profit. Nonprofits are authorized by different state statutes than standard for-profit corporations, but the incorporation process is similar. Nonprofit organizers must file nonprofit Articles of Incorporation or a Certificate of Incorporation with their home state’s business entity filing office (Secretary of State or similar office) and pay a filing fee.
Like for-profit corporations, nonprofits provide limited liability protection. Although they do not have shareholders, the personal assets of directors and officers cannot be used to satisfy the nonprofit’s debts and liabilities.
Many nonprofit corporations seek tax-exempt status. To obtain tax-exempt status, nonprofits must apply at the federal and state (if applicable) level — it is not automatically granted when the nonprofit is incorporated.
For federal tax-exempt status, a nonprofit must file Form 1023 with the IRS. For state requirements, it is best to contact the department responsible for taxation in your state of incorporation to determine whether a separate state-level tax-exemption filing is required.
The IRS code contains many different classifications of nonprofits. The most common type of tax-exempt nonprofit is the 501(c)(3). These nonprofits are generally organized and operated for religious, educational, charitable, scientific, or literary reasons; testing for public safety; fostering of national or international amateur sports; or for the prevention of cruelty to animals or children. Nonprofits may also be formed for other purposes. For example, 501(c)(6) nonprofits include business leagues and chambers of commerce. Real estate boards are classified as Section 501(c)(6) nonprofits, and a cooperative hospital service organization is classified as a Section 501(e) nonprofit.
Advantages
- Nonprofits can apply for both federal and state tax-exempt status.
- Some are eligible for public and private grants, making the obtainment of operating capital easier.
- With 501(c)(3) nonprofits, donations made by individuals to the nonprofit are tax deductible.
- The nonprofit affords limited liability protection to directors and officers.
Disadvantages
- Nonprofits incur formation expenses and face ongoing state filing requirements and fees.
- Nonprofits face ongoing formalities, such as holding and properly documenting regular meetings of directors.
- If the nonprofit corporation does business in states other than the state of incorporation, it will have to qualify to do business in those “foreign” states.
Limited liability company
The limited liability company (LLC) is the most common form of business entity in the United States. It is a hybrid business form, combining the liability protection of a corporation with the tax treatment and ease of administration of a partnership. The LLC is a relatively new form of business organization. The great bulk of laws authorizing LLCs in the United States was passed in the 1980s and 1990s. Many of those original LLC statutes have been updated since then.
LLCs enjoy pass-through taxation — sidestepping the double taxation of company profits borne by C corporations (although LLCs can elect with the IRS to be taxed as a corporation). Multi-owner LLCs file an informational tax return but pay no tax on company profits. The members (owners) report their share of the LLC’s profit or loss on their individual tax returns, and any tax due is paid at the individual level. Single-member LLCs report company profits on Schedule C, and any tax due is also paid at the individual level.
LLCs are created by filing a formation document, typically called Articles of Organization or Certificate of Organization, with the home state’s business entity filing office (Secretary of State or similar office) and paying the required state filing fee.
Advantages
- LLCs enjoy pass-through taxation.
- Members (owners) are not personally liable for business debts and liabilities.
- LLCs have no restrictions on the number of members allowed.
- Members have flexibility in structuring the company management.
- The LLC does not have to comply with as many management formalities as corporations.
- LLCs can choose to be taxed as a pass-through entity (like a partnership or S corporation), a disregarded entity (like a sole proprietorship), or a separate taxable entity (like a C corporation).
Disadvantages
- LLCs are more expensive to form than sole proprietorships and general partnerships.
- Ownership is typically harder to transfer than with a corporation.
- Because the LLC is a newer business type, there is not as much case law precedent to rely on
- LLCs face ongoing compliance requirements like filing annual reports and paying franchise taxes
- If the LLC does business in states other than the state of formation, it will have to qualify to do business in those “foreign” states.
Professional corporation
Professional corporations (PCs) are specialized entities organized and operated solely by licensed professionals such as attorneys, accountants, and doctors. Shareholders (owners) may enjoy personal liability protection from the acts of other shareholders, but each remains liable for his or her own professional misconduct.
State laws may require PCs to maintain insurance policies or cash reserves to pay claims brought against the corporation. PCs are formed in a similar manner to standard corporations by filing formation papers with the appropriate state agency and paying filing fees.
Professional limited liability company
Professional limited liability companies (PLLCs) are specialized entities organized and operated solely by licensed professionals such as attorneys, accountants, and doctors. The members (owners) enjoy personal liability protection from the acts of other members, but each remains liable for his or her own professional misconduct. Not all states recognize the PLLC business type.
State laws may require PLLCs to maintain insurance policies or cash reserves to pay claims brought against the PLLC. PLLCs are formed in a similar manner to standard LLCs by filing formation papers with the appropriate state agency and paying filing fees.
Where to incorporate
Once a business owner has decided to form a corporation or form an LLC, the next step is to choose a state of incorporation (also called your home state or domestic state). You are free to form your business entity in any state, but there are factors to consider when choosing, such as forming in the state where the business is located versus another state, state statutes, and state taxation requirements.
Incorporating in the state where your business is located vs. another state
Many business owners forming a corporation or LLC choose the state where their business is physically located. Corporations and LLCs must pay state filing fees at the time of formation, and are also subject to ongoing requirements and fees.
If the company is incorporated in one state but transacts business primarily in another state, it may need to “foreign qualify” in the state where it’s transacting business. Foreign qualification authorizes a corporation or LLC to transact business in a state other than the state of incorporation.
To foreign qualify, the proper document, usually called an Application for Certificate of Authority, must be completed and filed, and additional state filing fees paid. A company is subject to ongoing requirements and fees both in its state of incorporation and also in the state(s) of qualification.
What constitutes transacting business varies by state. Common factors are whether the company has a physical facility, employees, or a bank account in that state. To learn whether your company may need to foreign qualify, talk with an attorney.
Points to consider:
- State filing fees for forming a corporation or LLC in each state under consideration.
- State filing fees to register to transact business (foreign qualify) outside your home state.
- Ongoing fees imposed on corporations and LLCs by each state under consideration.
- Ongoing fees imposed on foreign-qualified corporations and LLCs by the state(s) of qualification.
State statutes and taxation requirements
When evaluating states for incorporation, be sure to research each state’s corporation and LLC statutes. For example, the corporation statute is one reason why Delaware is such a common and popular choice for publicly held and other large corporations. But that same law may not be as beneficial to corporations with only one or a few shareholders (owners).
Business owners should also understand how corporations and LLCs are taxed by each state under consideration and the taxation requirements for foreign-qualified corporations and LLCs in the state(s) of qualification. Consider the following:
- Does a state impose an income tax on corporations and LLCs?
- Does the state impose a minimum tax or a franchise tax?
- Try calculating your company’s projected revenue for its first years of existence and then evaluate the states in terms of the amount of taxes your company would be required to pay.
Delaware
Why has Delaware been one of America’s most popular corporate and LLC destinations? More than 50 percent of all U.S. publicly-traded companies and 60 percent of Fortune 500 companies call Delaware home. But these same advantages may not always apply to smaller businesses. For questions on which state is best for the formation of your business, talk with an attorney or accountant.
Common advantages of forming in Delaware
- Delaware’s corporation and LLC laws are very flexible.
- Delaware’s legislature reviews and updates the corporation and LLC laws every year.
- Delaware has a specialized court that hears cases interpreting the corporation and LLC laws and that decides cases involving management and owner rights and liabilities.
- The filing office is considered modern and helpful.
- There is no state corporate income tax for corporations and LLCs that are formed in Delaware but do not transact business there. (There is a franchise tax, however.)
- One person can hold multiple officer positions and serve as the sole director of the corporation or sole member/ manager of the LLC.
- Shareholders, directors, and officers of a corporation and members or managers of an LLC need not be residents of Delaware.
- Shares of stock owned by persons outside of Delaware are not subject to Delaware taxes.
While incorporating in Delaware holds potential advantages, one disadvantage is that if you operate your business outside of Delaware, you need to “foreign qualify” your business in that state. Foreign qualification is the process of registering a company to transact business in states other than its state of incorporation. When you foreign qualify your company, you must file paperwork with the states in which you’ll be transacting business and pay the necessary filing fees. You also have to appoint and maintain a registered agent.
You will also be subject to ongoing filings and fees (such as annual reports and/or franchise taxes) in your state of incorporation and state(s) of qualification.
The incorporation process
To form a corporation or LLC, a formation document must be filed with the appropriate state agency, usually the Secretary of State, and filing fees paid. This section describes the process typically required to form a corporation or LLC in any state, as well as typical costs and time frames.
Matters of public record and publication requirements
- Information included in the incorporation documents, such as names and addresses, becomes a matter of public record. In the internet age, they are easily searchable by individuals, regulatory and tax authorities, and data mining services.
- Some states require public announcement of new business formations. A state may require that notice of the formation be published in a legal journal or specific, local newspaper for a designated amount of time.