If you’re starting a business, you may wonder when to incorporate or form an LLC. While you can operate a business without being incorporated, there are benefits to becoming a corporation or LLC, including limited liability protection, potential tax benefits, and more.
For these reasons, small businesses are often advised to incorporate early in the startup process. That way, they can minimize exposure liability and take advantage of the benefits of incorporation.
However, you should consider the costs of being a corporation or LLC and the ongoing compliance requirements.
Let’s explore what incorporation means, things to consider before incorporating, the best time to incorporate, and how to incorporate a business.
What does it mean to incorporate a business?
Incorporation is the general term describing the process of creating a business by registering with a state. Through this process, the business becomes a separate legal entity independent of its owner(s), such as a corporation or LLC.
Technically, "incorporation" refers to creating a corporation, while "formation" or "organization" can refer to creating a business entity, such as an LLC.
As a separate legal entity, a corporation or LLC can own property, lend money, enter into contractual agreements, sue or be sued, and perform other functions.
A corporation or LLC also provides limited liability protection for owners by separating the business's assets, debts, and liabilities from those of the owners. However, corporations and LLCs differ in several ways, including management structure, ownership, and taxation.
For more information, see LLC vs. Inc: Understanding the differences between an LLC and a corporation.
Determining the best time to incorporate or form an LLC
While there is no definitive “right time” to incorporate or form an LLC, one of these factors may be a reason to go ahead with incorporating your business.
- Before entering into contracts: Having a corporation or LLC can help protect you from personal liability when you are conducting business on behalf of the company and signing contracts or other legal documents. If you initially sign a contract as a sole proprietor and then incorporate your business later, you will still be personally responsible for that contract.
- Establishing ownership roles: Conflict between owners on matters such as equity splits and other issues can often lead to complications. Early incorporation can mitigate these concerns, ensuring that co-founders are aligned from the outset.
- Liability exposure: Some industries, such as healthcare and construction, may face a higher risk of civil lawsuits. Your company may also be sued by customers who are dissatisfied with your services and products, experience interruptions or loss of service, or sustain injuries related to the company’s operations, staff, products, and services. In addition to having the necessary insurance, establishing your business as an LLC or corporation can create a separation between your personal assets and your company's liability in the event of a lawsuit.
- Hiring employees: Employers are generally liable for their employee's actions and mistakes during the course of employment.
- Applying for a loan: Lenders prefer working with an incorporated business and may be reluctant to provide a loan to a sole proprietor.
- Raising capital: For businesses that eventually seek to issue stock, a C corporation can easily issue shares to raise capital for further expansion.
- Protecting IP: Intellectual property (IP), such as patents, copyrights, trademarks, and trade secrets, is a valuable asset. It's crucial to establish early on that your business owns its IP. The simplest way to ensure this is through corporate ownership. Ambiguity about IP ownership can negatively impact investments, partnerships, and acquisitions.
- Establishing credibility: Many stakeholders view corporations and LLCs as more legitimate than unincorporated entities. Vendors, customers, and potential partners often see incorporated businesses as more legitimate and established.
Note: The end of the calendar year can pose challenges for businesses looking to quickly establish their incorporation. Secretary of State offices often experience a surge in filing paperwork during this time, leading to delays in processing. Suppose you want your LLC or corporation to be established with a future effective date of January 1. In that case, it's important to plan ahead, bearing in mind that not all states may offer the option for future effective date filing.
Things to consider before incorporating or forming an LLC
In addition to corporation and LLC benefits, there are legal and financial responsibilities to consider before incorporating, including:
- Formation and ongoing compliance requirements: While LLC compliance tasks vary from state to state, at a minimum you’ll need to file formation documents with your state agency responsible for business entities (usually the Secretary of State’s office) and pay a formation fee. You must also maintain a registered agent, file annual reports, and pay annual state franchise taxes to maintain good standing.
- Loss of good standing: When a corporation or LLC loses good standing, it may result in fines and penalties, difficulties in securing capital and financing, administrative dissolution of the entity, and the loss of limited liability protections for the owner(s)/members.
- Piercing the corporate veil: Any business that offers limited liability to its owners is also at risk of piercing the corporate veil and losing the protection and benefits provided by the business structure. For example, the corporate veil is pierced when there is no clear distinction between the company and its owners. With both a corporation or LLC, you must ensure that the business operates independently from its owner(s). This includes fulfilling necessary corporate formalities, documenting major business actions, and maintaining a clear separation between business assets and the owner(s)’ assets.
- Filing beneficial ownership information: Corporations and LLCs may also need to submit a beneficial ownership information (BOI) report to FinCEN and file updated reports for any changes to the information provided about the company and its owners.
How to incorporate a business
The basic steps to forming an LLC are:
- Choose the state you want to form/incorporate in
- Selecting a business name
- Filing formation documents with the Secretary of State
- Prepare an operating agreement or articles of incorporation
Keep in mind that there are additional requirements including appointing a registered agent, obtaining an EIN, getting the right business licenses and permits, and filing a beneficial ownership information report.
There are also different business formalities depending on whether you operate as a corporation or LLC.
For more information, see:
BizFilings can help
Learn about business formation and incorporation options, what they mean, how they work, and why they are important.
Then use our Incorporation Wizard Tool to help you determine the right type of corporation for your business.
