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The Basics of Small Business Incorporation

The incorporation of your small business can do wonders for limiting your liability for business debts, but you should be aware of the work that is still involved.

As many small business owners know, forming a corporation may provide you with limited personal liability for any debts that your business owes. However, incorporating a small business and maintaining it as a corporation is not as easy as just filing a few papers with the secretary of state's office. Along with filing the necessary papers and fees, you will also need to keep very accurate and detailed business records in order to file taxes for your corporation. As well, you will need to follow some formalities that go along with the decision making and record keeping for your corporation. To sum it all up, you have to be organized.

Small Business Incorporation: Limited Personal Liability

Perhaps one of the biggest draws of deciding to incorporate your small business is the limited personal liability that comes along with this decision. In most situations with corporations, the owners' personal assets and property are protected from creditors and others that have claims against the corporation. As an example, if a court finds that your corporation owes a creditor $20,000, the creditor cannot take that court judgment to claim the $20,000 against your personal assets, like your bank account or home. Instead, the creditor must take the claim against the corporation as a stand-alone legal entity. Corporate assets must be used to pay corporate debts. By choosing small business incorporation, you only stand to lose any money or property that you have already invested in the corporation.

Small Business Incorporation: Exceptions to Limited Personal Liability

In most situations, owners of corporations will be protected by the shield provided by the limited personal liability laws. However, there are some situations in which this limited liability will not protect the owners of a corporation. An owner of a corporation can be personally liable for corporate debts or obligations if the owner:

  • Personally guarantees (puts up personal assets) a bank loan or business debt which the corporation fails to pay off
  • Does not deposit the taxes that are withheld from employee paychecks
  • Personally and directly causes injury to someone
  • Performs an intentional act that is fraudulent or illegal and that causes the corporation, or someone else, harm, or
  • Behaves as if the corporation is an extension of his or her personal affairs, rather than its own, separate legal entity.

The last exception to limited personal liability is sometimes called the "alter ego" theory. It generally falls into the category of a court finding that the corporation does not really exist on its own and is just an extension of the owners, and that the owners should be held personally liable.

Courts look for these factors to see if a corporation is only an extension of the owners/alter ego:

  • The corporation is under-capitalized (under-funded)
  • The corporation never formally issued stock to the initial shareholders
  • The shareholders and directors of the corporation do not hold regular meetings, or
  • The owners of the corporation do not keep records showing that their personal transactions are separate from those of the corporation.

Small Business Incorporation: Liability Insurance

As tempting as it may be to disregard insurance once you have your personal assets protected, it is still important that you protect the assets of your corporation. Once you have formed your corporation, be sure to invest in corporate liability insurance.

Just like protecting your personal assets, corporate liability insurance will protect the assets of your corporation. As an example, if your small business is incorporated and runs a shopping mall, you should invest in liability insurance to help pay off a claim if someone falls while riding down an escalator.

In addition to protecting your corporation's assets, liability insurance can also protect your personal assets if you may be held personally liable. As an example (and a common one), if you are involved in a car accident while driving a corporate car and you injure someone, both you and the corporation may be held liable for the damages. However, corporate liability insurance would normally cover this situation. However, corporate liability insurance will generally not help if your corporation fails to pay its bills. If a creditor comes after your corporation for an unpaid debt, or the electricity gets turned off at your store, no amount of liability insurance will cover you here.

Small Business Incorporation: Corporate Income Tax

Because a corporation is its own legal entity, you are not responsible for paying personal income taxes on the profits that the corporation makes. Instead, if you own a corporation, you may take a yearly salary and bonuses from the corporation in exchange for your services. This is your personal income and you must pay income taxes on it.

As well, the corporation is responsible for paying corporate income tax on any profits that are left to the corporation after paying out all salaries, bonuses and overhead expenses. The corporation must file a corporate income tax return with the IRS and pay taxes at a special corporate rate.

However, if the owners of your corporate wish it, the corporation can be classified as an "S-type corporation," and the profits from the corporation are divided amongst the owners much like a partnership. If your corporation is an S-type corporation, you and all the other owns must divide the corporate profits amongst yourselves and pay personal income taxes on your respective shares.

Small Business Incorporation: Formation

In order to form a corporation, you must file your "articles of incorporation" with the appropriate office in your state (typically part of the secretary of state's office). In addition, you will need to pay a filing fee.

In most states, small businesses have an easy time when they choose to incorporate. Generally, the secretary of state's office can provide a "fill-in-the-blank" form that will be used as the articles of incorporation. This form normally requires the name, address and contact information of your business. In addition, some states require that the names and addresses of all the owners of the corporation be provided as well.

Additionally, when you file your articles of incorporation, you should also make a list of corporate by-laws. These by-laws are very important for a corporation as they govern the day-to-day running of the corporation. By-laws normally set out rules that dictate when shareholder meetings will occur as well as the voting rights of shareholders, directors and owners.

Lastly, when you decide to incorporate your business, you will need to issue stock to all of the initial shareholders (the owners) of the corporation.

Small Business Incorporation: Retaining Corporate Status

In order to retain the corporate status of your business once you have incorporated it, you must be sure to follow certain formalities. More specifically, corporations must:

  • Hold annual meetings for shareholders and directors,
  • Record the minutes for major decisions by shareholders and directors,
  • Ensure that any important documents are signed by directors in the name of the corporation,
  • Keep the corporate funds separate from private funds,
  • Keep detailed records of finances, and
  • File a separate tax return for the corporation.

If a corporation does not take these steps, it risks having its corporate status revoked.

Next Steps
Contact a qualified business organizations attorney to help you
choose the best formation for your business.
(e.g., Chicago, IL or 60611)

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