How to Incorporate a Startup
You’ve decided to start your own business. Congratulations!
As a founder, you have a lot of important decisions to make. Choosing the right legal structure for your startup is one of the most important. This decision will impact several aspects of your business, including how you file taxes, the number of shareholders you can have, and what your business is allowed to own.
We’ll cover all the types of corporations, but first we should point out that startups raising venture funding usually incorporate as Delaware C-corporations. There are several compelling reasons for this. Firstly, Delaware offers a business-friendly legal environment with a well-established body of corporate law and a specialized court system, the Court of Chancery, which provides predictability and efficiency in resolving corporate disputes. Delaware’s legal framework is familiar to investors, making them more comfortable investing in Delaware-incorporated companies. Secondly, Delaware C-corporations have advantages when raising capital, since they can issue multiple classes of stock (venture capitalists like preferred stock for its negotiable rights and protections). Lastly, Delaware’s tax structure offers lower corporate income tax rates and no sales tax, which can be particularly beneficial for startups seeking to minimize costs during their early stages. Below you’ll find a more detailed list of the benefits of incorporating as a Delaware C-corp.
In addition to C-corporations, there are several different ways to incorporate your startup, and each one comes with its own set of benefits and drawbacks.
Incorporating a Startup
Incorporating a startup means turning your business into its own legal entity, separate from you as the owner.
This usually involves filing some paperwork with the government—typically through your state’s secretary of state’s office—and paying a fee.
Once incorporated, your business will need to follow certain laws and rules, but it also comes with advantages like protecting your personal assets and making it easier to raise money.
Incorporation also helps simplify things like taxes, ownership, and liability.
Benefits of Incorporating Your Startup
Incorporating a startup might seem complicated, but it comes with important benefits.
Running a business as a Sole Proprietorship or Partnership is simple to set up but comes with major risks, such as personal liability for business debts and legal issues, as well as challenges with taxes and growth.
Incorporating creates a separate legal entity for the startup, which protects the owner’s personal assets and makes it easier to raise money, manage taxes, and transfer ownership.
Here are the top five benefits of incorporating your startup.
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Limited Liability
One of the biggest benefits of incorporating a startup is the protection it offers for personal assets. When a business is incorporated, it becomes its own legal entity, meaning the business, not the owner, is responsible for its debts and liabilities.
This shields the owner’s personal assets, like their home or savings, from being used to pay off business debts. For example, if a corporation has $5,000 in assets but owes more in rent, only the business’ assets are at risk, not the owner’s personal property.
Conversely, Sole Proprietorships and Partnerships don’t provide this protection, making the owner personally liable for any business debts.
By incorporating as a C Corporation, S Corporation, or LLC, owners can protect their personal assets from creditors, business debt, or even bankruptcy. However, it’s important to follow proper corporate rules to keep these protections in place.
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Tax Benefits
Incorporating a startup can offer valuable tax benefits.
Once incorporated, businesses can take advantage of a wider range of deductions that aren’t available to sole proprietors. These include deductions for startup costs, operating expenses, employee benefits, insurance, and advertising. Corporations can also spread out losses over time and may qualify for local or state tax incentives.
Additionally, corporations only pay half of the Social Security and Medicare taxes, while unincorporated business owners must cover the full amount through self-employment taxes.
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Easier to Raise Capital
Incorporating a business makes it easier to raise money.
Investors are more likely to invest in a corporation because it offers them partial ownership through shares. This allows the business to raise funds while still keeping control.
Banks and other financial institutions also see incorporated businesses as more trustworthy, making it easier to get loans and build credit.
Overall, incorporation boosts a business’s credibility and makes it simpler to raise the capital needed for growth and expansion.
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Ownership Transferability
Incorporating a business makes it much easier to transfer ownership.
Since a corporation is a separate legal entity, you can easily transfer ownership by selling or passing on shares. This makes it simpler to bring in new partners, sell parts of the business, or pass it on to family members.
Whether you’re planning for the future, bringing in co-owners, or looking to attract investors, incorporating helps the business run smoothly through any changes.
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Credibility
Incorporating a business can help build credibility by allowing it to use “Inc.” or “LLC” in its name, which makes it look more professional and trustworthy.
Customers and partners are more likely to see the business as legitimate and reliable. Following the rules that come with incorporation also shows that the business operates honestly.
This added trust can boost the business’s reputation and make it more appealing to potential customers.
Types of Corporate Structures
In general, there are five main types of corporations in the United States:
Sole Proprietorship
A Sole Proprietorship is the simplest way to start a business and is ideal for small business owners who are working alone and don’t need venture capital.
The owner and the business are the same for tax and liability purposes, meaning the owner is personally responsible for any debts or legal issues.
There’s no need to officially register, though many people get a DBA (“doing business as”) to secure a business name.
While it’s easy to set up, Sole Proprietorships have some drawbacks, like limited access to business bank accounts and no personal asset protection. If the business grows, involves more people, or needs outside funding, it might be time to consider incorporating.
Partnerships
A partnership is a simple way for two or more people to own a business together.
There are two common types:
- Limited Partnerships (LP)
- Limited Liability Partnerships (LLP)
In an LP, one partner has unlimited liability and control over the business, while the other partners have limited liability and less control, as explained in a partnership agreement. Profits go directly to personal tax returns, and the general partner must pay self-employment taxes.
An LLP, however, gives all partners limited liability, protecting each from the actions or debts of the others.
Partnerships are a good choice for businesses with multiple owners, professional groups like attorneys, or for those who want to test a business idea before committing to a more formal structure.
Profits and losses are reported on each partner’s personal tax return.
Limited Liability Company (LLC)
A Limited Liability Company (LLC) is a popular business structure because it combines the benefits of corporations and partnerships.
One of the biggest advantages is that the owners, called “members,” aren’t personally responsible for the company’s debts or legal issues.
LLCs are affordable to set up, and the business’s financial results are reported on the owner’s personal tax return, giving flexibility with taxes.
However, LLCs come with a few downsides, such as having to pay self-employment taxes, difficulty attracting investors, and the possibility of dissolving if a member leaves.
An LLC offers a good mix of protection and flexibility, making it a common choice for small businesses.
S-Corporation (S-Corp)
An S Corporation is a type of business that offers the benefits of being a corporation without the downside of double taxation. This means profits and losses go directly to the shareholders’ personal tax returns, avoiding taxes at the corporate level.
An S-corp is usually a small business, as they are limited to 100 shareholders and can only have one type of stock. Shareholders are protected from personal liability for the company’s debts.
However, S-Corps have specific rules, such as needing to meet IRS requirements and only allowing U.S. citizens, residents, and certain organizations to be shareholders.
While S-Corps provide tax benefits, they must follow the same strict filing and operational rules as C corporations.
C-Corporation (C-Corp)
A C Corporation is a business that exists separately from its owners, providing strong protection for personal assets. This structure is popular with large companies and startups looking to raise money.
While setting up a C-Corp costs more and requires more paperwork and reporting, it offers big benefits. C-Corps can raise money by selling stock, which can also help attract employees.
However, C-Corps also face double taxation—once on the company’s profits and again when shareholders pay taxes on dividends.
Despite the extra costs, C corps are a good choice for businesses that want to grow, raise funds, or eventually go public.
Other Types of Corporations
Less common, but here are three other types of corporations:
- Benefit Corporation: A for-profit company that focuses on both making a profit and benefiting the public. Shareholders ensure the company meets its social mission. It’s taxed like a regular corporation, but some states require annual reports showing its public impact. Third-party certifications exist but aren’t required for legal recognition.
- Close Corporation: A small, less formal corporation where a few shareholders run the business without a board of directors. Shares aren’t publicly traded, and rules vary by state.
- Nonprofit Corporation: A business set up for charitable, educational, religious, or scientific purposes. Nonprofits can get tax-exempt status, meaning they don’t pay income taxes. To do this, they need to apply with the IRS. Nonprofits must follow similar rules as regular corporations but can’t share profits with members or fund political campaigns. These organizations are often called 501(c)(3) because of the tax code that gives them tax-exempt status.
Table source: https://www.sba.gov/business-guide/launch-your-business/choose-business-structure
Business structure |
Ownership |
Liability |
Taxes |
|---|---|---|---|
Sole proprietorship |
One person |
Unlimited personal liability |
|
Partnerships |
Two or more people |
Unlimited personal liability unless structured as a limited partnership |
|
Limited liability company (LLC) |
One or more people |
Owners are not personally liable |
|
Corporation - C corp |
One or more people |
Owners are not personally liable |
|
Corporation - S corp |
|
Owners are not personally liable |
|
Why You Should Incorporate Your Startup in Delaware
For startups looking for venture capital, incorporating as a Delaware C-corporation is often a smart move.
Many investors prefer this option because Delaware has a business-friendly environment and strong legal protections. While not a tax haven, Delaware offers some tax benefits, such as exemptions from state corporate taxes for companies not operating there and no state tax on equity held by non-residents. Even though incorporating in Delaware can mean extra fees and paperwork, the advantages, like gaining investor trust and legal flexibility, make it a popular choice.
Here’s why incorporating in Delaware is beneficial for startups:
- Investor Preference: Many investors want startups to be incorporated in Delaware because it protects their interests and offers a favorable legal framework.
- Tax Benefits: If your business doesn’t operate in Delaware, you won’t have to pay state corporate taxes, and non-residents don’t pay state taxes on their shares.
- Legal Flexibility: Delaware has a strong legal system for businesses, giving companies more options and protection in legal matters.
- Franchise Tax: Delaware does require an annual franchise tax, even if your business isn’t operating in the state.
- Familiarity: Over 66% of Fortune 500 companies are incorporated in Delaware, which boosts its credibility with investors.
- Save Time: Starting your incorporation in Delaware can save you the trouble of moving your business there later when investors request it.
When To Incorporate Your Startup
Knowing when to incorporate a startup is essential for its growth and protection. Incorporation is more than just a legal step; it changes how a business operates and interacts with its stakeholders.
Startups should consider various factors to determine the right timing for incorporation, ensuring it aligns with their business goals and circumstances.
Reasons to Incorporate:
- Intellectual Property Security: By incorporating, startups can protect their intellectual property, ensuring that it remains with the company even if founders leave.
- Need for Funding: Most investors require businesses to be incorporated before they invest, as this offers better protection and tax benefits.
- Ability to Issue Stock: Incorporating allows startups to offer stock options to employees and advisors, which can help attract and retain talent.
- Establishing Business Credit: Incorporation is necessary to build a separate business credit profile, making it easier to obtain loans and credit.
- Clear Ownership Structure: Incorporating provides a clear framework for ownership and decision-making, reducing potential disputes among founders.
Changing the State of Your Incorporation
Some startups may want to extend their R&D Tax Credit benefits for another year after they start making money. They have five years to use the payroll tax offsets that come with this credit.
However, startups in California or Texas might think they can just change their state of incorporation to reset this five-year clock. Unfortunately, this doesn’t work because the IRS tracks companies by their Employer Identification Number (EIN), which stays the same no matter where the company is incorporated.
Startups need to keep things simple. Building a successful business is already tough, with demands on time and energy. When thinking about changing their incorporation state, founders might be overcomplicating things.
It’s a good idea for companies to ask their accountants for advice on these issues. Additionally, if a startup hires employees, owns property, or makes a lot of money in another state, it will need to file state tax returns and register to do business there.
Steps to Incorporate Your Startup
Incorporating a business involves a series of steps that legally establish your company as its own entity. Each state has its own rules, so it’s important to follow the specific requirements of the state where you’re incorporating.
Below is a step-by-step guide to help you through the process.
- Choose a Business Structure: Decide on the best structure for your business, such as an LLC or corporation, based on your needs and goals.
- Pick a Business Name: Ensure your chosen name is available in your state and doesn’t conflict with existing businesses. You may also check domain availability for a website.
- Register Your Business Name: After choosing a name, register it with the necessary state authorities, and consider applying for a trademark.
- Appoint a Registered Agent: Designate an individual or service to receive legal documents on behalf of your corporation.
- File Articles of Incorporation: Draft and submit the official paperwork to establish your corporation with the state’s secretary of state or similar agency.
- Get an Employer Identification Number (EIN): Obtain an EIN from the IRS for tax purposes and to open a business bank account.
- Open a Business Bank Account: Separate personal and business finances by opening an account solely for business transactions.
- Create Corporate Bylaws: Draft internal rules to govern your corporation’s operations, even if they aren’t legally required in your state.
- Issue Stock: Distribute shares to the company’s owners and maintain accurate records of ownership.
- Hold Initial Board Meeting: During this meeting, appoint officers, approve the bylaws, and handle other initial corporate formalities.
- Register for State and Local Taxes: Ensure your business is registered for any applicable taxes, such as sales taxes or employee withholding tax.
- Obtain Permits and Licenses: Research and secure any necessary federal, state, or local permits before starting business operations.
- Set Up Accounting Systems: Implement bookkeeping systems or hire an accountant to track income, expenses, and taxes.
- File Regular Reports and Taxes: Stay compliant with quarterly or annual filings, depending on your business type and location.
- Maintain Corporate Compliance: Keep your business in good standing by meeting filing deadlines, maintaining records, and holding annual meetings.
Steps to Take After You Incorporate
There are several important steps to take after you incorporate:
- File Where You Have a Team: If your business is incorporated in one state but operates or has employees in another, you’ll need to file in that state too. For example, if you’re a Delaware C-Corp but have a team in California, California will require you to file as a foreign corporation, meaning you’re doing business there.
- Pay Fees: No matter where you file, you’ll likely have to pay a fee. If you have employees, equipment, or property in a state, you may need to file there and pay taxes. For example, California has an $800 franchise tax, and New York’s annual tax is around $350. Most states have these fees, though some may be as low as $50 or $100.
- File Payroll Tax in the States Where You Have Teams: If you have employees in different states, you’ll need to file for a payroll tax ID and pay payroll taxes for each state through your payroll provider. For example, if an employee moves from California to Wyoming, you’ll need to update your payroll system with Wyoming’s tax ID and tax rate, and start processing payroll as if they’re based in Wyoming.
We Can Help Your Startup
If you have any questions about startup taxes, seed-stage tax returns, or state and local taxes, please contact Kruze Consulting for help.
