How to start a corporation: Setup and operations for small businesses

Forming a corporation, or incorporating, is a major step in the life of an entrepreneur — and one that is not to be taken lightly. Some potential business owners consider a limited liability company (LLC) or a sole proprietorship, as both are easy to set up and operate. However, small business owners with a growth mindset consider setting up their new business as a corporation. 

A corporation can make sense for businesses that need more capital to grow or want to protect their owners from personal liability, but it requires quite a lot of work, critical decision making, and careful adherence to a multi-step process if it is to be done correctly.

Before incorporating, use this helpful guide to get the basics — whether it’s a C corporation or an S corporation. Plus, get valuable resources and tips to get the small business up and running. 

What is a corporation?

A corporation is a legal entity separate from its owners — it can make profits, be held legally liable, and be taxed.

There are two fundamental kinds of corporations to know about:

• C corporation. Commonly called a C corp, this entity is entirely independent of its owners and provides the strongest protection from liability. It is taxed on its profits and can be held liable — but its owners cannot. There is no limit to the number of shareholders in C corps, so they tend to be bigger businesses.
• S corporation. Known as an S corp, this is also a separate legal entity from its owners. For S corps, profits and some losses pass through directly to owners’ personal income. Since they avoid the federal income tax on corporate profits, they avert the double taxation drawback of C corps. S corps must make a special filing with the IRS to gain their status, and some states tax them differently. They are limited to 100 shareholders, so they tend to be smaller businesses.

Whether incorporating is the best type of business structure depends completely on your business goals. As all kinds of business structures do, corporations have pros and cons, which we explore in the next section.

What are the pros and cons of incorporating?

The advantages of incorporating include limited liability protection for shareholders, the ability to raise capital, ease of ownership transferability, and some tax benefits. The disadvantages include formality, diffused control, and certain tax disadvantages.

First, let’s look at the pros:

• Limited personal liability. The corporate structure protects shareholders — each of whom is a partial owner — from the liability, business debts, and taxation of the corporation. This means their personal assets are not at risk for satisfying the business’s obligations. Generally speaking, each shareholder is only at risk for the amount of money they have invested.
• Capital raising. Corporations can issue stock to raise capital to fund ongoing operations and future endeavors.
• Ownership transferability. Stocks can be bought and sold, making transferring ownership easy and the business’s existence perpetual. This structure contrasts with an LLC or a partnership, each of which can end with the departure of one owner.
• Tax advantages. S corps offer pass-through taxation, meaning corporate profits are not taxed twice — once at the business level and a second time when they are distributed to shareholders. Both S corps and C corps can take advantage of some favorable tax treatment, like deductions for employee benefits.

Next, the cons:

• Formality. Incorporating takes more effort and resources than creating a simpler business structure, like starting an LLC or sole proprietorship.
• Loss of control. Each shareholder has voting rights, and the board of directors needs to approve major corporate decisions. This means the company's founders do not have as much control as they would in other forms of business structure.
• Tax disadvantages. For C corps, corporate profits are taxed at the corporate level and then again when dividends are distributed to shareholders. This double taxation is a significant drawback to the corporate structure. 

In summary, incorporating is a good choice for small businesses that have — or want to have — a formal structure, will become a public company, and have owners and management who like a predictable and recognized legal structure, limited liability, and perpetual existence. For a more comprehensive comparison, Practical Law’s Entity Comparison Chart highlights the various structure, liability, tax, and management differences of business entities, including C corps and S corps.  

What do you need to know before starting a corporation? 

Before incorporating, there are some vital decisions to answer that will determine the best approach to take.

Determine which state to incorporate 

The state you choose for incorporation is important because the arrangement and internal workings of a corporation are affected by that state's laws, including both common law and statutory law. Because it is widely perceived as a business-friendly state, Delaware is a common choice for incorporation. Even so, that does not necessarily mean it is the best choice. 

Entrepreneurs who wish to incorporate should remember other factors to include, such as where the eventual entity will transact business and whether any legal, financial, or tax considerations might make another state a better choice.

Determine which form of corporation is best

The main differences between an S corp and a C corp come down to tax treatment and restrictions on size. S corps avoid double taxation by having profits and losses pass directly on to the individual shareholders, with no tax burden at the corporate level. The tradeoff is that they are limited to 100 shareholders and face some tax constraints like being limited to paying their employees a salary the IRS deems reasonable. 

C corps are not limited to any specific number of shareholders, but they are double taxed: once at the corporate level and a second time when profits pass on to the shareholders. C corps are more common because many small business owners find the limitations of an S corp to be too great a hindrance to aspirations for growth. 

Once you have reached your decision on these crucial considerations, it’s time to finally start your corporation. What follows is a general step-by-step guide.

How do you start a corporation? 

Broadly speaking, the steps to incorporating are:

• Select a business name. Ensure the corporate name you plan to register is not already in use.
• Designate a board of directors. The board’s role is to create a corporate vision and high-level oversight. C corporations usually appoint the board members, while the shareholders of S corporations typically elect them. 
• File articles of incorporation. The registered agent files the articles — sometimes called a certificate of incorporation, corporate charter, or formation documents  —  to prove a company’s legal existence in the state where the business is registered. 
• Draft corporate bylaws. Bylaws are the governing document for corporations, like the regulations and rules of how you will run it. 
• Obtain an Employer Identification Number (EIN). The IRS requires an Employer Identification Number (EIN). It identifies a corporation for purposes of paying taxes and is needed to open bank accounts, apply for business licenses, and pay taxes by mail.  
• Issue stock. The board of directors must authorize the issuance of new stock, specifying the class and number of shares to be issued and their par value. Once it has approved the issuance, the entity sets the stock's valuation based on what it thinks it is worth, considering things like the current economy and its own recent financial performance. 

The shares are then offered for sale either through a public offering — which requires registration with the Securities and Exchange Commission (SEC) and a raft of disclosures and compliance requirements — or through private placement, in which shares are offered only to a specific group of investors and the public disclosure requirements are greatly reduced. These days, physical paper stock certificates are rare, and most stock ownership records are electronic.

For a more comprehensive list of the key steps involved and key issues to consider, see Practical Law’s checklist about forming a corporation.

The best time to incorporate

The best time to start a corporation is when you start your business, assuming you have determined the corporate form is the best for your needs.

However, incorporation does not have to coincide with the start of your business. Here are some common junctures when it makes sense:

• When the business owners determine more capital needs to be raised
• When a business has been successful but needs to grow and is constrained by its current form
• When company owners in a sole proprietorship or partnership desire greater protection from liability

No educational requirements, licensures, or examinations are required to incorporate. That being said, starting one correctly and running it properly afterward takes some degree of skill, business familiarity, and dedicated time. Engaging counsel, be it legal, tax, or some other field, is never a bad idea to ensure you are conducting your business properly and that you won’t get tied up in too many business and legal administrative issues.

Start a corporation with one person

Incorporating with one person is called a single-member or one-person corporation. You will be the sole shareholder, the director, and the officer. 

The benefit to a single-member corporation is that you avail yourself of all the benefits — like protection from liability — without the complexity of a multi-owner corporate structure. The drawback is that even a single-member corporation has obligations to fulfill under the corporate form, like administrative, record-keeping, and compliance requirements.

How do you operate corporations?

A combination of groups and individuals runs corporations.

The board of directors members hold organizational board meetings to make overarching strategic and governance decisions. They are responsible for endorsing significant corporate decisions, overseeing executive officers, and ensuring they represent the shareholders' interests.

Executive officers, sometimes called the C-suite, are the top-level employees of the corporation. Typically, they include the chief executive officer, chief financial officer, and chief operating officer. Sometimes, they include the chief information officer, chief human resources officer or chief people officer, chief marketing officer, and similar roles. These executives supervise the day-to-day operations and execute the high-level strategies set forth by the board. 

Many daily operations — like hiring and overseeing everyday functions — are handled by managers a step or two down the ladder from the C-suite.

Typical challenges when operating a corporation

The initial challenges of operating a corporation after its formation include legal complexity, ongoing management and administration, lack of financing, and, for C corps, double taxation:

• Legal complexity. Filing necessary documents, drafting bylaws, and compliance with state and federal regulations often require a level of legal dexterity beyond the knowledge of the average business owner.
• Ongoing management and administration. Corporations are required to go through certain steps, including holding shareholder meetings, preserving corporate records, and meeting specific tax and reporting regulations.
• Double taxation. For C corps, profits are taxed at the business entity level and again when dividends are distributed to shareholders. This is called double taxation, which is not true for S corps.
• Lack of financing. Many startups run out of money quickly. Selling shares is a prime way they raise capital, but it may not be as easy as it seems at first glance. For example, to raise $1 million, you have to determine a price per share to achieve that amount. Then, you must determine whether the issuance of the necessary amount of stock is worth the administrative, record-keeping, and accounting burden that comes with the issuance of that stock and whether it is worth decentralizing control.

Conclusion

Ultimately, incorporating can be a very positive step in the growth of your small business. To pull it off successfully, make sure you understand the basics of incorporating — including pros and cons — and how to set up and operate one. The corporate business form offers both advantages and disadvantages. 

The crucial question in determining whether the advantages are worth it is whether you are comfortable with the process involved — selecting a business name, designating a board of directors, filing a certificate of incorporation, drafting bylaws, and, eventually, issuing stock. If you are, then incorporating is likely a good step for you.

Additional resources for startups and small businesses

Practical Law’s startups and small businesses collection has helpful material to support your business at every stage, including insights on hiring, funding, and scaling your business.

Corporation Forms is a looseleaf, multivolume set that eliminates the need to draft documents from scratch — from pre-incorporation agreements to the dissolution of a business.

Forms for Small Business Entities is a set containing forms relating to the principal types of business entities. It includes structural forms, operating forms, and tax forms. 

Advising Small Businesses is a pragmatic, multivolume guide for small business practitioners and their attorneys. It provides detailed guidance on the life cycle of a business entity, from choosing the entity to termination.

Federal Income Taxation of Corporations and Shareholders is a book providing guidance on navigating the tax code.