Pros and Cons of Incorporating a Startup

One of the biggest advantages of (and most often stated reasons for) incorporating a business is limited liability. Limited liability is the legal concept that the owners’ or shareholders’ financial liability for a company’s actions or debts is limited to their investment in the company.

Unincorporated businesses (i.e., sole proprietorships and partnerships) have unlimited liability. Should an unincorporated business be unable to pay its debts, the owner or partners may be held personally liable, and their personal assets may be at risk.

Incorporated businesses (i.e., both LLCs and corporations) provide limited liability, protecting a company owner’s personal assets from things like lawsuits and being held personally responsible for the company’s debts.

Another advantage of incorporating a startup is the separation of personal and business assets. (Yes, incorporating requires that you separate personal and business assets.) This separation of personal and business assets establishes and maintains the corporate veil.

In order for the company to be considered a separate legal entity, a separation must actually exist. This means that you will have to establish and maintain a corporate veil. The corporate veil is the legal concept that the corporation is a legal entity separate from its owners (members or shareholders). This is the aspect of a corporation that provides personal liability protection for the owners of the corporation.

When your personal and business accounts are mixed, your personal assets (including your home, your car, and other valuables) could be at risk in the event someone sues your business. In business law, this is referred to as piercing the corporate veil.

Another major plus of incorporation is that LLCs and corporations have perpetual existence beyond the life of their owner(s). In fact, corporations have unlimited lifespans. 

In informal business structures (sole proprietorships and partnerships), the business is directly tied to its owner(s) and formally ends with the life of its owner(s). Incorporating, on the other hand, designates a business as a formal legal entity that is not tied directly to its owners. Even if the owners or shareholders of the business exit the business or pass away, the corporation will continue to exist.

Another pro of incorporating a business is that an incorporated business builds credibility and trust. When you incorporate a business, whether you form an LLC or a corporation, you make it its own entity, showing that you are serious about your startup and are in it for the long haul. 

Further, as you know, LLCs and corporations extend beyond the life of their owner(s) and can continue indefinitely. This communicates a sense of stability for customers, employees, investors, and other stakeholders.

Moreover, corporate designations such as “limited liability company,” “company,” “corporation,” and “incorporated” (LLC, Co., Corp., and Inc., respectively) build the legitimacy and credibility of your startup. They make your startup seem more real and more professional. 

Another major plus to incorporation is that incorporating provides ownership flexibility. When it comes time to take on investment or sell your stake in the business, the flexibility and transferability of ownership become extremely important.

The amount of ownership flexibility varies depending on the legal entity of the venture. LLCs, S corporations, and C corporations each have varying degrees of ownership flexibility, including who can have an ownership interest and the transferability of ownership.

LLCs have some ownership flexibility and may allow for some transferability. LLCs can be owned by individuals, trusts, other LLCs, or corporations, and there is no limit on the number of members unless the LLC chooses to be taxed as an S corporation. Although some states do not allow the sale or transfer of ownership in an LLC, many states allow ownership to be transferred without having to dissolve the business. However, there may be numerous restrictions in the transfer of ownership both by the state as well as in the LLC’s operating agreement. For instance, LLC operating agreements may require the approval of the other members to transfer ownership before admitting a new member.

S corporations also have some ownership flexibility and ease in transferability of ownership. LLCs and C corporations that choose to be taxed as S corporations are limited to 100 members or shareholders, all of whom must be US citizens. Other LLCs, corporations, trusts, or foreign investors can not invest in an S corporation. The transferability of S corporation shares will depend on whether the legal entity of the S corp is an LLC or corporation. 

C corporations have the most ownership flexibility and ease in transferability. C corporations can be owned by individuals, trusts, LLCs, or other corporations, and there are no limits on the number of shareholders. The shareholders in a C corporation can also typically transfer shares to others with limited restrictions (unless the shareholder’s agreement specifically states otherwise). This is part of what makes C corporations the preferred choice of investors.

Another pro of incorporating a business is that incorporated businesses are more attractive to investors. If you are seeking an investment, it is likely that your investors will want — or rather demand — that you are incorporated. Most investors are not willing to invest without the personal liability protection, taxation advantages, and ease of transferability of shares provided by incorporating. 

LLCs, S corporations, and C corporations each have differing rules for investors and treat taxation differently. While many founders and co-founders prefer the simpler pass-through taxation structure found in LLCs and S corporations, investors typically prefer the corporation to be taxed, and they themselves report and pay tax on the capital gains only when the gains are realized. 

And, because non-human investors (e.g., angel funds, venture capital funds, etc.) can not invest in LLCs or S corporations, if you hope to raise money from angel funds or venture capital, a C corporation is likely your only choice.

Another major plus is that LLCs and corporations may each provide several tax advantages, depending on your startup’s specific tax situation. There are numerous factors to consider when comparing the tax considerations of incorporating your startup.

First, both LLCs and corporations can choose their tax structures. By default, LLCs are taxed as a pass-through tax structure — either disregarded entities or partnerships. However, LLCs can also elect to be taxed as an S corporation or as a C corporation. Likewise, corporations can also choose between C corporation and S corporation tax statuses, providing flexibility in seeking the best tax structure for your startup.

Second, depending on the tax structure you choose to operate under, corporate tax structures provide you flexibility in determining how your income from the business is paid and taxed. In companies that choose C corporation and S corporation tax structures, after paying owners a fair salary, owners are compensated through dividends, distributions, retained earnings, and capital gains, which are all taxed at preferential tax rates.

Third, C corporations also allow you to reinvest profits back into the business without having to pay tax on them first. In LLCs and S corporations, profits are passed through to the members or shareholders as income; however, in C corporations, shareholders only pay tax on dividends, making it easier to reinvest profits back into the corporation.

One of the biggest hindrances to incorporation is the formation costs. Although the cost of incorporating a startup varies by state, the price typically ranges from a few hundred dollars for DIY options to thousands of dollars to have a startup attorney handle your incorporation.

You may also incur additional legal costs to draft and execute a Founder’s Agreement, confidentiality agreements, or assign IP rights.

Another big disadvantage of incorporating is the additional paperwork. Incorporating a business can be complex and requires an abundance of paperwork. This can be a huge administrative burden.

To establish and maintain an LLC or corporation, you must compose and adopt articles of formation (LLCs) or articles of incorporation and bylaws (corporations), keep detailed records of decision making and minutes from board meetings, and maintain a record of members, directors, officers, and/or shareholders.

You will also have to file annual paperwork in your state and complete and file local, state, and federal tax returns. Additionally, LLCs and corporations have to report earnings to their members and shareholders, and corporations are required to compose and file annual reports with their shareholders.

Another con of incorporating is the ongoing cost. Filing and reporting requirements, as well as the additional paperwork of an LLC or corporation, also result in ongoing costs to keep the corporation registered and compliant. 

For example, there may be fees associated with registering your business annually with your state, you may have to retain a registered agent for your business, and you may have to pay an accountant to compile and file financial records, tax filings, and annual reports. All of these costs add up, and in the early, cash-strapped days of a startup, they can be a huge burden.

“Double taxation” is when profits are taxed at both the business and personal levels. Incorporating your startup can lead to potential tax disadvantages. In some situations, you will pay income taxes on the same income twice and pay more in taxes. This is called “double taxation.” 

In sole-proprietorships, partnerships, LLCs, and LLCs with an S corporation tax structure, earnings are passed through to the owners or shareholders and taxed (only once) on the individuals’ personal tax return.

Double taxation occurs when corporations (C corporations) pay tax on their profit, distribute earnings to shareholders via dividends, distributions, or capital gains, and then shareholders pay tax on their dividend and capital gain income. 

Corporations can avoid double taxation by choosing to be taxed as an S corporation. However, S corporations come with their own drawbacks and disadvantages as well.

The next step is determining whether you should form an LLC or a corporation.

Or, if you have already determined whether an LLC or a corporation is right for you and you’re ready to get started, read our full guide on How to Incorporate a Startup.

Recommended: Need additional help choosing a business structure? Visit our LLC vs. Corporation or How to Choose a Business Structure guide to find out which structure is best for your small business.

1. Choose a Business Structure
2. Determine a Location
3. Establish Share Structure
4. Split Equity Among Founders
5. Hire a Professional Service or Incorporate Yourself By:
1. Appointing a Registered Agent
2. Holding an Organizational Meeting (Bylaws, Initial Directors, etc.)
3. Filing Articles of Incorporation
4. Getting an Employer Identification Number (EIN)

We recommend reading our full guide on how to start a corporation. You can also learn what to do after incorporating your startup.

Interested in a different business structure or haven’t launched your small business or startup yet? Check out our other formation guides:

• How to Form an LLC
• How to Form a Nonprofit
• How to Start a Business
• How to Start a Startup