Depending on which corporation type you decide is right for you, there is some flexibility on where you incorporate in the United States. Many entrepreneurs incorporate their enterprise - whether it’s nonprofit or for-profit - in the state where they live and conduct most of their business. However, each state differs in their incentives and penalties for doing business. Some states provide tax breaks to entrepreneurs, while others charge more heavily. Many entrepreneurs have found incorporating in another state to be better for their bottom line.
The vast majority of all U.S. corporations (by some estimates, 85%) incorporate in either Delaware or California, which have the most elaborate set of court decisions governing corporate law. The top states for incorporation include Delaware, California, Nevada, Maryland, Pennsylvania, and Connecticut. If you incorporate in a state other than the location of your principal place of business, or if you have employees or operations in other states, you will need to consider qualifying as a foreign corporation to do business in other states as well.
Nonprofits most often incorporate in the state where its programs or services will be conducted, because of the requirement to register the corporation and apply for separate tax exemptions in each state in which the nonprofit organization conducts business.
The process is the same for both nonprofits and for-profits.
Find a qualified lawyer knowledgeable about your industry and equipped to help you navigate your dual goals of profit and purpose. Legal fees for incorporation can range from $500 to $1,000 or more. (It is possible to file for incorporation without the help of an attorney by using books and software, however the process can be time-consuming and there’s a chance you could make a mistake or miss small but costly details. We do not recommend incorporating without qualified legal counsel.)
Conduct a name search prior to filing your articles of incorporation to ensure that your desired corporation name is available in your state. In most states, you can file a name reservation, for a fee, if you wish to place a hold on the name until you incorporate.
Contact the state office responsible for registering corporations in the state where you seek to incorporate. You will need instructions, forms, and fee schedules on business incorporation.
Prepare articles [or certificate] of incorporation. Some states will provide you with printed forms to complete, that include the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation. Typically, this document will appoint the first board of directors or, if a company prefers to avoid public disclosure of the board of directors, the name of a sole incorporator with power to appoint a board of directors.
Define a set of bylaws that describe the governance mechanisms for how your corporation will operate, including the responsibilities of the shareholders, when stockholder meetings will be held, and other details important to running the organization. These will include the rules your management will follow in leading the organization, and your board of directors will follow in overseeing management.
Formally adopt the organization’s mission, articles of incorporation, and bylaws at your first board meeting.
If a for-profit, issues stock to the initial stockholders. This will typically be approved at the first board meeting and is important to accomplish at the earliest time, as state law will often not consider a company to be duly incorporated until shares of stock have issued.
Obtain a business license or foreign qualification to do business, if necessary. Your state, city or county government may require a business license or additional registration before you start operations.
There are numerous types of tax-exempt organizations, detailed in IRS publication 557. Social enterprises are most frequently categorized as 501(c)(3) or 501(c)(4) exempt organizations. Applying for exempt status happens after incorporation:
Establish your nonprofit corporation, which is a state-level process that establishes a nonprofit corporate entity by the filing of articles of incorporation or similar charter document. The articles of incorporation must explicitly state that a corporation’s activities will be limited to the purposes set out in section 501(c)(3) of the Internal Revenue Code (or other relevant provision), that the organization will not engage in political or legislative activities prohibited under section 501(c)(3), and that upon dissolution of the corporation, any remaining assets will be distributed to another nonprofit, government agency, or for another public purpose. (The vast majority of nonprofits organize as corporations for a variety of reasons detailed above, especially to limit liability for the officers, directors and other key individuals.) The incorporation process also requires preparation of bylaws.
Obtain a federal tax ID number (FEIN) for your corporation from the IRS
Apply to the IRS with Form 1023 to request exempt status. Form 1023 is nearly 30 pages long and requires attachments, schedules and other materials that can easily cause submissions to be more than 50 pages long. The IRS wants to ensure that the organization is formed for exclusively for exempt purposes and that its programs are designed to fulfill these stated purposes. In addition, the IRS is looking closely for conflicts-of-interest and the potential risk that the operations of the organization might result in personal benefit to insiders, either of which could be possible grounds for denial.
Address State compliance issues, which vary based on your state(s) of operation.
Forty U.S. states require “Charitable Solicitations Registration.” Most states require registration prior to soliciting donations.
State Corporate Tax Exemption – Most states recognize the federal exempt status as valid for a similar state exemption. California is a big exception, requiring its own application and review process for charitable status. Several other states require a separate application, but those are typically simpler registrations.
State Sales Tax Exemption – Many states grant an exemption to charities allowing them to purchase items for use by the organization without paying sales tax. Applying for exemption usually requires that a nonprofit has already obtained federal exempt status.
As stated in the section “What If I’m Not Ready to Incorporate?,” fiscal sponsorship is an option that allows social-purpose projects to get their charitable status through their fiscal sponsor, where the fiscal sponsor assumes responsibility for all legal, taxation, and regulatory issues for sponsored projects, as well as decision-making discretion over the use of funds.
For the most part, we have spoken in terms of for-profit and nonprofit corporations. Lawyers possess a much broader array of tools in their toolkit, including various types of pass-through entities (limited liability companies, sole proprietorships, partnerships, S corporations, etc.), cooperatives, unincorporated associations, and trusts. These structures are not explored in depth in this content because, in most cases, they do not position social entrepreneurs to optimize their goals around the seven factors. In particular, other than the use of pass-through entities with tandem structures, as a broad generalization, these other options are seldom used and are rarely funded by institutional capital.
In the United States (unlike most other countries), corporations are subject to “double taxation:” 1) they are taxed on corporate income at the entity level, and 2) individual shareholders are taxed again on the income when it is distributed to them, either as a dividend or distribution of profits. For tax efficiency reasons, some will recommend that entrepreneurs establish a pass-through entity that pays no income taxes at the corporate level, but rather only at the individual owner level. Such advice, while well-intentioned, often fails to fully appreciate the circumstances of the classic start-up which rarely pays dividends. In the typical case, start-ups (even highly profitable start-ups) re-invest income to scale and grow their impact, making double taxation concerns inapplicable.
Sometimes, entrepreneurs will be advised to create a pass-through entity as a way to harvest losses on an individual tax return, rather than capturing them inside a corporation. Although this can sometimes be advantageous to investors, it seldom results in a significant advantage to entrepreneurs because they must have income against which to offset the losses, and individuals, unlike a corporation, cannot carry losses forward into future years. More importantly, however, just as losses hit the individual owners’ returns, so too will income, without necessarily assuring that the company will desire, or be able, to distribute the cash needed to pay taxes on that income.
Finally, institutional capital will rarely invest in a pass-through entity, primarily for tax reasons relating to the regulation of pension assets invested in most venture funds, but also because the diligence involved in reviewing a pass-through is more time-consuming (and therefore, more costly) than the diligence required in reviewing a corporation (particularly the very familiar Delaware corporation). As a result, most entrepreneurs (knowing that they will ultimately be required to convert a pass-through to a corporation) will opt to start with a corporation rather than bearing the additional cost of starting as a pass-through entity and then converting to a corporation.
Nevertheless, if your social enterprise is likely to raise funds from high net-worth individuals only, you may want to consider some of the pass-through forms and whether they could work for you.
Cooperatives are owned by and operated for the benefit of their members and distribute profits and earnings among the members. Depending upon the cooperative, members can be any of the various stakeholders in the business -- customers, vendors, growers, employees, etc. Members can become part of the cooperative by purchasing shares, although the number of shares held does not affect the weight of their vote. The amount a member has invested in the cooperative does not affect the weight of each vote, so no member can dominate the decision-making process. The "one member-one vote" approach can appeal to smaller investors because they have as much “voice” in the organization’s governance as a larger investor. However, larger investors often prefer to invest money elsewhere where they can wield decision-making power proportionate to the size of their investment. Generally, cooperatives suffer from slower cash flow, given that a member's incentive to contribute depends on how much they use the cooperative's services and products. This limitation can be a barrier to scaling the size and impact of the venture. Cooperatives are more frequent in some industries like agriculture. Often, the member structure of a cooperative affects governance in a variety of ways -- some positive and some negative. Entrepreneurs seeking to empower a variety of stakeholders in their governance structure and considering structures other than a corporation should remember that just as a corporation produces shareholder primacy in governance considerations, the cooperative elevates some other stakeholder (the customer, grower, vendors, employee members) to the same position of primacy. Without other features added, governance typically becomes a challenge in cooperatives, in addition to the other challenges noted above.
Unincorporated associations are formed when people get together and decide to perform some task without filing legal paperwork or establishing a formal legal structure. If their work generates profit, then most states deem them to have formed a partnership. But if their work creates a public benefit (by example, from raising funds for a particular cause or conducting a public education campaign), they will be deemed to have formed an unincorporated nonprofit association. An unincorporated nonprofit association has no separate legal existence apart from its members, and members generally can be personally liable for its debts and liabilities. A few states have legal protections for members or enabling statutes for unincorporated associations, but more frequently these entities cannot hold property or sign contracts. An association with revenue exceeding $5,000 must apply for IRS recognition by filing a Form 1023 along with written bylaws or a constitution. Nonprofit unincorporated associations generally form to accomplish a specific short-term goal and are not adequate vehicles for pursuing a social mission in the long term.
Trusts are typically used as estate planning vehicles that give responsibility for managing and preserving property to a person or entity called the trustee, and are otherwise typically used only in specialized circumstances (for example, as part of a special feature to a social impact bond deal or other specialized transaction). The beneficiaries of the trust receive trust assets according to terms established in the trust instrument. Charitable lead trusts allow certain benefits to go to a charity and the remainder to beneficiaries. Charitable remainder trusts allow the investor to receive an income stream for a defined period of time and stipulate that any remainder go to a specified charity. Trusts are sometimes used as an “anchor owner” of shares or interests in the social enterprise. This approach to mission anchoring aims to provide a longer-term solution for mission anchoring than when shares are held by an individual, who is subject to life changes such as death, divorce or a change of heart, that can also alter ownership. Typically, however, investors wish to see that the founder personally holds sufficient ownership in the social enterprise to align the founder’s interests with those of the investor and are reluctant to have trustees bear power of decision-making involved in voting shares. If a significant portion of the founder’s interest is held in trust, it may not be viewed the same by an investor.
When helping entrepreneurs select the “right” legal structure, two questions inevitably arise: (1) “Can’t I simply incorporate cheaply and fix it all later when I have the time and money?” and (2) “So what if I get it wrong, can’t I just switch later?” Each deserves a brief answer here, although you should remember that this resource was specifically designed to help the entrepreneur to make a carefully informed choice in the first instance.
With web enabled services helping entrepreneurs incorporate and set up basic form documents, law firms, especially in Silicon Valley, have been publishing form documents for some time, mostly as a lead generation tool in their business development models. Often, to make this economical, firms relegate the incorporation work to low-level lawyers with limited experience to compete with software-enabled solutions, or engage social entrepreneurs as pro-bono clients or on a deferred payment basis. Finally, there are services that take a “form” approach to setting up a social enterprise (whether in a traditional mode, or new services that are tailored to those seeking B Corporation certification). None of this is inherently wrong or bad. In fact, many of these options are attractive in the “lean start-up” environment.
But they also deserve a word of caution for the social entrepreneur: sometimes you get exactly what you pay for. As other content on this site makes clear, the needs of the social entrepreneur often require specialized considerations that won’t fit a template or form, or are not easily navigated by a less experienced lawyer. In addition, pro bono services (or services where lawyers are not getting paid) can often produce slower turn-arounds on documents and, occasionally, can result in lower quality work. For the unsuspecting entrepreneur, these risks are typically not discernable on the front-end of the choices made around documenting legal structure, but only become painfully obvious later -- sometimes when it is too late.
The entrepreneur often considers incorporating cheaply using form documents obtained online, and then cleaning it up later (including switching legal forms later, if needed), often around the time of the first institutional investment in the case of a for-profit corporation. Often, this is easier said than done.
First, there are certain aspects of organizational structure that are difficult or impossible to change later once a for-profit is ready to take institutional funding. For example, implementing mission anchoring features once a potential investor is engaged can be quite challenging.
Second, changing certain features can be more costly than doing it right the first time, albeit, in most cases, only marginally so. But in the case where potential investors are involved in due diligence, some changes can pose governance concerns and/or raise other questions.
Finally, changing the type of entity can be challenging or even impossible. For example, changing from for-profit to nonprofit requires approval from all the stockholders. Changing from a nonprofit to a for-profit is likely to be impossible or very expensive and time consuming, at the least.
For these reasons, most entrepreneurs opt to spend the effort to get it right in the first instance, albeit as inexpensively as possible.