How to Incorporate

An LLC is a better option in the event that you simply dissolve the company. The IRS considers an LLC's assets to belong to its members, so when a business is dissolved and its property distributed, the IRS does not recognize a taxable event. Instead, the transaction officially occurs when the individual sells those assets. When a corporation is terminated, on the other hand, the IRS does view the distribution of assets to owners as a taxable event.

In some states, LLC members may not sell their stake without the consent of other members. A corporation shareholder, by contrast, can sell his or her stake without such approval -- assuming there's no prior agreement to the contrary.

Regardless of the form you choose, consider drafting a buy-sell agreement that determines how partners can cash out. It is not cheap; Karp charges from $5,000 to $10,000 to draft one. But it can head off serious trouble. At the outset, "nobody is planning on retiring, getting disabled, or getting divorced, so the agreement is more likely to be fair and impartial," says Karp. If you wait until later, it becomes harder to negotiate.

And if you don't accurately anticipate your exit strategy? You may be able to change structures. See "Conversion Factors".

CONVERSION FACTORS

Once a sole proprietorship or partnership becomes a corporation, it can't revert without great tax consequences. Apart from that, you have flexibility when it comes to changing the legal structure of your business and can, with some limitations, go from an S corp to a C corp and back.

What are the limitations? The IRS generally frowns on conversions that are obviously intended to avoid tax on transactions. For instance, a C corp that sells an asset that has appreciated in value cannot take the "S" election simply to avoid capital gains tax. (For the first 10 years, an S corp is liable for a special "built-in gains" tax when selling appreciated assets.) And a company that switches to S-corp status and revokes it can't do it again for five years.

Go corporate. Karp recommends making the transition to a C corp in the tax year prior to the year in which, say, you plan to go public or merge. A good rule of thumb is to allow at least six months, and ideally more than a full year, between the changeover and the transaction.

Wait for the new year. If you change your business entity in the middle of the year, you will have to file two tax returns, says Gail Rosen, a CPA in Martinsville, New Jersey. That will cost you more in accountant fees.

Switching to an LLC. It is easy to change a sole proprietorship or partnership into an LLC. Depending on the state, you file either a conversion form or new articles of organization, pay fees, and transfer authorities and IDs. In some states, partnerships also have to publish a notice of termination in the local paper.

Doing the Paperwork

LLC: After choosing a unique name (which must end in a variation of Limited Liability Company), you file articles of organization with your state. Many states allow you to do so online; others provide a template to use. Though not required by law, an operating agreement that defines the basic rights and responsibilities of the LLC's members is also crucial.

Corporation: Incorporation begins by selecting a name and filing articles of incorporation, which in most states simply entails completing a registration form. (Filing fees vary by state, from $100 to $1,000.) Then, the founders must appoint directors and draft the company's bylaws, which stipulate how the business will operate. Finally, the new corporation must deliver stock certificates to its shareholders.