Lately I’ve received a lot of questions from entrepreneurs about incorporation. This may be a reflection of the large number of businesses in start-up mode, or it could be a sign that the sole proprietorships formed a few years ago are ready to take the next step to a more formal business structure.

The decision to incorporate is an important one, and one that should be timed in the way that makes the most sense for your business. Incorporating can make a business appear more professional to clients, investors and business partners, but it’s not always essential. Before incorporating, you should understand the ways in which it impacts cash management, liability and taxes.

Since there is as much mystique as misinformation about incorporation, here are some facts that should help you decide whether to pursue an “Inc.” behind your company’s name.

• What is a corporation? A corporation is a legal entity that is separate from the people who own it. By existing on its own, it is viewed as acting separately from its owners when entering into business deals, borrowing money and managing other business-related activities. Its structure includes shareholders, who own the corporation and influence it through elections and votes; directors, who manage its affairs on a macro level; and officers, who handle day-to-day business decisions.
• Why incorporate? In many cases, incorporation provides a level of protection from personal liability for a business. This means your personal assets may be protected if something goes awry.

There are exceptions to this protection, including wrongs that you personally commit, personal guarantees you make to creditors, and laws at the state level that affect your personal liability. In addition, some professions may be found personally liable regardless of whether or not their businesses are incorporated. These include doctors, lawyers and accountants, among others.

• Why not incorporate? A corporation’s profits may be taxed twice. The first taxation occurs when the corporation declares its income. The second happens when profits are distributed to shareholders, who then pay tax on these earnings.
  Pursuing status as an “S corporation” can help to alleviate this double tax. S corporations elect a special tax status with the Internal Revenue Service. Under this arrangement, the business’s income is reported on only shareholders’ tax returns. To qualify for “S corp.” classification, a company must be a U.S. business with one class of stock and fewer than 75 shareholders.

• Where should a business incorporate? While companies are not required to incorporate in their own state, many choose this option because it is often more affordable than pursuing incorporation in another state. In general, consult an attorney or accountant when choosing an incorporation location because the decision involves weighing the advantages and disadvantages of each state’s corporate laws and tax structure.
• Who should incorporate? I’ve seen many businesses rush to incorporate though they would have been just as well off postponing the decision. Incorporating because you will feel like your business is more legitimate is not good motivation. Incorporating to limit your shareholders’ liability, pursue financing or enhance the benefits you offer employees are more legitimate motivations. Consult with an attorney if you are unsure whether incorporation is right for you.
• How do I start the incorporation process? In order to incorporate, businesses must file articles of incorporation with their state and pay related fees and taxes. You may want to work with an attorney to gather advice on how to proceed.

Another option is to work with an online service that specializes in handling companies’ incorporation paperwork. To find out more about the incorporation process, visit the Web site of one such company Business Filings Inc. at www.bizfilings.com.

Alice Bredin is author of the “Virtual Office Survival Handbook” (John Wiley & Sons) and a nationally syndicated columnist.