What is a corporation?

Corporations are misunderstood.

As a consequence, misconceptions about them abound. And while some entrepreneurs benefit from incorporating, at least as many do not.

To make an informed and intelligent decision as to whether you should incorporate and objectively evaluate what you accomplish when you do, you must understand what a corporation is, how to form one, and how to remain compliant.

What are the characteristics of a corporation?

A corporation is a legally independent entity owned by its shareholders. As such, the corporation is legally liable for its actions and debts, not the shareholders who own it.

Corporations are more complex than sole proprietorships, partnerships, and limited liability companies because they tend to have more administrative, tax, and legal responsibilities imposed on them. Because of this, corporations are generally better suited for more established and larger companies.

Because it is a legally distinct entity, separate from its owners, a corporation has many of the legal rights of an actual person. And its owners don't have to risk their assets if the corporation can't satisfy its obligations. But it also means that corporations are usually taxed separately from their owners.

You don't need to be a large company to be a corporation. In recent years, many small business owners also incorporate. The reason? To limit personal liability, protect assets, gain credibility, attract outside investment, and access more sophisticated tax-planning strategies.

How do you form a corporation?

A corporation exists when prospective shareholders file Articles of Incorporation with a state's business entities department, usually the Secretary of State.

The owners of a corporation are called shareholders, and shares of stock represent their ownership interests.

A corporation must have at least one shareholder. There is usually no limit on a corporation's number of shareholders, the most notable exceptions being an S-corporation limited to 100 shareholders and close corporations in states that recognize them.

Corporations and the IRS

In the eyes of the IRS, there are two types of corporations: C-corporations and S-corporations.

By default, all newly formed corporations begin as a C-corporation and are taxed separately from their owners under subchapter C of the Internal Revenue Code.

C-corporations file IRS Form 1120 and pay taxes on their profits. In turn, shareholders pay taxes when the corporation distributes the after-tax earnings as dividends. Thus the claim of "double" taxation.

Electing S-corporation status is one way to avoid double taxation. Once IRS Form 2553 is filed and approved, the IRS treats the corporation as a "pass-through" entity.

An S-corporation files IRS Form 1120-S but doesn't pay taxes at the corporate level. Instead, profits and losses are "passed" to and reported on the shareholder's tax return. Voila! No more double taxation.

What is a close corporation?

There are two types of corporations in some states: regular and close. Up to now, I've been referring only to regular corporations.

A close corporation is generally a smaller corporation that elects close corporation status at the state level and is entitled to operate without the strict formalities required to operate a regular corporation.

The shareholders and directors of a close corporation are allowed to operate more like a partnership because there are typically fewer than 30 shareholders.

Note: Not all states recognize close corporations.

What corporate formalities are mandatory?

Corporations have a set management structure. The shareholders elect a Board of Directors, who in turn elects officers. Other than the election of the directors, the shareholders do not usually participate in corporate operations.

The Board of Directors manages the corporation strategically, issues stock, and makes significant macro decisions. At the same time, corporate officers are responsible for the company's day-to-day operations.

A corporation must follow various formalities to preserve its status as a legally distinct entity. These formalities include appointing directors and officers, adopting bylaws and resolutions, holding formal meetings, and completing other compliance tasks that keep the corporation in good standing.

Failure to follow these formalities has serious consequences, including holding the shareholders personally liable for corporate debts and actions.

Advantages of a corporation

Limited liability protection. The foremost benefit of a corporation is the liability protection that corporate status affords its shareholders. Although the shareholders may lose their initial investment in the corporation, their assets remain protected.

Ability to raise capital. Second is the relative ease by which a corporation can raise money and attract talent. Investors are lured by capital gains if their stock appreciates and dividends for when the corporation makes a profit.

Unlimited life. Finally, a corporation has a perpetual duration. The corporation continues as a separate and distinct legal entity indefinitely. It exists until the shareholders decide otherwise.

Disadvantages of a corporation

Double taxation potential. In the case of C-corporations, there is the possibility of double taxation. Profits are taxed to the corporation when earned and then taxed to the shareholders when distributed as dividends.

Administratively complex. Corporations are highly regulated. Compliance and administrative complexities often require attorneys, accountants, and other specialists.

Lots of paperwork. There is much paperwork: bylaws, notices, waivers, annual reports, and multiple tax returns. And then there's the obligatory yearly meeting. And the list goes on.