Corporations are misunderstood and, as a result, misconceptions about them abound. Some entrepreneurs definitely benefit from incorporating while at least as many do not. For you to make an informed and intelligent decision as to whether or not you should incorporate and objectively evaluate what can and cannot be accomplished when you incorporate you must have a basic understanding of what a corporation is, how you form one, and what the advantages and disadvantages are.
A corporation is an independent legal entity owned by its shareholders. This means that the corporation itself 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 is given many of the same legal rights as an actual person. And its owners don’t have to risk their personal assets in the event the corporation can’t satisfy its obligations. But it also means that corporations are usually taxed separately from its owners as well.
You don’t need to be a large company to be a corporation. In recent years, many small businesses have made the decision to incorporate to not only limit their personal liability and protect their personal assets but also gain credibility, attract outside investment, and access more sophisticated tax-planning strategies.
How to form a corporation
A corporation comes into existence when prospective shareholders file a charter document with a state’s business entities department, which is 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 owner. There is usually no limit on the number of shareholders a corporation can have, the most notable exception being an “S” corporation that is limited to 100 shareholders.
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. They file a corporate tax return and pay taxes on their profits. When these profits are then distributed to the shareholders the shareholders will pay taxes on the distribution.
Certain corporations elect to be treated as an “S” corporation for federal tax purposes by filing Form 2553 with the IRS. This election causes the corporation to be treated as a “pass-through” entity. The corporation files an informational tax return but doesn’t pay taxes at the corporate level. Rather, the profits and losses are “passed through” the business and reported on the shareholders personal income tax returns. Electing “S” corporation status is one way of avoiding “double” taxation.
Sometimes, at the state level there are two types of corporations as well: 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 and is entitled to operate without the strict formalities required in the operation of a regular corporation. Simply stated, it is a corporation whose shareholders and directors are allowed to operate more like a partnership because there are typically less than 30 shareholders. The close corporation election is made at the state level but a number of states do not recognize them.
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 the operations of the corporation. The Board of Directors manages the corporation at a strategic level, issues stock, and makes major decisions and the Officers are responsible for the day-to-day operations of the company.
A corporation must follow various formalities to be recognized as a legally distinct entity. Failure to follow these formalities can have serious consequences, including holding the shareholders personally liable for corporate debts and actions. These formalities include: the appointment of directors and officers, adoption of bylaws and resolutions, holding formal meetings, and completing other compliance tasks that keep the corporation in good standing.
Advantages of a corporation
Limited liability protection—the foremost benefit of a corporation is the limited liability protection that corporation status affords its shareholders. Although the shareholders may loose their initial investment in the corporation, their personal assets remain protected.
Ability to raise capital—Second is the relative ease in which a corporation can raise capital and attract talent. Investors can be lured with the prospect of capital gains if their stock appreciates and dividends for when the corporation makes a profit.
Unlimited life—a corporation has perpetual duration. The corporation can continue as a separate and distinct legal entity and its shares transferred from one owner to another 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 and often require attorneys and accountants to remain in compliance with the state and to navigate all the administrative complexities.
Lots of paperwork—there is a lot of paperwork: bylaws, notices, waivers, annual reports, and multiple tax returns. Not to mention regular annual meetings. And the list goes on.