What is a corporation?
What sets the corporation apart from all other types of businesses is that a corporation is an independent legal entity, separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners. Other important characteristics also result from the corporation's separate existence: A corporation does not dissolve when its owners (shareholders) change or die, and the owners of a corporation have limited liability -- that is, they are not personally responsible for the corporation's debts.
What is "limited liability" and why is it important?
If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and obligations of the corporation. In other words, if the corporation is sued, only the assets of the business are at risk, not the owners' (shareholders) personal assets, such as their houses or cars. The corporation's owners must comply with certain corporate formalities, keep up with paperwork requirements, and adequately fund ("capitalize") their business to maintain this limited liability privilege.
Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating. However, other business structures, such as limited liability companies (LLCs), now offer this limited personal liability to business owners. Sole proprietorships and general partnerships do not.
How are corporations different from partnerships, sole proprietorships, and LLCs?
Unlike corporations, partnerships and sole proprietorships do not provide limited personal liability for business debts. This means that creditors of those businesses can go after the owners' personal assets to collect what's due. However, organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, because no formal paperwork is required.
A limited liability company (LLC), on the other hand, does offer limited personal liability, like a corporation. And while formal paperwork is required to form an LLC, running an LLC is less complicated than running a corporation. LLC owners do not have to hold regular ownership and management meetings or follow other corporate formalities, for example.
Corporations also differ from other business structures in the way they are taxed. The corporation itself must pay corporate income taxes on its profits -- whatever is left over after paying salaries, bonuses, and other deductible expenses. In contrast, partnerships, sole proprietorships, and LLCs are not taxed on business profits; instead, the profits "pass through" the business to the owners, who report business income or losses on their personal tax returns.
Who should form a corporation?
Because of the expense and formalities involved in setting up a corporation and issuing stock (shares in the corporation), you should form a corporation only if you have good reason to do so. If you merely want to limit your personal liability for business debts, forming a limited liability company (LLC) is probably smarter, because LLCs cost less to form and are easier to run. But here are some situations in which incorporating your business instead of forming an LLC might make sense:
- Your business needs the ability to issue stock or stock options to attract key employees or outside investment capital.
- Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year. This strategy, called "income splitting," takes advantage of the lower tax rates on corporate income of up to $75,000.
- You own a family business and you want to begin making gifts of ownership to your family as part of your financial or estate plan or to plan for the next generation of owners. You can easily make gifts of shares in your corporation without necessarily giving up management control and, if it's done correctly, without paying gift tax.
- Others insist that you incorporate your business. For example, if you are an independent contractor, companies you want to work for may ask you to incorporate before they will sign contracts for your services. These companies don't want the IRS or another government agency to reclassify you as an employee, which is very unlikely if you are incorporated.
How do I form a corporation?
There are several steps required to legally create a corporation. The first is filing a short document called "articles of incorporation" with the corporations division of your state government. (Some states refer to this organizational document as a "certificate of incorporation," a "certificate of formation," or a "charter.") You'll have to pay a filing fee that ranges from about $100 to $800, depending on the rules of the state where you file. This document contains basic information such as:
- the name of your corporation
- the corporation's address
- the name and address of your "registered agent" (the person to be contacted by any member of the public who needs to speak to someone about the corporation), and
- in some states, the names of the corporation's directors.
When forming your corporation, you must also create "corporate bylaws," a longer document that sets out the rules that govern your corporation, including decision-making procedures and voting rights.
Finally, before you start doing business, you must hold an initial meeting of your board of directors to take care of some formalities, and you need to issue shares of stock to the initial owners (shareholders).
Does running a corporation involve more paperwork than running other types of businesses?
Yes. Corporations must comply with statutory rules that unincorporated businesses, such as limited liability companies (LLCs), partnerships, and sole proprietorships, do not. For instance, corporations must observe corporate formalities such as holding and taking minutes of annual shareholder and director meetings and documenting important decisions. Also, corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping system to record business transactions, complete with daily journals and a general ledger.
How is corporate income taxed?
Unlike sole proprietors and owners of partnerships and LLCs, a corporation's owners do not pay individual taxes on all business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends. (Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings").
Note that this taxation scheme does not apply to S corporations, which are corporations that have elected partnership-style taxation. (Regular corporations, discussed above, are called C corporations.) If your corporation elects to be taxed as an S corporation, all of the corporation's profits and losses will "pass through" to the owners, who will report them on their individual income tax returns.
What is double taxation? Does it mean that corporate income is taxed twice?
Many people have heard that corporate income is taxed twice: once to the corporation itself and then a second time when earnings are paid out to the corporation's owners (shareholders). This is true only for earnings paid out to shareholders in the form of dividends -- that is, profits paid by the corporation to its shareholders in return for their investment in the company.
In practice, this sort of double taxation seldom occurs in a small corporation. The reason is simple: Shareholders rarely pay themselves dividends. Instead, they work for the corporation and pay themselves salaries and bonuses. Because the corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay corporate tax on them. (Dividends, on the other hand, are not a tax-deductible corporate expense, so both the corporation and the shareholder must pay tax.) As long as you work for your corporation, even in a part-time or consulting capacity, you can avoid double taxation by taking home profits in the form of a salary and bonuses rather than dividends.
What is a professional corporation?
A professional corporation is a special kind of corporation that only members of certain professions, such as lawyers, doctors, and healthcare workers, can create. By forming a professional corporation, professionals can limit their personal liability for the malpractice of their associates.
Do I need to worry about securities laws when I issue stock in my corporation?
Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to jump through some hoops before accepting investments in exchange for shares of stock (the "securities"). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Registration takes time and typically involves extra legal and accounting fees.
Fortunately, many small corporations can skip the registration process because of exemptions provided by both federal and state laws. For example, SEC rules don't require a corporation to register a "private offering," which is a non-advertised sale of stock to either:
- a limited number of people (generally 35 or fewer), or
- those who, because of their net worth or income earning capacity, can reasonably be expected to take care of themselves in the investment process.
Most states have enacted their own versions of this popular federal exemption.
If you and a few associates are setting up a corporation that you'll actively manage, you will no doubt qualify for an exemption, and you will not have to file any paperwork. For more information about federal exemptions, visit the SEC website at www.sec.gov. For more information on your state's exemption rules, go to your secretary of state's website; you can find links to each state's site at the website of the National Association of Secretaries of State, www.nass.org.
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