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Operating a Corporation
What distinguishes a Corporation from all other business structures is that a Corporation is a distinct, legal entity, independent from the individuals who own, manage, and control it. Another way of putting it is that Corporation and Tax Laws recognize a Corporation as an individual that can enter contracts, have debt, and pay tax separately from its owners. There are also other benefits that are the result of a Corporation being a recognized as a separate entity, including the fact that a Corporation can survive the change or death of its shareholder owners. In addition, the shareholders are not personally liable for the Corporation’s debts because of the limited liability protection that is inherent in a Corporation.
Why is “Limited Liability” so important to a business owner?
Since the owner of an incorporated business has “limited liability” protection, this means that he cannot be held personally liable for the debts and other business obligations of the Corporation. Should any legal action ever be brought against the Corporation, only the Corporate assets are vulnerable, not the personal assets of the owner shareholders, such as their cars or houses. In order to maintain this privilege of limited liability, the owners of the Corporation must abide by several Corporate formalities, maintain their Corporate paperwork, and provide adequate capital to fund their Corporation.
Traditionally, limited liability has only been attributed to Corporations, so it is the main reason most business choose to incorporate. However, other formal business structures have evolved, such as the Limited Liability Company (or LLC), which also offer limited liability to its owners as well. Sole Proprietorships and General Partnerships do not offer any type of personal liability protection.
How do Corporations differ from Sole Proprietorships, Partnerships, and LLCs?
The most significant difference between a Corporation and a Sole Proprietorship or Partnership is the personal liability protection that is provided by a Corporation. What this means is that creditors can seize not only the business assets but also the personal assets of the owners of a Sole Proprietorship or Partnership. However, one of the benefits of operating a Sole Proprietorship or Partnership is that these unincorporated business structures are much easier to form and maintain than a Corporation because there are no formal requirements for a Sole Proprietorship or Partnership.
On the other hand, a Limited Liability Company (or LLC), is similar to a Corporation because it too provides a certain degree of personal liability protection for the owners of the LLC. In addition, there is less formal paperwork and other complications required to establish and maintain an LLC than a Corporation. For example, Corporations must hold regular ownership/management meetings as well as other formal Corporate requirements.
Another significant difference between a Corporation and other formal business entities is the way it is taxed. Corporate income taxes are assessed by applying a significantly higher Corporate tax rate to the profits generated by a Corporation. These profits are calculated by deducting salaries, bonuses, and may other legitimate business deductions. On the contrary, Sole Proprietorships, Partnerships, and LLCs are not assessed taxes on their profits. These profits are eligible to “pass through” the business to the owners who are required to claim the income on their personal income tax returns, where taxes are assessed at a significantly lower personal tax rate.
Who should incorporate?
Due to the expenses and formal requirements of establishing and maintaining a Corporation properly, including issuing stock (or Corporate shares), business owners should only consider incorporating if they have a valid reason. If limited personal liability protection from Corporate debt is the main reason a Corporate structure is considered, a Limited Liability Company may be a smarter choice. There are fewer costs associated with LLCs than Corporations, and they are much simpler to maintain.
However, the following situations are valid reasons to consider incorporating a business rather than forming an LLC:
- The business requires the option of issuing stock options in order to attract investors or employees.
- There is significant profit being generated by the business, so significant tax savings can be made by retaining some of those profits within the Corporation each year. This is known as Corporate “income splitting,” and it basically allows Corporate shareholders to capitalize on lower tax rates for Corporate income that is less than $75,000.
- The business is owned by a family, and the owner wants to start to pass on ownership to other family members as part of a financial estate plan. Gifts of Corporate shares easily made without relinquishing management control, and are free from gift tax (if done properly).
- Other issues dictate that you form a Corporation. For instance, an independent contractor may be required to incorporate in order to contract business from another company. Incorporating your business firmly establishes to the IRS that you are NOT an employee of the company you are hired to perform services for.
How do I form a Corporation?
In order to legally incorporate a business, there are several requirements. First, the business owner must file Articles of Incorporation with the Corporations division of the state government where the Corporation will be established. This short document is also known as a Certificate of Incorporation, a Certificate of Formation, or a Charter. Depending on where the Corporation is established, fees ranging from $100-$800 are due when the Articles of Incorporation are filed. The information included in the Articles of Incorporation is
- Corporate name
- Corporate address
- Name and address of Corporate contact person, also known as the Registered Agent
- Names of the Directors of the Corporation (required by some states)
Corporate Bylaws are also required when establishing a Corporation. This is a longer document that dictates the rules governing the Corporation, including procedures to make decisions and rights of voters.
Once the Articles of Incorporation and the Corporate Bylaws have been filed, the owners should hold the first Board of Directors meeting in order to handle some of the Corporate formalities.
The last step required to form a Corporation is to issue shares of stock to the initial owners, who then become Shareholders.
Is there more paperwork required to run a Corporation than other formal business entities?
The simple answer is Yes. There are statutory rules that Corporations must comply with that other unincorporated business structures, such as Limited Liability Companies (LLCs), Sole Proprietorships, and Partnerships, do not have to comply with. One example of a Corporate formality is the Annual Shareholder and Director Meetings, which require that minutes be taken and important decisions be documented. In addition, Corporations must record business transactions in a double-entry bookkeeping system that includes daily journals and a general ledger. Finally, Corporations must file Corporate tax returns (U.S. Corporation Income Tax Return, IRS Form 1120) and pay taxes on Corporate profits.
How are Corporations taxed?
The owners of Sole Proprietorships, Partnerships, and LLCs are required to pay income tax on all profits generated by the business. On the other hand, the owner shareholders of a Corporation (also known as a C Corporation) are only required to pay taxes on profits paid out to them through salaries, bonuses, and dividends (portions of the Corporate profit paid directly to shareholders in return for their Corporate investment). The Corporation pays corporate tax rates only on “retained earnings” which are profits that are left in the company from year to year.
These taxation requirements differ slightly for S Corporations, which are Corporations which have elected taxation similar to Partnerships. In the case of an S Corporation, all of the profits and losses of the Corporation will “pass through” to the owner shareholders who are required to report them on their individual income tax returns (IRS Form 1040).
Does Double Taxation mean that Corporate income is taxed twice?
Many people oversimplify the taxation of Corporations and make it seem like the Corporate income is taxed twice – once at the Corporate level, and again at the individual level. This is only true in the case of dividends that are paid to shareholders as a return on their investment in the Corporation.
In actuality, this type of double taxation is rarely seen in a small Corporation because owner shareholders rarely pay themselves dividends. Instead, they pay themselves salaries and bonuses as regular employees of the Corporation. Whereas dividends are non-tax-deductible Corporate expenses, these salaries and bonuses are legitimate business deductions that reduce the overall profit of the Corporation at the end of the year.
What is the definition of a Professional Corporation?
A Professional Corporation is a unique type of Corporation reserved for members of certain professions, such as doctors, healthcare workers, architects, and lawyers. These types of individuals often form Professional Corporations to limit their personal liability for any malpractice committed by one of their associates.
Should I be concerned about securities laws when I issue my Corporate stock?
Securities laws require Corporations to meet certain requirements before issuing stock in a Corporation. These laws are intended to protect investors from dishonest business owners. Technically, all sales of Corporate shares are required to be registered with the Securities & Exchange Commission (SEC) and its local state securities agencies prior to granting stock options to the initial owner shareholders. This step takes time and usually involves additional accounting and legal fees.
The good news is that many small Corporations are exempted from these requirements, if the Corporation conducts a “private offering” (or non-advertised sale of stock) to less than 35 people.