Choosing a Business Entity: Corporations

A corporation is a creation of law. It is governed by the laws of the state where it was incorporated and of the state or states in which it does business. In recent years it has become the business structure of choice for many small businesses. Corporations are, generally, a more complex form of business operation than either a sole proprietorship or partnership. Corporations are also subject to far more state regulations regarding both their formation and operation. The following discussion is provided in order to allow the potential business owner an understanding of this type of business operation.

The corporation is an artificial entity. It is created by filing Articles of Incorporation with the proper state authorities. This gives the corporation its legal existence and the right to carry on business. The Articles of Incorporation act as a public record of certain formalities of corporate existence. (For more information, see the Articles of Incorporation Kit for your state, available at www.findlegalforms.com). Adoption of corporate bylaws, or internal rules of operation, is often the first business of the corporation, after it has been given the authority to conduct business by the state. The bylaws of the corporation outline the actual mechanics of the operation and management of the corporation.

There are two basic types of corporations: C-corporations and S-corporations. These prefixes refer to the particular chapter in the U.S. Tax Code that specifies the tax consequences of either type of corporate organization. In general, both of these two types of corporations are organized and operated in similar fashion. There are specific rules that apply to the ability to be recognized by the U.S. Internal Revenue Service as an S-corporation. In addition, there are significant differences in the tax treatment of these two types of corporations. These differences will be clarified below. The basic structure and organizational rules below apply to both types of corporations, unless noted.

C-Corporation

In its simplest form, the corporate organizational structure consists of the following levels:

Shareholders: who own shares of the business but do not contribute to the direct management of the corporation, other than by electing the directors of the corporation and voting on major corporate issues.
Directors: who may be shareholders, but as directors do not own any of the business. They are responsible, jointly as members of the board of directors of the corporation, for making the major business decisions of the corporation, including appointing the officers of the corporation.
Officers: who may be shareholders and/or directors, but, as officers, do not own any of the business. Officers (generally the president, vice president, secretary, and treasurer) are responsible for day-to-day operation of the corporate business.

Disadvantages

Due to the nature of the organizational structure in a corporation, a certain degree of individual control is necessarily lost by incorporation. The officers, as appointees of the board of directors, are answerable to the board of management decisions. The board of directors, on the other hand, is not entirely free from restraint, since it is responsible to the shareholders for the prudent business management of the corporation.

The technical formalities of corporation formation and operation must be strictly observed in order for a business to reap the benefits of corporate existence. For this reason, there is an additional burden and expense to the corporation of detailed recordkeeping that is seldom present in other forms of business organization. Corporate decisions are, in general, more complicated due to the various levels of control and all such decisions must be carefully documented. Corporate meetings, both at the shareholder and director levels, are more formal and more frequent. In addition, the actual formation of the corporation is more expensive than the formation of either a sole proprietorship or partnership. The initial state fees that must be paid for registration of a corporation with a state can run as high as $900.00 for a minimally capitalized corporation. Corporations are also subject to a greater level of governmental regulation than any other type of business entity. These complications have the potential to overburden a small business struggling to survive.

Finally, the profits of a corporation, when distributed to the shareholders in the form of dividends, are subject to being taxed twice. The first tax comes at the corporate level. The distribution of any corporate profits to the investors in the form of dividends is not a deductible business expense for the corporation. Thus, any dividends that are distributed to shareholders have already been subject to corporate income tax. The second level of tax is imposed at the personal level. The receipt of corporate dividends is considered income to the individual shareholder and is taxed as such. This potential for higher taxes due to a corporate business structure can be moderated by many factors, however. (For more information about entity taxation, see the Taxation Kits available at www.findlegalforms.com).

Advantages

One of the most important advantages to the corporate form of business structure is the potential limited liability of the founders of and investors in the corporation. The liability for corporate debts is limited, in general, to the amount of money each owner has contributed to the corporation. Unless the corporation is essentially a shell for a one-person business or unless the corporation is grossly under-capitalized or under-insured, the personal assets of the owners are not at risk if the corporation fails. The shareholders stand to lose only what they invested. This factor is very important in attracting investors as the business grows.

A corporation can have a perpetual existence. Theoretically, a corporation can last forever. This may be a great advantage if there are potential future changes in ownership of the business in the offing. Changes that would cause a partnership to be dissolved or terminated will often not affect the corporation. This continuity can be an important factor in establishing a stable business image and a permanent relationship with others in the industry.

Unlike a partnership, in which no one may become a partner without the consent of the other partners, a shareholder of corporate stock may freely sell, trade, or give away his or her stock unless this right is formally restricted by reasonable corporate decisions. The new owner of such stock is then a new owner of the business in the proportionate share of stock obtained. This freedom offers potential investors a liquidity to shift assets that is not present in the partnership form of business. The sale of shares by the corporation is also an attractive method by which to raise needed capital. The sale of shares of a corporation, however, is subject to many governmental regulations on both the state and federal levels.

Taxation is listed both on an advantage and as a disadvantage for the corporation. Depending on many factors, the use of a corporation can increase or decrease the actual income tax paid in operating a corporate business. In addition, corporations may set aside surplus earnings (up to certain levels) without any negative tax consequences. Finally, corporations are able to offer a much greater variety of fringe benefit programs to employees and officers than any other type of business entity. Various retirement, stock option, and profit-sharing plans are only open to corporate participation.

S-Corporation

The S-corporation is a certain type of corporation that is available for specific tax purposes. It is a creation of the Internal Revenue Service. S-corporation status is not relevant to state corporation laws. Its purpose is to allow small corporations to choose to be taxed, at the Federal level, like a partnership, but also to enjoy many of the benefits of a corporation. It is, in many respects, similar to a limited liability company. The main difference lies in the rules that a company needs to meet in order to qualify as an S-corporation under Federal law.

In general, to qualify as an S-corporation under current IRS rules, a corporation must meet certain requirements:

It must not have more than 75 shareholders
All of the shareholders must, generally, be individuals and U.S. citizens
It must only have one class of stock
Shareholders must consent to S-corporation status
An election of S-corporation status must be filed with the IRS

The S-corporation retains all of the advantages and disadvantages of the traditional corporation except in the area of taxation. For tax purposes, S-corporation shareholders are treated similarly to partners in a partnership. The income, losses, and deductions generated by an S-corporation are “passed through” the corporate entity to the individual shareholders. Thus, there is no “double” taxation of an S-corporation. In addition, unlike a standard corporation, shareholders of S-corporations can personally deduct any corporate losses.

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C-Corporation

Disadvantages

Advantages

S-Corporation

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