Forty years ago, corporations were the predominant form of business structure for small businesses, but that is no longer the case, as other entity types (notably LLCs) provide added flexibility and less administrative burden. Nevertheless, there are many advantages of a corporation and circumstances where it might be prudent to utilize the corporate business structure. A discussion with your advisors is always warranted before forming any new company.
What is a corporation? A corporation is a business entity that functions as a distinct legal “person,” one that is separate from its owners and offers them protection from personal liability for business debts. There are two different kinds of corporations:
Corporations are required to keep good records, file a corporate tax return, and, in order to retain limited liability for owners (i.e. shareholders), they must follow corporate formalities involving finances, decision making and record keeping.
To create a corporation, Articles of Incorporation (in some states called a “Certificate of Incorporation”) must be filed with the business division of the state government, which is usually, but not always, part of the secretary of state’s office. Filing fees are usually no more than a few hundred dollars.
In most states, the state has a prescribed form that may be used, which requires a few basic details about the corporation, such as its name, address and contact information for the person who will receive legal papers on its behalf (usually called a “registered agent”). Some states also require a list of the names and addresses of the corporation’s directors and officers. If the corporation will be conducting business in more than one state, then it must also register with the business division in each additional state. Usually, that entails filing a form and paying fees similar to the filing of the original Articles of Incorporation, but the original state of incorporation remains the “home” state.
State statutes also require the adoption of corporate bylaws that address issues of corporate operation and management, such as: how and when to hold regular and special meetings of directors and shareholders, as well as the number of votes that are necessary to approve corporate decisions. It is also a good idea for the shareholders to adopt and follow a shareholders’ agreement, which typically addresses issues of ownership and economics. The bylaws and shareholder agreements are internal company documents that are not filed with the state, but instead maintained in the corporate minute book.
Finally, corporations are required to issue stock to the shareholders of the corporation (which may or may not be certificated), as well as record who owns the ownership interests (i.e., shares or stock) in the business.
Corporations have a multi-tier management structure. The top tier of management, known as the board of directors, are elected by the shareholders, and are responsible for making big picture decisions on behalf of the corporation. Those decisions might include such actions as taking on investors, starting a new product line or entering into a multi-year lease. The directors in turn elect the corporate officers—think CEO, CFO, president, etc.—who are tasked with running the day-to-day affairs of the corporation. These types of activities would include sales, operations, employment decisions and such other tasks necessary for successfully running a business.
Once the corporation has been formed, most states require annual franchise tax filings, which essentially amounts to a tax for the privilege of being registered in that state. Corporations are required to hold annual meetings of its shareholders and directors, or to prepare annual consents that formally approve the actions of management over the prior year. Doing so will help in establishing the separate company existence (as discussed below), and is good corporate practice.
Corporations and their shareholders must observe certain formalities to retain the corporation’s status as a separate entity. Specifically, corporations must:
One of the main advantages of a corporation is that the shareholders’ personal assets are protected from creditors of the corporation. For example, if a corporation owes a vendor $50,000, but doesn’t have the money to pay, the shareholders are not forced to use personal assets to pay the debt (absent a separate personal guarantee). Because only corporate assets need to be used to pay business debts, the shareholders’ exposure is limited to money that has already been invested in the corporation. Notwithstanding, as in any type of business entity, a shareholder can be held personally liable if the shareholder:
That last exception could lead to what is known as “piercing the corporate veil,” where the shareholders may in fact become personally liable for business debts notwithstanding the corporation’s separate legal existence. In order to prevent that from happening, it is essential that the following happen:
In addition, business funds should be treated separate from personal funds (e.g. personal expenses should not be paid out of business accounts), and the corporation should create, file and maintain proper documentation of its existence and operation (e.g. make sure that all federal and state forms have been filed).
Finally, while not required under statute, obtaining a comprehensive business insurance policy should help to protect personal and business assets. Such a policy will cover most business activities where they occur in the course of the business’s performance. However, insurance won’t help if the corporation doesn’t pay the bills, as commercial insurance usually does not protect personal or corporate assets from unpaid business debts – whether or not they’re personally guaranteed.
If an owner, i.e., a shareholder, of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her personal tax return.
The tax advantages of a corporation depend on the type of filing: C-corp or S-corp.
A C-corporation pays taxes on whatever profits are left in the business after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return through Form 1120 with the IRS, and pays taxes at a special corporate tax rate. The Tax Cuts and Job Act established a new single flat tax rate of 21% for corporations, which replaces corporate tax rates ranging from 15% to 35% under prior law.
Alternatively, the corporation can elect what’s called “S-corporation” status by filing Form 2553 with the IRS. Upon making this election, the corporation will be treated like a partnership for tax purposes, with business profits and losses “passing-through” the corporation to be reported on the owners’ individual tax returns. While there are tax benefits to making the S-corporation election (namely the payment of a single layer of tax rather than multiple layers of tax), S-Corporations have several limitations that are not applicable to C-Corporations. These include the types and amounts of shareholders, and it may only issue a single class of stock to shareholders (although there is a limited exception that permits separate classes for voting and non-voting stock).
©All Rights Reserved. April, 2020. DailyDAC™, LLC d/b/a/ Financial Poise™
Jeremy chairs the Corporate Group at the Sugar Law Firm (Sugar Felsenthal), a national boutique serving the affluent and the companies they own or otherwise control. He advises his clients on significant transactions and operational issues in their businesses. Described by clients as "an essential business advisor" and "a partner in the success of my…
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