Corporations

C-Corporations (Regular Corporation)

A C-Corporation is an incorporated entity chartered under the laws of a particular state. It is sometimes referred to as a “regular” corporation, because it enjoys no special tax status. The basic structure and attributes of a corporation do not change much regardless of the state, although there can be a great deal of variety concerning the more particular characteristics and duties of a corporation in any particular state.This type of entity is taxed under Subchapter C of the Internal Revenue Code (hence the name).

C-Corporations are easily formed with the help of a professional. You do not have to incorporate in the state where you live and just because you live in a particular state, does not mean you want to incorporate there. Articles of Incorporation are filed with the Secretary of State. All states are not alike in their corporate laws. That being said, the differences among the states are hardly so stark that you will ruin yourself by choosing one state over another.

Laws governing incorporation must be strictly followed, otherwise the attempt at incorporation may fail and a partnership may result. The necessary actions to incorporate are fairly standard:

  • Prepare and file Articles of Incorporation (may be generic or specific to the type of business)
  • Prepare by-laws
  • Hold an organizational meeting of the shareholders and board of directors
  • Elect the Officers of the corporation
  • Prepare the Minutes of the meeting
  • Establish the books, records,, home office etc.
  • File any additional reports the state may require

Mistakes in these documents can cause problems ranging from minor annoyance to business-killing litigation. If you have any hope of building a sophisticated business, do not try to create a corporation on your own; use a professional who is experienced in this area.

The downside to C-Corporations are their tax aspects, at least as far as small businesses are concerned. With a corporation, you do not get the “flow-through” tax benefits that all of the other small business entities enjoy. What this means is that the profits and losses of the company are the company’s profits and losses, not yours. The corporation will have to file a tax return and pay taxes on the income it receives. Then, if there are any dividends to be paid to the owners (you!), those owners will have to pay taxes again on the money received as dividends. This is the double taxation of corporations that so many shareholders grumble about.

There are ways, however, for small corporations to avoid the double taxation of income. Often, a small corporation will pay its owners salaries rather than pay dividends, so the corporation gets a deduction for the amount paid to shareholders. But the IRS watches such salary payments very closely, and if you push it too far, they may be treated as dividends. Not surprisingly, startup businesses rarely adopt the traditional corporate format (unless it is going to “go public” almost immediately after creation, something that occurs about as often as Immaculate Conception). Instead, small businesses opt for one of the other corporate forms such as the S-Corporation (below) or the LLC.

S-Corporations

An S-Corporation is a hybrid between partnerships and C-Corporations and elect special status for federal tax purposes. An S-Corporation is a creature of federal tax law. It is a “regular” corporation under state law that elects special tax status for federal tax purposes. This type of entity is taxed under Subchapter S of the Internal Revenue Code. S-Corporations are generally pass-through entities and thus not taxable entities for federal income tax purposes.

S-Corps are formed much like a C-Corp and have a very similar structure. There are shareholders, by-laws, articles, stock, etc. just like a C-Corp. But the tax treatment of the S-Corp is markedly different from that of the C-Corp. You will also need to file a tax election with the Internal Revenue Service; IRS Form 2553.

First, S-Corporations are a pass through entity, so all income and losses of a S-Corp are attributed pro-rata to the owners. In other words, S-Corporations pass the profit/loss through to the shareholder directly on an annual basis, avoiding the double taxation of C-Corporations. Tax treatment on the pass through amount depends on each separate shareholder situation.

Another advantage to a S-Corp is the lower taxation rates applicable to S-Corp income as compared to the C-Corp. You see, the tax rates applied to regular C-Corps are generally higher than those applicable to individuals. Thus, when S-Corp’s income (i.e., profits) is distributed, it will be taxed at the rate of the individual owners, rather than the higher rate applicable to C-Corps.

It should be noted that there are certain types of income that can be taxed on the entity or corporate level as well though. For instance, built-in gains, and large amounts of passive income such as rentals. With respect to how your state might tax you is completely dependent on each individual state. Some states follow the Federal laws and compliance, and other state tax corporations the same whether they are an S – type or C – type.

Still in many cases, the S-Corporation provides the highest tax savings to its owners.

Limited Liability

Unlike partnerships and sole proprietorships, corporate shareholders are not liable for any of the corporation’s debts. This means that what you pay for the stock or what you pay to incorporate is the total sum that you are risking, and nothing more. This is true regardless of how much a shareholder participates in management. A shareholder who owns 100% of a business and makes every decision cannot be held liable for the debts of the corporation, unless of course he runs afoul of a certain area of law known as “piercing the corporate veil”. Also, the corporation will be liable for the acts of its employees and agents who commit tortious acts, but the owner will not.

The protection against liability for corporate debt can be deceptive.Most lenders (banks, investors, etc.) who offer money to small corporations make the principal owners sign personal guarantees for the loans made to the corporations, so the limited liability of this structure (and all other structures) is somewhat misleading. You are likely to take on some of the liabilities of the corporation. Some professions also still have personal liabilty for their acts of malpractice (doctors, lawyers C.P.A.’s) The benefit to incorporating still exists, however, because you usually only take on those liabilities to which you consciously agree.

Limited liability will not protect you against lawsuits alleging fraudulent or criminal actions by you in the course of corporate business, but that is just common sense. After all, you cannot expect corporate laws to protect crooks from suffering the consequences of breaking the law.

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