Table of Contents
- What are Corporations?
- Types of Corporations
- Corporations, Uncle Sam, and His Taxes
- Advantages of Corporations
- Disadvantages of Corporations
- Final Thoughts
In my last three blog posts of this series, I was examining sole proprietorships, partnerships, and limited liability companies. Today I want to cover the last topic in the series- corporations. While corporations can be a large step up from sole proprietorships, partnerships, and limited liability companies, the requirements and more expensive qualities of setting them up are more than compensated by the added protection when done correctly.
What are Corporations?
Probably the most advantageous way to start a business is corporations because they exist as separate entities. Outside of some rights like voting, a corporation has legal rights just like a living breathing person. It can own land and other assets, it can borrow money or create other debt, and it can be sued. The corporation gets its right to exist through the state that issues its charter. But don’t forget that if you incorporate in one state to take advantage of their corporate laws, you still have to file for “qualification” in other states you actually do business in.
You incorporate by filing articles of incorporation with the state’s secretary of state’s office. After being approved by the secretary of state, remember to apply for a free EIN number with the IRS. (Beware of fake scam application sites)
After incorporation, the stock is issued to the shareholders of the corporation in exchange for cash or other assets. The stockholders then vote in proportional standing to the number of stocks they own to elect a board of directors.
These directors meet to discuss and vote on the overall affairs of the corporation, create bylaws, and elect officers needed to run the day-to-day operations. This board election is then held once a year to re-affirm or elect new directors. Directors may meet anywhere from once a month to once a year.
It is important to remember that these requirements need to be adhered to regardless of the size of the business, number of shareholders, type of business. The reason for this is that if properly formed, capitalized, and operated, the liability of the shareholders is limited. It forms what the law calls a “corporate veil”. Even if the corporation is unable to be profitable, owes debts, or is found liable in court, the most the shareholder can lose is their investment into the corporation, i.e., their stock investment amount. Each stockholder’s personal assets are protected by the corporate veil.
Types of Corporations
There are several types of corporate structures. The most common two types are S-Corps and C-Corps. S-Corps are limited to US residents only, must be 100 or fewer owners, and must be a privately held business. C-Corps are unlimited in ownership and can be private or public.
I’ll discuss more below, but an S-Corp is a pass-through entity, meaning the owners pay through their personal taxes their portion of the profits. C-Corps are considered separate entities in every way so they pay taxes on the business and owners only pay for money (salary and/or dividend) on their personal taxes.
There are also nonprofit corporations and in some states B-Corps. A nonprofit is a tax-exempt entity that can not distribute its profits (i.e., pay dividends) that is limited to charity, education, religious, literary, or scientific work. They are considered to benefit society so they do not pay taxes to help them have more to work within their benefits. B-Corps are a hybrid of C-Corp and nonprofit in that they are for-profit but are deemed a benefit (hence the name) to society.
Corporations, Uncle Sam, and His Taxes
As a separate entity, C-Corp and B-Corp taxes are paid by the corporation through their own tax returns and not through the owner’s personal income tax returns. Employees of the corporation, even if stockholders, are paid a salary which is an expense of the company and tax-deductible. However, dividends paid to the shareholders are not deductible, and because of this, you may have heard of the term “double taxation”. Since the dividends are not deducted, the corporation pays its corporate taxes on its profits, including those paid as dividends; plus, the shareholders pay taxes on receiving the dividends. Hence those dollars are taxed twice.
C-Corps and B-Corps file a Form 1120 to pay their taxes. The owners pay their salary, dividends, or corporate gains if any stock is sold through their individual 1040’s. An S-Corp, which is still a separate entity, is a pass-through tax status entity, and therefore owners pay their portion of the profits through their personal 1040 tax returns.
As I discussed in the S-Corp selection for LLC’s tax election in my last post, the profits of the business can be divided between salary and dividends. The salary must be a reasonable amount as defined by the IRS, but each owner can draw a salary, which will be taxed personal and self-employment, but dividends are only taxed personally. Also, remember to pay your quarter tax estimates since they are not withheld as an employee’s paycheck would be.
So Todd, What are the Advantages of Corporations?
- Protection for personal assets (if all requirements met)
- Protection from business’s debts
- Protection from business liabilities such as lawsuits
So Todd, What are the Disadvantages or Corporations?
- Lots of requirements to set up and maintain protections
- Lots of paperwork needed compared to sole proprietor/partnership
- Double taxation
Final Opinion
In my opinion, the C-Corps work better for hands-off owners that want to hire officers to run the day-to-day and owners oversee the “big picture” goals. Also good for owners looking to build large organizations that operate in multiple states, have more than 100 owners to organize, or will be traded on the stock exchanges at some point.
S-Corps are better for smaller (100 or fewer owners) with no desire to “go public” on an exchange but need more of a corporate structure with board and officers that an LLC doesn’t.
These corporate structures lend a lot of protection to the owners, but usually, no more than a properly structured LLC or LLP would, which both require less paperwork to maintain than corporations.
If you missed any of my previous “Easy Guide to 4 Types of Business Structures” posts in this series, click the corresponding button below.
Here are some suggested books on business to help you along.