IncorporationDefinition: To legally form a corporation
A corporate structure is perhaps the most advantageous way to start a business because the corporation exists as a separate entity. In general, a corporation has all the legal rights of an individual, except for the right to vote and certain other limitations. Corporations are given the right to exist by the state that issues their charter. If you incorporate in one state to take advantage of liberal corporate laws but do business in another state, you'll have to file for "qualification" in the state in which you wish to operate the business. There is usually a fee that must be paid to qualify to do business in a state.
You can incorporate your business by filing articles of incorporation with the appropriate agency in your state. Usually, only one corporation can have any given name in each state. After incorporation, stock is issued to the company's shareholders in exchange for the cash or other assets they transfer to it in return for that stock. Once a year, the shareholders elect a board of directors, who meet to discuss and guide corporate affairs anywhere from once a month to once a year.
Each year, the directors elect officers such as a president, secretary and treasurer to conduct the day-to-day affairs of the corporate business. There may also be additional officers such as vice presidents, if the directors so decide. Along with the articles of incorporation, the directors and shareholders usually adopt corporate bylaws that govern the powers and authority of the directors, officers, and shareholders.
Even small, private, professional corporations, such as a legal or dental practice, need to adhere to the principles that govern a corporation. For instance, upon incorporation, common stock needs to be distributed to the shareholders and a board of directors elected. If there is only one person forming the corporation, that person is the sole shareholder of stock in the corporation and can elect himself or herself to the board of directors as well as any other individuals that person deems appropriate.
Corporations, if properly formed, capitalized and operated (including appropriate annual meetings of shareholders and directors), limit the liability of their shareholders. Even if the corporation is not successful or is held liable for damages in a lawsuit, the most a shareholder can lose is his or her investment in the stock. The shareholder's personal assets are not on the line for corporate liabilities.
Corporations file Form 1120 with the IRS and pay their own taxes. Salaries paid to shareholders who are employees of the corporation are deductible. But dividends paid to shareholders are not deductible and therefore do not reduce the corporation's tax liability. A corporation must end its tax year on December 31 if it derives its income primarily from personal services (such as dental care, legal counseling and business consulting) provided by its shareholders.
If the corporation is small, the shareholders should prepare and sign a shareholders buy-sell agreement. This contract provides that if a shareholder dies or wants to sell his or her stock, it must first be offered to the surviving shareholders. It also may provide for a method to determine the fair price that should be paid for those shares. Such agreements are usually funded with life insurance to purchase the stock of deceased shareholders.
If a corporation is large and sells its shares to many individuals, it may have to register with the Securities and Exchange Commission (SEC) or state regulatory bodies. More common is the corporation with only a few shareholders, which can issue its shares without any such registration under private offering exemptions. For a small corporation, responsibilities of the shareholders can be defined in the corporate minutes, and a shareholder who wants to leave can be accommodated without many legal hassles. Also, until your small corporation has operated successfully for many years, you will most likely still have to accept personal liability for any loans made by banks or other lenders to your corporation.
While some people feel that a corporation enhances the image of a small business, one disadvantage is the potential double taxation: The corporation must pay taxes on its net income, and shareholders must also pay taxes on any dividends received from the corporation.
Business owners often increase their own salaries to reduce or wipe out corporate profits and thereby lower the possibility of having those profits taxed twice--once to the corporation and again to the shareholders upon receipt of dividends from the corporation.
A Subchapter S corporate structure makes sense for many closely held businesses. Instead of profits being taxed twice as they are with regular C corporations (once at the corporate level and again as dividends when they're distributed to shareholders), profits flow through the S corporations and are taxed once, at the personal tax rate. Subchapter S corporations offer advantages to new business owners with income from other sources, which can be offset by business deductions to reduce the individual's overall federal tax liability. Take note, however, that some states don't recognize a Subchapter S election for state tax purposes and will tax Subchapter S earnings at the regular corporate rate.
To qualify under Subchapter S, the corporation must:
- Be incorporated within the United States;
- Not be part of an affiliated group that can file a consolidated tax return;
- Have fewer than 75 shareholders;
- Have shareholders who are individuals, estates, or certain types of trusts; and
- Have only one class of outstanding stock.
For more information on the rules that apply to a Subchapter S corporation, talk with your CPA.