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What to Consider Before Incorporating

By Toolkit Staff | July 03, 2012

In our previous column on business forms, we discussed the two simplest options: the sole proprietorship and the partnership. Now we'll turn to a more sophisticated form: the corporation.

The main advantage of a corporation is the liability protection it provides its owners or shareholders. Liability is limited because the corporation is a legal entity that is separate from its shareholder-owners. It can buy and sell assets, take out loans, create contracts, hire employees, and do many other things that a person can do. As a separate legal entity, the corporation is liable for its own debts and can only be held liable to the extent of the corporation's assets (unless the owners have signed personal guarantees on business loans or contracts).

The other major advantage of the corporate form is its flexibility: There may be hundreds of shareholders or just one. Also, there may be several classes of stock (preferred, nonvoting etc.) that give different attributes of ownership to different stockholders. For a mature business, the corporate structure makes succession planning easier, since different family members can be given different types or numbers of shares in the business at different times.

Incorporating your business. Forming a corporation is more complicated and more expensive than forming a sole proprietorship or a simple partnership. Articles of incorporation must be filed with the secretary of state's office in the state in which the corporation is being organized. If the articles are accepted, the state will send you a certificate of incorporation. Many states require that a copy of the certificate be recorded in the local recorder's office where the corporation resides.

A corporation can be organized in any state, and many larger corporations organize in Delaware to take advantage of favorable corporate laws. However, the corporation will generally have to register (as a "foreign corporation") in any state where it will conduct business outside of the state of organization.

One point to be aware of is that the corporation's name must be unique--if your proposed name is already in use by another corporation, the incorporation documents will be rejected. You can save time and effort by calling your state's secretary of state's office and asking them to reserve the name for you, before you file your articles of incorporation. If the name is already being used, they'll tell you.

Operating a corporation. While shareholders own a corporation, they don't have any direct control over the day-to-day operations of the business. Instead, they elect directors who meet at least annually to oversee the operation of the corporation and make major corporate decisions, assessing past performance and planning for the future. The officers are the ones who are responsible for the day-to-day operations.

After the corporation is set up, it's important that it continues to observe all corporate formalities, which include, among other things, issuing stock certificates to the shareholders, holding annual meetings, recording the minutes of the meetings in the corporate register, and electing directors or ratifying the status of existing directors. An even more basic requirement is that the corporation's assets be properly titled (owned) in its name, that separate bank accounts are maintained for the corporation, and that the owner doesn't treat the corporation like his own back pocket.

Some states allow a type of corporation called a close corporation, which may be managed by its shareholders. In this type of corporation, directors do not have to be elected and officers do not have to be appointed, and the laws usually streamline some of the other meeting and voting requirements.

If the corporate formalities that apply to your business are not observed, somebody suing the corporation may be able to show that the corporation is not truly a separate entity from the shareholders. If so, the shareholders may become personally liable for any business debts or damages awarded.

In addition to the time required to follow the formalities, corporations have to make annual filings and pay franchise taxes to the state, which can also mean ongoing legal fees to ensure that all the necessary steps have been taken.

The other major drawback to the corporate structure is the corporate income tax. The business income of a corporation is taxed both by the federal government and by most states. When that income is passed on to the shareholders as a distribution or dividend, it is taxed again on the shareholder's individual tax return. Double taxation may be partially or completely avoided in a small service business by paying a larger salary to the employee-shareholders. However, the tax laws governing this area are complex and should be discussed with your accountant or your attorney.

Also, be aware of the tax consequences upon dissolution of a corporation. With all forms of business entity except a C corporation, dissolution and distribution of the business's assets to the owners is, at worst, a single taxable event. In a C corporation, a double tax may be due; the corporation may owe a capital gains tax on liquidation, and the individual shareholders also must recognize a gain upon the transfer of proceeds from the corporate entity to the individual recipient.

S Corporations. For most purposes, an S corporation operates in the same manner as a regular corporation, as discussed above. It must have directors, officers, and shareholders who function in the same manner as their regular corporation counterparts. However, for federal (and some state) tax purposes, the S corporation has elected to be taxed much like a partnership. After making the S election, the income, losses, tax credits, and other tax items of the corporation flow through the corporation to the shareholders. Thus, income is only taxed once, at the shareholder level, and items such as capital gains retain their character on the shareholders' tax returns.

At first blush, it may appear that every corporation should elect S corporation status to eliminate the double taxation of income. However, there are some disadvantages to making the election. There is less flexibility: S corporations may have no more than 100 shareholders. A C corporation, however, can have an unlimited number of shareholders and, in addition, can issue several different classes of shares, such as preferred stock.

Although shareholders of S corporations have the ability to deduct pass-through losses on their individual tax returns, such losses are only available to the extent of the shareholder's basis (or investment) in the S corporation. Such owners are in better shape than the owners of a C corporation, since those shareholders ordinarily can't deduct any losses at all, unless their stock becomes worthless or is sold at a loss.

However, in the early years of a business's operation, when losses are common, it's usually more advantageous to begin as a sole proprietorship. In that form, business losses can be used to shelter your other income from a part-time job, investments or a spouse's job. You can always incorporate later, when the business becomes profitable. Unless your business is in a high-risk industry (your insurance agent or lawyer can give you advice on this point), it's generally advisable to avoid incorporation until your business is fairly well established.

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