This type of general, for-profit corporation is referred to as a “C” corporation (referring to Chapter C in the IRS code). "C Corporation" merely refers to a regular, state-formed corporation. A corporation is owned by shareholders and is managed and controlled by the board of directors who elect the president and are responsible for the management and policy decisions of the corporation. The dealings of the corporation are carried out by the officers and employees of the corporation under the authority delegated by the directors of the corporation. To be incorporated an Incorporator must draft legal documents and, file the documents with the appropriate government agency, usually the Secretary of State, and pay the required fees. In order to maintain corporate status, certain formalities must be observed, such as annual meetings must be held, corporate minutes of the meetings must be taken, officers must be appointed, and shares must be issued to shareholders. The corporation should issue stock to its shareholders and keep adequate capitalization on hand to cover any foreseeable business debts.
Some reasons to choose this business structure include:
- Your business needs the ability to issue stock or stock options to attract key employees or outside investment capital.
- Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year. This strategy is called "income splitting" because profits are essentially split between the individual owners and the corporation itself.
- You own a family business and you want to begin making gifts of ownership to your family as part of your financial or estate plan or to plan for the next generation of owners. With a corporation it is possible to make gifts of shares in your company without necessarily giving up management control and without paying gift tax.
- Others insist that you incorporate your business.
Forming a corporation in the home state is the easiest route, but incorporation may be chosen in another state. In most states, one or more persons may form and operate a corporation. Some states, however, require that the number of persons required to manage a corporation be at least equal to the number of owners. For example, if there are two shareholders, there must also be a minimum of two directors.
The shareholdes must agree on the following to create a corporation:
- The name of the business.
- The total number of shares of stock the corporation can sell or issue (known as "authorized shares").
- The number of shares of stock each of the owners will buy.
- The amount of money or other property each owner will contribute to buy his or her shares of stock.
- The business in which the corporation will engage.
- Who will manage the corporation (i.e., who will be the directors and officers of the corporation).
The shareholders must then prepare and file articles of incorporation or a certificate of incorporation with the corporate office of the state in which they want to incorporate. Most states charge an initial fee for filing the corporate documents and an annual fee for allowing the corporation to continue. These fees are sometimes based upon the number of shares of stock authorized and the par value of the stock. Each state has its own rules and schedule of fees.
State rules on naming corporations vary, but generally:
- The name cannot be the same as the name of another corporation on file with the corporations office.
- The name must end with a corporate designator, such as "Corporation," "Incorporated," "Limited," or an abbreviation of one of these words (Corp., Inc. or Ltd.).
- The name cannot contain certain words prohibited by the state, such as Bank, Cooperative, Federal, National, United States or Reserve.
Your state's corporations office can tell you how to check if your proposed name is available for your use. Often, for a small fee, you can reserve your corporate name for a short period of time until you file your articles of incorporation. Incorporation will not protect you from another company or corporation using your name. It will prevent another business from incorporating using the same name or a name that could confuse the identity of the two separate companies, but it is the responsibility of the corporation to protect its good name and reputation. It is common practice to register a trade name as a service mark or trademark in order to protect the name from being used in your line of business.
The directors must hold an initial board meeting to see to a few corporate formalities and make some important decisions. At this meeting, directors usually:
- set the corporation's fiscal or accounting year
- appoint corporate officers
- adopt the corporate bylaws
- authorize the issuance of shares of stock, and
- adopt an official stock certificate form and corporate seal.
SEPARATE ENTITY STATUS
Although a corporation is not a "citizen" under the privileges and immunities clause of the Fourteenth Amendment to the U.S. Constitution, a corporation may exercise some of the constitutional protections granted to natural persons, such as the right to due process and equal protection, free speech, and the right to be represented by an attorney. However, because a corporation faces no risk of incarceration, it has no right to appointed counsel if it cannot afford to retain private counsel.
Because the corporation is a legal entity separate from its owners, it will need a separate bank account and separate records.
One of the main advantages of the corporate business structure is that the owners/shareholders are shielded from individual liability for the debts of the corporation. However, when corporate formalities are not observed, shareholders may be held personally liable for corporate debts. For example, if an undercapitalized corporation is created, funds are commingled with employees and officers, stock is never issued, meetings are never held, or other corporate formalities required by your state of incorporation are not followed, a court or the IRS may "pierce the corporate veil", finding no valid separate corporate exists, and hold the shareholders personally liable for corporate debts.
Also, if the shareholders "guarantee" the obligations of the corporation in order to borrow money or to rent space, for example, then they are legally responsible for the obligations guaranteed. If the shareholders make loans to the corporation and the business fails, their loans may be paid off only after the other loans of the corporation are paid.
BOARD OF DIRECTORS
The board of directors elect the president and are responsible for the management and policy decisions of the corporation. In a few instances, such as amendment to the articles of incorporation, sale of substantially all of the corporate assets, the merger or dissolution of the corporation, etc., shareholders are required to approve the actions of the board of directors. A corporate director is generally elected by the shareholders. Each director must attend meetings of the board, which must be held no less than once a year. Each director on the board is given one vote; usually the vote of a majority of the directors is sufficient to approve a decision of the board. Directors must make sure that major corporate actions are clearly written and were taken behalf of the corporation. Directors may be paid for their services, although payment is not required. Directors have a fiduciary responsibility to the shareholders to keep their best interests in mind.
Corporate officers are elected by the Board of Directors and are responsible for conducting the day-to-day operational activities of the corporation. Corporate officers usually consist of the followinga President, Vice-President, Secretary, and Treasurer. Terms of directors often are for more than one year and are staggered to provide continuity. Shareholders can elect themselves to be on the board of directors.
ARTICLES OF INCORPORATION
A corporation’s Articles of Incorporation are the documents filed with the state office that brings the company into legal existence. Once the documents are filed the corporation is a legal entity. Each state has its own requirements regarding the contents of the articles of incorporation. Most states do not require publication of a notice of incorporation. An exception may be if an unincorporated business is incorporating but it will keep the same name.
Articles of incorporation contain:
- the name of your corporation
- the corporation's address
- a "registered agent" (the person to be contacted by any member of the public who needs to speak to someone about the corporation, accepts official documents on behalf of the corporation), and
- in some states, the names of the corporation's directors.
Whoever signs the articles is called the "incorporator" or "promoter."
The bylaws of a corporation are the internal rules and guidelines for the day-to-day operation of a corporation, such as when and where the corporation will hold directors' and shareholders' meetings and what the shareholders' and directors' voting requirements are. Typically, the bylaws are adopted by the corporation's directors at their first board meeting. They may specify the rights and duties of the officers, shareholders and directors. They may also specify how the company may enter into contracts, transfer shares, hold meetings, pay dividends and make amendments to corporate documents. They may specify a fiscal year, how the corporate seal is to be used and which offices are required. Most states do not require bylaws to be filed with the state office.
Shares must be issued to those individuals who will be owners of the corporation. This is also the case even if only one individual will own the corporation. Ownership of a corporation can be transferred by sale of all or a portion of the stock. Additional owners can be added either by selling stock directly from the corporation or by having the current owners sell some of their stock. Small businesses that are corporations are often owned by a small group of shareholders who all work in the business. Often these shareholders formally agree to certain restrictions on the sale of their shares, so they can control who owns the corporation.
Shares may either be common or preferred shares. “Par value” is the minimum price for which each share may be sold. For a company with shares of “no par value,” the board of directors sets the minimum value for which a share may be sold. The sale of shares raises capital for the corporation, allowing corporate funds to remain separate from individual shareholders’ or directors’ funds. There is no minimum number of shares that must be issued but a company may only issue the maximum number of shares approved in the articles of incorporation or as amended.
A dividend must be paid equally to all shares of common stock and is usually expressed as an amount per share, such as "$5 per share." The board of directors decides whether dividends shall be paid. If dividends are not allowed in any given period, a shareholder has no right to any of the money the corporation's business has made (except as an employee receiving a salary or wages).
Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to follow certain procedures before accepting investments in exchange for shares of stock (the "securities"). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Many small corporations are exempted from the registration process under federal and state laws. For example, SEC rules don't require a corporation to register a "private offering," which is a non-advertised sale of stock to either:
- a limited number of people (generally 35 or fewer), or
- those who, because of their net worth or income earning capacity, can reasonably be expected to take care of themselves in the investment process.
Most states have enacted their own versions of this federal exemption.
A corporation is a separate legal and tax entity from the owners. A corporation pays taxes at its own corporate income tax rates and files its own corporate tax forms each year (IRS Form 1120). The “EIN” (also called tax ID number) is assigned to corporations for taxation purposes. The Federal Tax I.D. number of a corporation is the equivalent of the social security number of an individual . An EIN is needed to open a bank account and establish corporate credit.
The corporation must file its own income tax returns and pay taxes on its profits. The corporation must report all income it has received from its business and may deduct certain expenses it has paid in conducting its business.
Dividends paid to shareholders by the corporation are taxed to each shareholder individually. This is why there is said to be a "double tax" on corporations. Generally, the corporation is taxed for its own profits; then, any profits paid out in the form of dividends are taxed again to the recipient as dividend income and the individual shareholder's tax rate. However, most small corporations rarely pay dividends. Rather, owner-employees are paid salaries and fringe benefits that are deductible to the corporation. The result is that only the employee-owners end up paying any income taxes on this business income and avoid double taxation.
As a separate legal entity, a corporation is capable of continuing indefinitely. Its existence is not affected by death or incapacity of its shareholders, officers, or directors or by transfer of its shares from one person to another.
- A corporation's life is not dependent upon its members. A corporation possesses the feature of unlimited life. If an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business.
- Retirement funds and qualified retirement plans (like 401k) may be set up more easily with a corporation.
- Ownership of a corporation is easily transferable.
- Capital can be raised more easily through the sale of stock.
- A corporation possesses centralized management.
Corporations may often offer their employees unique fringe benefits. For example, owner-employees may often deduct health insurance premiums paid by the corporation from corporate income. In addition, corporate-defined benefit plans often afford better retirement options and benefits than those offered by non-corporate plans.
The primary disadvantage to a corporation is double taxation. Profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then as income to the shareholder. All reasonable business expenses such as salaries are deductions against corporate income and can minimize the double tax. Further, the double tax can be eliminated by making an S corporation election.
- There is more complexity and expense with forming a corporation.
- There are more extensive record keeping requirements.Corporations must observe corporate formalities such as holding (and taking minutes of) annual shareholder and director meetings and documenting important directors' decisions. Also, corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping system to record business transactions, complete with daily journals and a general ledger.
- Operating a corporation across state lines often requires the corporation to qualify to do business in the other state.
When a small business incorporates, it is automatically a C corporation, also called a regular corporation. The most basic characteristic of the corporation is that it is legally viewed as an individual entity, separate from its owners, who are now shareholders. This means that when the corporation is sued, shareholders are only liable to the extent of their investments in the corporation. Their personal assets are not on the line, as they would be if the business was a partnership or sole proprietorship. Any debts that the corporation may acquire are also viewed as the corporation's responsibility. In other words, once the business is incorporated, shareholders are protected by the corporate veil, or limited liability.
Because the corporation is a separate entity, it is viewed as an individual taxpayer by the Internal Revenue Service (IRS). As a result, corporations are subject to double taxation, which means that the profits are taxed once on the corporate level and a second time when they are distributed as dividends to the shareholders. If a business is eligible, it may elect S corporation status upon incorporating to avoid this negative characteristic of C corporations.
Most small businesses that consider incorporating do so for the limited liability that corporate status affords. The greatest fear of the sole proprietor or partner—that his or her life's savings could be jeopardized by a law suit against his or her business or by sudden overwhelming debts—disappears once the business becomes a corporation. Although the shareholders are liable up to the amount they have invested in the corporation, their personal assets cannot be touched. Rather than purchase expensive liability insurance, then, many small business owners choose to incorporate to protect themselves.
It can be much easier for a corporation to raise capital than it is for a partnership or sole proprietorship, because the corporation has stocks to sell. Investors can be lured with the prospect of dividends if the corporation makes a profit, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital. However, from a banker's perspective, a newly formed corporation is a more risky loan applicant than an individual with a home and other assets.
Attracting Top-Notch Employees
Corporations may find it easier to attract the best employees, who may be lured by stock options and fringe benefits.
One advantage C corporations have over unincorporated businesses and S corporations is that they may deduct fringe benefits (such as group term life insurance, health and disability insurance, death benefits payments to $5,000, and employee medical expenses not paid by insurance) from their taxes as a business expense. In addition, shareholder-employees are exempt from paying taxes on the fringe benefits they receive. To be eligible for this tax break the corporation must not design a plan that benefits only the shareholders/owners. A good portion of the employees (usually 70 percent) must also be able to take advantage of the benefits. For many small businesses, providing fringe benefits for all employees is too expensive, so in these cases the tax break is not a particular advantage.
Continuance of Existence
Transfer of stock or death of an owner does not alter the corporation, which exists perpetually, regardless of owners, until it is dissolved. While this is usually considered an advantage, Fred Steingold argues in The Legal Guide for Starting and Running a Small Business that, in reality, "You don't need to incorporate to ensure that your business will continue after your death. A sole proprietor can use a living trust or will to transfer the business to heirs. Partners frequently have insurance-funded buy-sell agreements that allow the remaining partners to continue the business."
After they deduct all business expenses, such as salaries, fringe benefits, and interest payments, C corporations pay a tax on their profits at the corporate level. If any of those profits are then distributed as dividends to the shareholders, those individuals must also pay a tax on the money when they file their personal tax returns. For companies that expect to reinvest much of the profits back into the business, double taxation may not affect them enough to be a serious drawback. In the case of the small business, most if not all of the company's profits are used to pay salaries and fringe benefits, which are deductible, and double taxation may be avoided because no money is left over for distributing dividends.
Bureaucracy and Expense
Corporations are governed by state and federal statutes. In order to abide by all of the sometimes complex regulations related to C corporations, it is often necessary to hire lawyers and accountants to assist with tax preparation. Regular stockholder and board of directors meetings must be held and detailed minutes of those meetings must be kept. All of the actions taken by a corporation are to be approved by its directors and this necessity can reduce a company's ability to take quick action on pressing matters. Another difference between a sole proprietor and a C corporation that imposes a bureaucratic burden arises if and when a corporation wishes to bring a case in small claims court. The corporation is required to be represented by a lawyer, whereas sole proprietors or partners can represent themselves. In addition, if the corporation does interstate business, it is subject to taxes in other states.
Rules Governing Dividend Distribution
A corporation's profits are divided on the basis of stockholdings, whereas a partnership may divide its profits on the basis of capital investment or employment in the firm. In other words, if a stockholder owns 10 percent of the corporation's stock, she may only receive 10 percent of the profits. However, if that same person was a partner in an unincorporated firm to which she had contributed 10 percent of the company's capital, she might be eligible to receive more than 10 percent of the business's profits if such an agreement had been made with the other partners. Strict rules, though, govern the way corporations divide their profits, even to the point, in some states, of determining how much can be distributed in dividends. Usually, all past operations must be paid for before a dividend can be declared by the corporation's directors. If this is not done, and the corporation's financial stability is put in jeopardy by the payment of dividends, the directors can, in most states, be held personally liable to creditors.
STRUCTURE OF A CORPORATION
In small businesses, the owners often hold more than one or all of the following positions, which are required of all corporations:
- Shareholders: They own the company's stock and are responsible for electing the directors, amending the bylaws and articles of incorporation, and approving major actions taken by the corporation like mergers and the sale of corporate assets. They alone are allowed to dissolve the corporation.
- Directors: They manage the corporation and are responsible for issuing stock, electing officers, and making the corporation's major decisions.
- Officers: The corporation must have a president, secretary, and treasurer. These officers are responsible for making the day-to-day decisions that govern the corporation's operation.
- Employees: They receive a salary in return for their work for the corporation.
FINANCING A CORPORATION
Financing the operations of a corporation may involve selling stock (equity financing), taking out loans (debt financing), or reinvesting profits for growth.
This is cash, property, or services exchanged for stock in the company. Generally, each stock is equivalent to one dollar of investment. If the small business owner is planning to exchange property to the corporation for stock, then a tax advisor should be consulted; if the property has appreciated, taxes may be due on the exchange.
This is money lent by banks or shareholders. In the former case, a personal guarantee by the corporation's principals is usually required, which makes an exception to the limited liability rule. The owner of a corporation who personally guarantees a loan is also personally responsible for paying it back if the corporation goes under. Many corporations have preferred to fund the corporation with shareholder money in exchange for promissory notes because unlike dividends, the repayment of debts is not taxable. The Internal Revenue Service monitors such debt closely, though, to make sure it is not excessive and that adequate interest is paid. It should be noted that the interest accrued on money borrowed is taxable when paid to the lender.
PAYING C CORPORATION TAXES
After the C corporation deducts all business expenses, such as salaries, fringe benefits, and interest payments, it pays a tax on its profits at the corporate level. Then dividends may be distributed to the shareholders who must pay a tax on the money when they file their personal tax returns. In the case of the small business, though, double taxation may not be a consideration, because most, if not all of the company's profits are reinvested in the business or go to pay salaries and fringe benefits, which are deductible, and no money is left over for distributing dividends.
To avoid double taxation, corporations sometimes pay their shareholder-employees higher salaries instead of distributing income as dividends. The IRS, however, watches out for such tax avoidance measures and often audits corporations, claiming that executive salaries are not "reasonable" compensation. To prevent this charge, then, the corporation should consider the duties performed, the experience and/or special abilities of the employee, and how much other corporations pay for similar positions before determining "reasonable" compensation. A corporation should keep salaries somewhat consistent over time as fluctuating salaries—high salaries in high earning years and low salaries in lean years—will attract a review of salary payments by the Internal Revenue Service. A charge might be made, for example, that the high salary payments were in fact dividend payments.
RUNNING A CORPORATION
Once a small business has been incorporated, the day-today management of business affairs should not be that much different than it was beforehand. It is important, though, that the business is treated like a corporation. The courts have been known on occasion to overlook a business's corporate status and find the shareholders/owners liable because the business was run as if it were still a sole proprietorship or partnership. Simply filing the articles of incorporation does not guarantee limited liability. In order to maintain corporate status in the law's eyes, these guidelines should be followed:
Act Like a Corporation Before doing business, stock certificates should be issued to all stockholders, and a corporate record book should be established to hold the articles of incorporation, records of stock holdings, the corporation's bylaws, and the minutes of board and shareholder meetings. In addition, such meetings should be held regularly (once a year is the minimum requirement). In this way, the corporation can record all important actions taken and show that such actions were approved by a vote. It is also important to treat the corporation like the separate entity it is by keeping personal and corporate accounts separate. Whereas a small business owner may have previously used one account to pay the company's accounts and personal expenses, as a corporate shareholder, he now needs to receive a regular salary from the corporation, deposit it in a separate account, and pay his personal expenses from that account. In all respects, the corporation and owner must be treated as distinct individuals. Fred Steingold advises, "document all transactions as if you were strangers. If the corporation leases property to you, sign a lease." In addition, the corporation's full name (which should indicate the company's corporate status through use of "Inc." or an equivalent) must be used on all correspondence, stationery, advertising, phone listings, and signs.
Act Like a Corporate Officer When the corporation's owner signs her name to checks, contracts, or correspondence for the corporation, she must always indicate that she is the president to show that she is not acting on her own but as an agent of the corporation.
Adequate Capital Investment and Insurance Coverage It is important to protect the corporation against failure due to debts and lawsuits. In other words, simply trying to protect the owners' assets by becoming a corporation and neglecting to fortify the business can be viewed as reason to disregard a business's corporate status in a lawsuit. Therefore, enough capital should be invested in the corporation to handle all business activities. Likewise, if business activities pose a risk to employees or customers and reasonably priced insurance is available to protect against such risks, such coverage should be secured.
SEE ALSO Incorporation; S Corporation
Byrd, Stephen, and Brett Richey. "The Choice of Entity for the Small Business Owner." Mid-Atlantic Journal of Business. 1 December 1998.
Cornwall, Dr. Jeffrey R., David Vang, and Jean Hartman. Entrepreneurial Financial Management. Prentice Hall, 13 May 2003.
Epstein, Lita. Reading Financial Reports for Dummies. December 2004.
"New Ventures and Start-Ups: Which Form of Business Is Best for You?" Business Owner. January-February 1999.
Selecting the Legal Structure for Your Business. Small Business Administration. n.d.
Steingold, Fred S. The Legal Guide for Starting and Running a Small Business Fifth Edition. Nolo Press, 2005.
Taylor, Peter. Book-Keeping & Accounting for Small Business. Business & Economics, 2003.
Hillstrom, Northern Lights
updated by Magee, ECDI