Organizing Your Business Part 3: Corporations
The creation of a corporation is the creation of an artificial person. For legal and tax purposes, a corporation is a separate entity from its owners. A corporation can make purchases, enter into contracts, pay taxes, and sue and be sued.
What Is a Corporation?
For our purposes today, by “corporation” we mean S Corporation, C Corporation, or Nonprofit Corporation. Each of these types of corporations has its own pros and cons, and we’ll do our best to address those.
Corporations must be established in compliance with state requirements. Each state has its own set of guidelines governing corporations. In general, a corporation will have more requirements concerning things like filings, annual reports, and registered agents than will a sole proprietorship or a partnership. By default, a corporation is a C Corporation.
Both C Corporations and S Corporations are owned by shareholders. A board of directors, who may or may not be shareholders, are responsible for managing a corporation. Income, expenses, and losses of the business are filed on the corporation’s tax returns.
C Corporation: Pros
A corporation protects shareholders from business debts and responsibilities in most cases. Unlike the business options previously discussed, a corporation’s creditors may not seek to collect debts from the owners, or shareholders, of the corporation; only in cases of fraud can the courts pierce the corporate veil. However, owners of a new corporation may be required by financial institutions to give personal financial assurances in order to receive funding through loans.
There is continuity of a corporation regardless of individual shareholder status. Even if several shareholders sell their shares in a business or a principal stockholder dies, the existence of the corporation is not affected. A corporation may also sell stock or shares in its business to raise capital. Corporations may have several types of stocks or shares available, such as voting shares and nonvoting shares.
C Corporation: Cons
One drawback of a corporation is double taxation. The corporation pays taxes on its profits before paying dividends to the shareholders. Shareholders must then pay tax on their dividends received from the corporation. But, as with almost anything in US Tax Code, there are exceptions, and we’ll get to those.
For smaller businesses this double taxation can be a big turn off. When coupled with the extra paperwork most states require for corporations, many entrepreneurs choose a sole proprietorship or partnership instead of a corporation.
Subchapter S Corporation
A Subchapter S corporation derives its name from a section of the Internal Revenue Code. Under Subchapter S in the Internal Revenue Code, a corporation that meets certain requirements may be treated as a corporation for liability purposes but treated as a partnership for taxation purposes. Shareholders of a Subchapter S corporation receive limited liability protection, and their profits from the business are included on their individual income tax return.
The requirements of a Subchapter S corporation typically include:
- No more than 100 shareholders
- Shareholders must be natural persons (not corporations or partnerships)
- Shareholders must be US Citizens and cannot be nonresident aliens
- One class of stock only
After a business has incorporated, all shareholders must consent to Subchapter S treatment. The S Corporation Election Form, IRS Form 2553, must be filed with the Internal Revenue Service in a timely manner.
In order to be considered nonprofit, a corporation must have been formed for a purpose other than the financial benefit of its shareholders. Also, a nonprofit corporation cannot pay any dividends or other financial rewards to its shareholders. To receive tax exempt status, an organization must first incorporate as a nonprofit corporation.
After incorporation, applications for tax exempt status must be filed with the Internal Revenue Service and the state’s Department of Revenue. In order for contributions to the organization to be tax deductible, other requirements must be met.
[Recommended Reading: “Starting a Nonprofit: Checklist“]
[This has been Part 3 of our 4-part Organizing Your Business series. For our next installment, please see “Organizing Your Business Part 4: LLCs.”]