Small Business Corporation FAQ
Choosing the right business structure is an important step for any small business. Below are answers to some of the most frequently asked questions about organizing as a small business corporation.
What exactly is a corporation?
Unlike many other types of business structures, a corporation stands by itself as its own legal entity. This means that a corporation is separate, legally, from its owners and the other decision makers. To put it in different terms, both corporate and tax laws view a corporation as its own "person" that can form contracts, incur debt and pay its own taxes. And because a corporation is its own legal entity, it does not dissolve if the original owners or shareholders die. In addition, the owners of a corporation enjoy limited liability, meaning their personal assets are shielded from the liabilities of the small business corporation.
What is limited liability and why is it important?
"Limited liability" is the term that is generally used to describe the limited personal liability that corporation owners enjoy. Generally, an owner cannot be held personally responsible for the debts and liabilities of his or her corporation. For example, if a corporation is sued for failing to pay off a debt it owes, the creditor that wins the lawsuit can only seek compensation from the corporation itself.
The creditor cannot "reach through" the corporation to touch the personal assets (bank accounts, homes) of the owners of the corporation. However, in order to maintain this limited liability, the owners of the corporation must ensure that the business complies with certain corporate formalities. In addition, the owners must provide adequate funding for the corporation and the owners cannot use the corporation merely as an extension of their own persona.
Are corporations different from partnerships, sole proprietorships, or LLCS?
For small businesses, corporations are somewhat unique in that they offer their owners a form of limited personal liability. Unlike a partnership or sole proprietorship, the small business corporation structure shields the personal assets of their owners form the liabilities of the corporation.
However, much like corporations, limited liability companies (LLCs) also offer their owners limited personal liability. In addition, although formal paperwork is generally required to start a LLC, LLCs are normally less complicated than corporations to keep running once they are formed. Owners of LLCs do not have to hold regular meetings for owners, nor do they have to follow strict corporate formalities.
The way that corporations are most unique and different from other business structures is in the way that the corporations are taxed. Because corporations are considered to be their own legal entities, they are taxed accordingly. Taxable corporate income is calculated as any profits that are left in the corporation once salaries, bonuses, overhead and other expenses are paid out.
Unlike corporations, the profits from LLCs, partnerships, and sole proprietorships are passed through to the owners of those businesses. As such, those businesses are not separately taxed. Instead, the owners of LLCs, partnerships and sole proprietorships are personally taxed on their own respective shares of the business profits.
Who would benefit from forming a corporation?
If your sole reason for forming a corporation is to gain the limited liability that comes with it, you may want to consider forming a LLC instead. However, here are some situations in which forming a small business corporation could benefit both you and your small business:
- You feel that you need the option of issuing stocks (shares in your business) to attract or retain good employees.
- Your business is already very profitable and you would save money by keeping some of your profits inside of your business. Corporate taxes can be lower than personal income taxes.
- Your business is a family business and you want to start making gifts of shares of your business for estate planning reasons. You will be able to give away shares of your business while still maintaining ownership and control of your business.
- You are getting pressure to incorporate your small business from others. As an example, if you are an independent contractor, the people you want to work for may insist that you first incorporate before they give you their business.
I want to form a small business corporation. How do I do it?
Depending upon the state that you are in, there are generally several steps that you have to take to incorporate your small business. First, you will have to file your "articles of incorporation" with the office in your state government that deals with corporations (generally this is part of the secretary of state's office). You will have to pay a filing fee when you file your articles of incorporation. This fee can range from about $100 to $800. The articles of incorporation must generally include:
- The name of your corporation,
- Your corporation's legal address,
- The name and address of your corporation's "registered agent." This person is the person of record that will be contacted by any member of the public that needs to sue or speak about your corporation, and
- Depending on the laws of your state, the names of all of your corporation's owners.
In addition, when you form a corporation, you must also create your "corporate by-laws." This document will set out the rules that will govern how your corporation will be run and will also lay out the decision making process that your corporation will use.
Lastly, before your small business corporation gets up and running, you must hold a meeting with all of the directors of the corporation where you will need to issue stock to the initial owners of the corporation.
Do corporations require more paperwork than other types of businesses?
In short, yes. This is because corporations must abide by laws and rules that unincorporated business do not. As one example, corporations must hold annual meetings for shareholders and take minutes for any important decisions that are made. In addition, corporations must file their own taxes, which mean that you must keep a very detailed financial record that includes a double-entry bookkeeping system.
Is corporate income taxed differently than other types of income?
Yes. Unlike unincorporated small businesses, small business corporation owners do not pay taxes on any business profits that are kept within the corporation. Instead, the owners of corporations only pay taxes on any salaries, bonuses or dividends that they are paid in return for their services to the business. The corporation itself must pay taxes on any profits that are left inside of the corporation from year to year.
You should be aware that this tax scheme does not apply to S-type corporations. An S-type corporation is one where the owners of the corporation elected to be taxed as if the business were a partnership. Under an S-type corporation, all of the business profits are passed through to the business owners, who will report these profits as income on their personal tax returns.
What is double taxation and does corporate income really get taxed twice?
Many people are anxious to form a small business corporation because they have a fear of "double taxation," meaning certain income is taxed twice, once on the corporation and once when the money is paid out to the owners. However, double taxation only applies to income that is paid out to owners in the form of dividends. A dividend is a corporate profit that is paid by the corporation to its shareholders in return for their investment in the business.
Double taxation really only occurs when a corporation pays out money to people that do not work for the business. This is because any money that is paid out to people that work for the corporation can be classified as a salary or a bonus. Salaries and bonuses can be deducted from the corporate tax as reasonable and necessary business expenses and the corporation does not have to pay taxes on them. However, if money is paid out to people that do not work for the business, it can really only be classified as a dividend, which is then double taxed.
What are professional corporations?
A professional corporation is a special type of corporation where only members of a certain profession can create. Professional corporations are often formed by lawyers, doctors and other healthcare workers. Professional corporations have the advantage of providing its owners a limited personal liability for malpractice of their associates.
Should I worry about securities laws when I decide to issue stock in my corporation?
Generally speaking, securities laws are designed to protect investors from the bad acts of business owners. Securities laws provide requirements for corporations to follow before they can accept investment in exchange for shares in the company. Generally, a corporation is required to register the sale of stock with the Securities Exchange Commission (SEC) and the relevant state securities agency before granting any stock to the original shareholders.
However, if you have a small business corporation, you may be able to skip this registration process because of some exemption laws. As an example, the SEC does not require a corporation to register a "private offering" (a non-advertised sale of stock) to either:
- A small number of people, normally less than 35, or
- Those who are in a financial situation where they can take care of themselves in any investment proceedings.
Most states also have similar versions of these SEC exemptions.
If you are planning on setting up a small business corporation with yourself and a few associates, you will most likely qualify for an exemption and will you not have to file paperwork for your first sale of stock.
Do I need legal help when incorporating my business?
Probably. Incorporation is the most complicated of all the business legal structures and typically benefits from the help of one or more attorneys. To get started, find a business organizations attorney near you.