Your friends keep telling you that you should incorporate your business, but you brush them off. You own a small business; corporations are giant entities like GE and Apple.
The truth is, you can incorporate your business regardless of its size. The question is instead whether it makes sense for you and your business to incorporate.
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| Picture borrowed from www.cgglobal.com |
You have to answer that question for yourself, perhaps with the help of a trusted adviser, but in order to make an informed decision you need to have a general understanding of what a corporation is and what the tax implications are to incorporating your business.
The goal of this blog post is to give you an overview of what a corporation is. I strongly recommend talking to a business transactions attorney if you are considering forming a corporation as there are many important details not discussed here.
As opposed to a sole proprietorship, a corporation is a legal entity that is separate and distinct from you as its owner (shareholder). There is, essentially, a legal fiction that a corporation is its own person. What exactly that means has been the subject of many Supreme Court cases and continues to evolve, but for purposes of our discussion it means that the corporation can: enter into contracts, purchase assets, loan and borrow money, sue or be sued, and pay taxes.
Corporations are organized under state law, and must recognize certain formalities. These vary to some degree from state to state, and for purposes of this discussion I will be discussing the formalities that California corporations are subject to. Again, this is a very general discussion and I strongly recommend discussing this with a business transactions attorney. Some of the formalities include:
Corporations are organized under state law, and must recognize certain formalities. These vary to some degree from state to state, and for purposes of this discussion I will be discussing the formalities that California corporations are subject to. Again, this is a very general discussion and I strongly recommend discussing this with a business transactions attorney. Some of the formalities include:
- Filing Articles of Incorporation with the California Secretary of State;
- Electing a Board of Directors;
- Enacting Corporate Bylaws;
- Holding Board meetings at least once a year;
- Holding shareholder meetings at least once a year;
- Maintaining separate bank accounts for the corporation; and
- Maintaining corporate records.
This is not an exhaustive list of the corporate formalities that must be followed by a California corporation.
As mentioned in my previous post, Why Form a Business Entity?, one of the primary benefits of forming a corporation is that it has limited liability protection. Because of the importance of limited liability, it will be discussed in the next blog post. For now, the general rule is that your financial risk is limited to the amount of your investment.
Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual. Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person. To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.
However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation. That means that any income that the corporation earns will be taxed first at the corporate level. If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).
It is possible to for a shareholder to take money out of the corporation and only have it be subject to one level of taxation if that owner is also an employee. An owner-employee is paid wages or a salary, and that is W-2 income to the owner-employee but a valid deduction to the corporation. However, as W-2 income it is subject to payroll taxes. Any additional distributions (i.e., money taken out of the corporation that is not run through payroll) is again taxable at the corporate and individual level.
This hopefully will give you a general understanding of what a corporation is, what formalities it is subjected to, and some of its benefits and drawbacks. If you are interested in a referral to a business transactions attorney or if you have any questions about the tax implications of corporate ownership, please send me an e-mail.
Another benefit of the corporate form of business ownership is that your ownership interests can, relative to other forms of business ownership, be easily transferred to another individual. Your ownership interest in the corporation is represented through shares of stock, and generally there are no restrictions on you in transferring your ownership of the stock to another person. To be clear, this does not necessarily mean that there is an active market for your stock, but once there is a buyer the sale process is much simpler than, for example, the sale of a partnership interest.
However, one of the main drawbacks to the corporate form of business ownership is double-taxation. As I mentioned, a corporation is a separate legal entity that is subject to taxation. That means that any income that the corporation earns will be taxed first at the corporate level. If that income is then distributed to the shareholders, it may be taxed again at the individual level (the taxation of distributions will be discussed further in a future blog post).
It is possible to for a shareholder to take money out of the corporation and only have it be subject to one level of taxation if that owner is also an employee. An owner-employee is paid wages or a salary, and that is W-2 income to the owner-employee but a valid deduction to the corporation. However, as W-2 income it is subject to payroll taxes. Any additional distributions (i.e., money taken out of the corporation that is not run through payroll) is again taxable at the corporate and individual level.
This hopefully will give you a general understanding of what a corporation is, what formalities it is subjected to, and some of its benefits and drawbacks. If you are interested in a referral to a business transactions attorney or if you have any questions about the tax implications of corporate ownership, please send me an e-mail.
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