What is a Corporation?

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.

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:

• 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.

Why Form a Business Entity?

Congratulations!  You decided to turn your passion into a business, and you are doing everything you can to make sure that it is a success.  You've heard people talk about incorporating their business or forming a partnership or LLC, and now you are wondering if that is the right thing for your business.

Table borrowed from www.strategicofficesupport.com

The answer is...maybe.  It is a cliche, but every business and every business owner is different and has different needs that must be considered.

However, there are some factors that impact this decision.

One factor is whether you would like your company to have limited liability protection. Corporations, S-corporations, limited liability companies (LLCs), and limited partnerships (for the limited partners) all provide limited liability protection.  Sole proprietorships and general partnerships do not.

Limited liability protection will be discussed in great detail in a future blog post, but in very general terms it means that only the entity's assets (i.e., not your personal assets) are at risk of loss.  For example, let's say that your business has $10,000 worth of assets and you have $250,000 of personal assets outside of the business.  If your business is sued, the plaintiffs can only attempt to collect on the $10,000 of business assets and cannot seize your personal assets.

You may feel that it is very unlikely that you will be sued or that if you are that is the reason why you have insurance.  You may be right, but you also want to keep in mind that your business is not only potentially liable for your actions but for the actions of your employees.  For many business owners, the desire to hire employees makes having limited liability protection a more significant factor to consider.

Another factor that you must consider is whether the business will have multiple owners.  The general rule is that if a business has multiple owners and no action has been taken to form a different type of entity (such as a corporation or LLC), it is a general partnership.  In a general partnership, each partner is personally liable for the actions of every other partner, their employees, and the business.  While for various reasons it may make sense to you to be in a general partnership, you want to make sure that it is a conscious decision and not simply the default because your business has multiple owners.  Therefore, if your business has multiple owners generally it will be an entity, so the decision then is what type of entity.

A third factor to consider are the tax implications to either operating your business as a sole proprietorship or as a business entity.  There are a number of different tax implications, not the least of which is whether or not you are then considered "self employed" and subject to the self-employment tax, that are outside of the scope of this blog post.  The important thing to remember is that there are a number of tax implications to how you choose to structure your business.  I would recommend talking to a CPA to discuss the specific impact that operating your business as a sole proprietorship versus a partnership, corporation, S-corporation, or LLC will have on your tax situation.

The final factor to consider when deciding to operate your business as a sole proprietor or as a separate business entity is the likelihood of an IRS audit.  There is a widespread belief among tax professionals, for various reasons, that a sole proprietorship is more likely to be subjected to an IRS audit than a business entity.  This is not to say that business entities are not audited by the IRS- they are all the time- but many tax professionals believe that sole proprietors are audited more frequently.  Of course you will be filing your taxes properly, but an IRS audit can be expensive for taxpayers even if the IRS does not make any changes to your tax return.

I highly recommend talking to a business transactions attorney about whether forming a separate entity for your business makes sense for you.  Please also feel free to e-mail me if you have any questions about the tax implications of how you structure your business.

What Type of Business Entity is Right for My Business?

Are you considering starting your own business?

According to data released from the U.S. Small Business Administration, hundreds of thousands of businesses are created  in the United States every year.  Every one of these new business owners must decide whether they want to operate as a sole proprietorship or whether they would prefer to operate the business as a separate entity.  Then, they have to decide what type of business entity best serves their needs.

Over the following weeks, I will assist you in answering these critical questions by discussing the factors that business owners should consider in determining whether they should form an entity, and the differences that exist between corporations, S-corporations, partnerships, and limited liability companies (LLCs).

If you are currently going through this process, I would be happy to talk to you about the tax implications of forming a business and to refer you to a business transaction attorney to answer any legal questions you may have.  Just send me an e-mail.