Okay, so things get rather complex quick when trying to clearly identify what a corporation is, can be, and how it’s viewed/treated under U.S. law along with taxing authorities.
In the content that follows our goal is to address common concerns of average folks interested in founding one, or in switching from another business entity (like an LLC) into a conventional corporation.
If you're planning on forming a corporation, it's highly recommended you do your homework or consult with a lawyer, have a CPA on hand, and know what you’re in for. There are many resources online to assist you, but please bear in mind not all websites contain accurate information. An article you read online isn't a substitute for actual legal advice from an in-person or telephone lawyer consultation.
Core Characteristics of Corporations
An independent business entity legally separate from management including founders, owners, officers, and directors. It's registered with the Secretary of State and has an independent tax identification number. In the eyes of the law, a corporation is a separate legal entity with "corporate personhood".
- Owners of corporations have what’s called Limited Liability, in most cases. Part of whether an individual corporate director can be liable for the acts of a corporation depends on the acts involved. For example, if a corporation is involved in shady business practices and engages in a lot of self-dealing, those individuals could be personally and criminally liable for intentional acts. These are usually reserved for situations in which individuals try to shield themselves from liability using the corporation as just a ruse. This is why it's important a corporation is properly capitalized and observes corporate formalities.
- A corporation will continue to exist despite new owners or new shareholders and deemed to have a legal existence until it's formally dissolved. Changes in personnel, directors, and shareholders doesn't usually affect a corporation’s legal status.
There are two formal types of corporations, but keep in mind it can be far more complex (especially if and when you talk to a lawyer). Where they differ primarily is in taxation and corporate ownership, but some similarities include the following.
- Both have Limited Liability protection, in most situations.
- Both require formal Articles of Incorporation and that each corporation observes the proper formation requirements as set forth by the Secretary of State. The laws may differ depending upon which state you form in.
- Both have a board of directors, shareholders, officers, and directors.
- Both have a registered agent for service of process.
These are some examples of corporations and their various forms.
- C-Corporation: The most common form of a corporation, unlimited growth, unlimited shareholders, sells stock, better access to funding, double-taxation (but can deduct business expenses), no restriction on ownership, etc.
- S-Corporation: Typically for smaller platforms, 100 shareholder limit, pass-through taxation (no double-taxation, instead taxation passes through corp to owners who file individually), ownership restrictions – can’t be owned by a c-corp, another s-corp, an LLC/Partnership, or many trusts.
Primary Advantages of Forming a Corporation
Oh, there are so many, but we’re going to streamline them down into the core-five which are easy to understand.
Limited Liability Protection: This means owners and shareholders enjoy “limited” liability protection so they aren’t personally responsible for debts or being sued. The corporation is. However, this protection can be taken away very easily if there’s been unethical, illegal, or irresponsible behavior some of which is described above.
Unlimited Capital Generation: Corporations can generate and issue stock, so their ability to raise capital is unlimited far beyond that of much smaller organizations and business entities.
Corporate Taxation Benefits: Because corporations are separate from their owners, they pay taxes separately. Owners only have to pay taxes on profits paid (salaries, bonuses, and dividends), then everything else is filed under the corporate tax rate which is often going to be better than individual income tax rates.
Attractive to Potential Employees/Investors: Because of their growth and income potential (stock options), as well as certain taxation benefits, it’s typically going to be much easier for a corporation to attract talent and acquire investor funds. This, of course, depends on the nature and size of the corporation.
Management: Corporations are known for more dependable structures thanks to the formalities of maintaining a board of directors, elected officers and committees, bylaws, articles, minutes of meeting, etc.
How About Disadvantages?
Now, if we had to narrow down the field of disadvantages into three, this is how we'd wrap them up but keep in mind these aren’t disadvantageous in all circumstances.
Resource Demands: Unlike an LLC or partnership, corporations can cost a fair amount in terms of both man-hours and money. It takes time to go through the motions, assemble a board, set up bylaws, and everything else involved. When choosing to start a corporation, as with any business, you have to ask yourself whether this makes economic sense and whether your corporation will realistically be profitable this year, next year, five years from now and ten years from now.
Double-Taxation: First when the company makes a profit, and again when dividends are paid to shareholders.
Formalities & Paperwork: Corporations are highly regulated entities on all levels – federal, state, and sometimes locally – so that’s also a lot more paperwork, documents to be filed, forms, record keeping burdens, etc. If you're not good at record keeping, then you need to find someone who is.
When's The Right Time to Form a Corporation?
An odd question, though common nonetheless. But this needs to be said:
In an ideal world, no one should attempt to form a corporation in any state without first consulting with trained legal and accounting professionals! That’s the truth.
There’s a smorgasbord of expenses and formalities to consider and founders can get in trouble quick if they don’t have help or know what they’re doing. If all you’re trying to do is set up a business entity for limited liability protection, consider other less complex options like an LLC. That being said, here are some realistic situations in which forming a corporation might be a better idea.
- Your platform has reached a point where the issuance of stock options makes sense to attract the best talent in your industry and bring in much larger amounts of investment capital.
- The tax year has ended. It sounds unusual but some states, such as California, do have an alternative minimum tax for corporations. So, for example, if it's November or December and you want to form a corporation, you might be better off waiting until the following tax year (just a few months away) to avoid paying the alternative minimum tax for that year. Consult with your accountant or lawyer on this issue. Your state’s tax website ought to give some guidance on this issue as well.
- Your company profits have reached a point where it makes financial sense to leverage corporate tax benefits.
- Forming a corporation provides you and your founding team with the ownership control you need. For example, to keep the company “in the family” as part of an estate plan, or to give shares to people without having to pay gift taxes (with the help of a good attorney of course).
- You intend on forming a non-profit corporation, which means you form the corporation first and then apply for 501(c)(3) tax-exempt status.
- You may be getting pressure from clients, family, friends, and your professional network to incorporate. Bear in mind that well-meaning people giving their input may not fully understand the implications of forming a corporation, all that it entails, and whether it's the best business choice for you. Just be sure to think it through and really balance the positive and less positive impacts this decision may have on you, your business, and your relationships.
Great, Have Any Good Resources?
Absolutely, Startup Savant has a TON to offer just about anyone interested in starting their own business venture and learning how to form a corporation.
- State Guides: To be prudent, bookmark our Map Page so you can explore options state by state.
- Services Guides: Start with our, “Top 7 Business Incorporation Services” article.