When to Form a Corporation: Small Business
Most small business owners will benefit from forming a separate legal entity to protect their personal assets. This protection is called limited liability protection and without it, you'll be held personally liable in the event of a lawsuit or unpaid debt.
You can get limited liability protection by forming a limited liability company (LLC) or corporation.
Corporations are the right choice for small businesses and startups that will rely on investors. This is because of the way corporations are taxed compared to an LLC. If a business won't need capital from outside investors, forming an LLC will be the best choice.
Why Corporations Attract Investors
Corporations attract investors because investors are only taxed on the distributions (dividends) they receive from the corporation. In an LLC, the investor would be taxed on their portion (based on ownership interest) of the profits even if they don't receive a dividend.
When LLC ownership changes, it can be challenging to transfer investment interest in the LLC. Corporate shares make this process easy.
Need Help Forming a Corporation? Check out our How to Start a Corporation guide to learn how to get started.
When to Use an LLC for a Small Business
LLCs are great for small businesses that need a low-cost, simple way to get limited liability protection. Corporations can be complex to run and maintain and unless a small business needs to attract investors, small businesses should form an LLC.
Forming an LLC is Easy. Check out our How to Form an LLC guide to get started.
The corporate structure has several advantages when compared to some other business types, including:
- Limited Liability: A corporation is a separate legal entity from its owners. Under a corporation, owners won't be held personally liable in the event of a business loss if the corporation maintains its corporate veil. This means that if the corporation goes into debt or loses a lawsuit, the owners’ personal financial assets are not at risk. Limited liability companies (LLCs) also offer personal liability protection, but sole proprietorships and partnerships generally do not.
- Greater Investor Appeal: Corporations tend to be more attractive to outside investors due to their stock ownership structure. This is the structure with which most investors are familiar and comfortable. Corporations generally also have more formal management and operations, which investors may find appealing.
- Simplified Transfer of Ownership: A corporation’s stock structure allows for easy transfer of ownership stakes. Shares can be bought or sold on the stock market or in private transactions, depending on the company.
- Potentially Lower Taxes: Corporations pay a federal corporate tax on corporate profits. Profits are taxed at the current federal corporate tax rate is 21%, which is lower than the personal tax rate that some owners of LLCs, partnerships, and sole proprietorships must pay.
- Added Credibility: Incorporating your company can make it seem more legitimate to both potential investors and customers.
- Perpetual Life: Unlike sole proprietorships and partnerships, corporations will continue to exist even after the departure or death of their owners.
While forming a corporation provides a number of advantages, it also comes with some potential disadvantages. It’s important to weigh these pros and cons when deciding whether or not to incorporate your business.
The main disadvantages of a corporate structure include:
- Double Taxation: While corporations may have a lower tax rate than what some other types of businesses pay, they also are subject to “double taxation.” This means the profits of a corporation are taxed at the corporate level and then the owners must pay taxes on the dividends they receive.
- Potentially Higher Formation Fees: It’s more complicated to form a corporation than other types of businesses. The formation process often requires hiring an attorney or other outside professionals, which can significantly increase start-up costs.
- More Regulation and Oversight: Corporations are subject to more rules and regulations than other types of businesses. This includes keeping and filing more paperwork to stay compliant, which can be a time-consuming and expensive activity.
Types of Corporations
When most people think about a standard corporation, they probably think of a for-profit C corporation (C corp). This is the structure of some of the world’s most well-known corporations, like Coca-Cola, Apple, and Walmart.
This isn’t the only type, however, and some corporations can fall under more than one of the below categories (e.g., as both a C corp and a public corporation):
- C Corp: This type of corporation pays tax at the corporate level and then its owners pay tax on the dividends they receive from the company.
- S Corp: This type of corporation is still owned by shareholders, but there’s a limit to the total number of shareholders (usually 100) and profits aren’t taxed at the corporate level. Instead, profits or losses pass through to the shareholders’ individual tax returns.
- Nonprofit Corporation: Nonprofits are exempt from paying taxes. This type of corporation can pay salaries, but it retains any additional profits after expenses to fund operations rather than distributing those profits to shareholders.
- Professional Corporation: A professional corporation is owned by professionals who are licensed for a particular profession (e.g., attorneys, doctors, and architects).
- Benefit Corporation: A benefit corporation is a for-profit corporation that also has a legal obligation to produce a public benefit for society and/or the environment.
- Public Corporation: Public corporations list their shares on a stock exchange, such as the New York Stock Exchange or Nasdaq, and make their shares available to be bought and sold by the public.
- Closely Held Corporation: These corporations have a relatively small number of shareholders and don’t list their stock on a public exchange.
Corporate taxes can be complicated and may vary significantly, depending on the type of corporation:
- C Corp: In general, a for-profit C corp pays a federal income tax of 21% and then its shareholders pay personal income tax on any dividends they receive. This is often referred to as “double taxation.”
- S Corp: S corps don’t have to pay a corporate income tax. Instead, the corporation’s profits or losses pass through to its owners’ personal tax returns and are taxed at the owners’ individual tax rate.
- Nonprofit Corporations: Nonprofit corporations are exempt from taxes.
Corporate laws and regulations can vary, depending on the corporation type and state laws, but most corporations must meet several general requirements. These include:
- Issuing Shares of Stock: One of the primary things that make a corporation different from other business structures is that corporations issue shares of stock. These shares represent an ownership stake in the company and can be bought and sold.
- Appointing a Board of Directors: Corporations must appoint a board of directors to oversee the company’s operations.
- Holding an Annual Shareholder Meeting: Corporations generally must hold an annual shareholder meeting during which shareholders elect directors and vote on other proposals. These proposals can be initiated by the corporation or by shareholders.
- Keeping Meeting Minutes and Company Records: Corporations usually have stricter record-keeping requirements than other types of business structures. This can include keeping minutes of shareholder and board meetings.
Forming a Corporation
Forming a corporation is a multistep process that’s more complicated than forming an LLC, partnership, or sole proprietorship. It’s often a good idea to hire someone to assist with the process.
ZenBusiness offers affordable coropration formation services.
You can form a corporation yourself by creating an initial board of directors and filing the articles of incorporation. Choose your state to get started:
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Carolina
- North Dakota
- Rhode Island
- South Carolina
- South Dakota
- Washington D.C.
- West Virginia
What are the types of corporations?
There are several types of corporations, including C corp, S corp, B corp, nonprofit, and professional.
How are corporations taxed?
Different types of corporations can be taxed in different ways.
C corps generally face “double taxation,” which means they pay a federal corporate income tax, then shareholders pay personal income tax on their dividends.
As pass-through entities, S corps don’t pay income tax at the corporate level and all profits and losses pass through to their shareholders’ personal income tax returns.
Nonprofit corporations are not taxed.
What is an example of a corporation?
There are many examples of corporations, but two popular examples of a standard C corp include Walmart and Apple.
How do I start a corporation?
Starting a corporation includes several different steps and may require hiring professional assistance. Read our How to Start a Corporation guide for more details. If you’d like to hire a professional service to set up a corporation for you, take a look at our Top 7 Business Formation Services review.
What is an S corp?
An S corp is a type of tax designation that allows a corporation to pass all of its profits or losses through to its shareholders’ personal tax returns rather than paying a corporate income tax. A corporation must meet certain conditions to qualify for this status. It's best to form an LLC and elect S corp tax status for the LLC.