What Is a Corporation?

C Corp & S Corp Explanation

What is a corporation

The corporation is America’s oldest and most respected business structure, with hundreds of years of history as the business type of choice for all types of entrepreneurs. Even today, with as many alternatives as there are available, the corporation remains the gold standard of American business formation.

Despite their popularity, the intricacies of corporations, how they compare to other business structures, and their two potential tax structures – C corporations and S corporations – can cause some confusion. Before deciding if this is the right business structure for you, it’s important to understand what a corporation is, how it’s formed, and how it operates.

What Is a Corporation?

The corporation is a business structure that exists as a separate legal entity from its owners and shareholders. Because they are distinct entities from their ownership groups, corporations have their own set of rights. A corporation can buy, sell, own property, enter into contracts, and sue other persons and firms just like an individual.

Corporations also offer personal liability protection to their owners and shareholders. What this means is that if your business is sued, creditors cannot pursue your personal possessions and assets. Instead, they are limited only to the assets of the corporation itself, such as the contents of your business bank account.

How Is a Corporation Taxed?

One of the most important considerations when forming a company and choosing a business structure is how your company will be taxed. When it comes to taxation, there are two different structures for corporations, the S corporation and the C corporation, and they are treated very differently by the IRS.

 

C Corporations

The C corporation is the more common designation, as all new corporations are automatically classified this way.

When a C corp files taxes, its profits are first taxed at the current corporate tax rate of 21%. While this is high, it’s a considerable drop from the 35% rate corporations paid before the Tax Cuts and Jobs Act of 2017 reduced it to its present rate.

Any business income paid out to the company’s ownership as dividends is then subject to personal income tax. This means the same profits are first taxed at the corporate level and then taxed at the personal level.

While this tax burden can be high, one benefit of a C corp is that benefits such as health, disability, and life insurance policies are deductible. These benefits aren’t taxable to your shareholders if you provide them to at least 70% of your employees.

 

S Corporations

The alternative to a C corporation is an S corporation. This format is less common since a company must fit the following criteria to qualify:

  • Must not have more than 100 shareholders
  • May only issue one class of stock
  • Shareholders must all be United States citizens or residents
  • Cannot be owned by another corporation, or by an LLC, partnership, or trust

If your business fits those criteria and you want to form an S corp, you can do so by filing an “Election by a Small Business Corporation” form with the IRS along with any paperwork required by your state of formation.

The main benefit of designating your company as an S corp is that it avoids double taxation. An S corp is taxed much like a limited liability company, in that the profits are “passed through” the company to its shareholders. This means profits are subject only to personal income tax, not corporate tax.

S corp owners will still be responsible for paying self-employment taxes (15.3% for Social Security and Medicare). Still, self-employment tax for S corp owners is only paid on the salary portion of your business income — distribution income will be taxed at your regular income tax rate.

Unfortunately, S corps cannot deduct benefits like C corps can. Instead, benefits are taxed for any shareholder who owns at least 2% of the corporation’s stock.

 

Which One Is Best for Me?

Whether a C corp or an S corp is right for you will depend on the size, scope, and function of your business. You will have to take into account your growth potential, and how much flexibility you need in terms of stock type, ownership, and future shareholders.

For larger companies who want to keep all of their options open, a C corp may be the best choice. Smaller companies with few shareholders and limit growth moving forward may benefit from the tax incentives of an S corp.

How Do I Form a Corporation?

The process of forming a corporation can vary depending on what type of business you own and where it’s being formed. There are, however, some standard steps required for every corporation.

First, you’ll need to draft your articles of incorporation. This form will contain the most vital aspects of your company such as company name, location, and ownership, as well as what type of business your company conducts.

You will also want to create a set of corporate bylaws. This document will outline information about your registered agent, critical details about running shareholder meetings, how your company will issue and transfer stock, and details about your board of directors and their governing power. The bylaws are also where you will designate corporate officers and outline how your business will declare dividends.

Next, you’ll need to generate stock certificates and provide them to your shareholders to represent their partial ownership. If you choose to register as an S corporation, you’ll need to file the appropriate paperwork to request this designation.

The process of setting up a corporation can be daunting. While it’s possible to handle this on your own, it may be beneficial to hire a professional business services company to take care of the leg work and avoid errors. There are several reputable companies that offer corporation formation services at a reasonable rate.

  • IncFile: $49 – At only a slightly higher price point, IncFile offers the benefits of a larger, industry leading company and a full year of registered agent service.
  • Rocket Lawyer: $99 – While Rocket Lawyer’s standard formation package is not the best on the market, it’s comprehensive business and legal services package can be a great choice when forming your corporation. It combines the benefit of formation services with additional features like attorney consultations.

Pros and Cons of a Corporation

While the specific nature of your business, it’s size, scope, and needs will all come into play when deciding if a corporation is the right structure for you, there are some fairly universal pros and cons to consider when making your decision.

 

Pros

Limited Liability Protection: As mentioned above, just like limited liability companies (LLC), corporations offer their owners and shareholders personal asset protection by limiting their liability in times of legal action. This protection stems from the fact that a corporation exists as a separate entity from its owners.

This means that, in the face of legal action, creditors can only pursue company assets. By contrast, owners of sole proprietorships and partnerships are not afforded this protection.

Established Legal Precedent: Because the corporation as a business structure has been around for hundreds of years, the courts have ruled on just about every aspect of how they operate.

Unlike newer business structures like the LLC, the courts are extremely predictable in the way they’ll rule on issues related to corporations. This means that you can feel confident in the rights and protections afforded to you and your business under your corporation’s legal framework.

Ability to Issue Stock: This is a major advantage for corporations in a few different ways. First, the ability to issue stock is a great incentive to potential investors, and gives owners a big leg up when it comes to raising capital for their businesses. LLCs, sole proprietorships, and partnerships are not able to offer this options when seeking investments.

Beyond outside investors, the ability to offer stock and/or stock options is also an attractive option for employees. It can give your company a competitive edge against other business structures when it comes to attracting and retaining the best talent. It also serves as an incentive for employees to do their best work, since they are vested in the company as stockholders.

Ability to Transfer Ownership: Because a corporation exists as a separate entity from its owners and shareholders, a transfer of ownership is fairly simple. Unlike sole proprietorships and partnerships that are legally indistinguishable from their owners, and thus difficult to sell or transfer, a corporation can change hands in a number of ways.

For example, shareholder responsibilities may be reorganized or the entire company may be sold to another party. No matter who owns a corporation, the core of the business can continue uninterrupted.

 

Cons

Expensive and Complicated to Form and Maintain: Compared to other business types, corporations can be much more expensive and complicated to run. When all formation fees, maintenance fees, and taxes are taken into account, some estimates put the annual cost of running a corporation anywhere from $2000-$7500.

Beyond this, the day-to-day requires more effort than some other business types. Holding shareholder meetings, keeping impeccable accounting records, and filing any required reports with your state of formation are all critical parts of keeping a corporation in good standing.

Double Taxation: Unless you meet the qualifications for an S corp, your corporation will likely be subject to double taxation, which means that business income is taxed both on the corporate level and the personal level. You will need to claim this income on your personal tax return and your company’s business return.

Low Flexibility: The corporation is a fairly rigid business structure, with little flexibility in terms of how it is operated. You will need to follow the legal formalities of the business structure in great detail, from the way the company is managed and operated, to the way your shareholders vote on important business matters.

Final Thoughts

There are quite a few things to consider when you’re deciding whether or not to form a corporation for your business. Because of the costs and work required, it’s may make sense to rule out other business structures before making your final decision.

Perhaps your business can succeed just as effectively as an LLC or partnership. If you do decide a corporation is the best choice for your business, you’ll need to determine whether you will designate as a C corp or an S corp.

Each step of the decision making process should be taken with care and consideration of your specific circumstances, resources, and goals.

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