Business Formation: Forming a Corporation
June 23, 2014
Forming a corporation is the focus of this installment of our series on business formation and choosing the right business structure. This article follows the one about forming an LLC. So, track back and read that one if you missed it.
What is a Corporation, and How Is It Created?
A corporation is a person. That might seem counter-intuitive, especially to people who believe corporations should not have certain rights and constitutional protections (e.g., freedom of speech, etc.) we normally extend to persons who are citizens of the U.S. This article will not discuss whether corporations should enjoy such rights; Citizens United has been decided, and the propriety of the outcome of that case is not the focus of this article. What we want to zero in on, here, is the essence of a corporation, and to really understand that, we need to acknowledge that, under current U.S. law, a corporation is a person.
Obviously, a corporation is not a natural person; so, how does it come to exist? The short answer is: an incorporator files the corporation’s charter with the Secretary of State (and pays the related fee). “The charter is the document filed to become incorporated. It is composed of the articles of incorporation that set forth certain minimum information about the corporation that is required by law. The incorporator is the person that files the charter of the corporation. The incorporator must be of legal age to enter into contracts. Once the articles of incorporation are filed, the incorporator’s function is complete.”1 (This applies specifically to Tennessee corporations. Depending on your jurisdiction, your mileage may vary.) Once a corporation’s charter has been filed and approved, it becomes incorporated. This is the birth of the corporation.
The corporation’s charter defines the corporation’s structure, hierarchy, and articulates much about how it will operate. What is not in the charter is often contained in the corporation’s bylaws and other documents–for example, its Employee Handbook, etc. Every corporation is required by law to have at least one annual meeting, and corporations, generally speaking, are owned by one or more stockholders, and, therefore, they all issue one or more shares of stock in the corporation. This is a defining characteristic of corporations that sets it apart from partnerships (who have partners, not stockholders or members) and LLCs (who have members, not stockholders or partners). Often, Corporations also have either Executive Officers or Boards of Directors or both. Ultimately, the Executive Officers report to the Board of Directors and the Board of Directors usually reports to the shareholders. These are broad, general statements, but are true more often than not. Again, depending on the corporation and jurisdiction, your mileage may vary.
S-Corporations vs. C-Corporations
The default designation or status for a corporation is for it to be a “C-Corporation;” if the incorporator takes no specific action to specify the corporation as an “S-Corporation,” it will be incorporated as a C-Corporation. Whichever form of corporation you choose, your corporation is entitled to limited liability, which is the primary reason most people incorporate. Beyond limited liability, people are familiar with the structure of a corporation–a separate legal entity (“person”), owned by shareholders, governed by a board of directors, the day-to-day operations of which are run by officers elected by that board.
Whether one chooses to file a one-page an “S-election” with the IRS or to remain a C-Corporation (by default) is largely a decision based on the preferred tax liability for the business. S-Corporations can be taxed almost like an LLC or Partnership. Corporations can switch between “S” and “C” status, but this decision should not be made lightly, as the tax ramifications of this decision are quite serious as we will discuss more, below.
Generally speaking, income from a corporation–specifically a C-Corporation–is taxed twice (three times, if you count Capital Gains Tax on the sale of shares of stock). The corporation first pays taxes on its net income. Then, shareholders pay tax, again, on distributions of profits (dividends, etc.). An S-Corporation can elect to be taxed only once, at the shareholder level, and, in this way, it is more similar to a partnership or a pass-through LLC for tax purposes.
Why to Form a Corporation
As mentioned, above, most people consider forming a corporation to obtain limited liability, to protect their personal assets from business risk, and to benefit from the corporate structure, the inherent benefits of which include a built-in system of checks and balances, among others. There is no limit to the number of shareholders a C-Corporation can have; S-Corporations, on the other hand, are limited to 100 shareholders who may only be U.S. citizens and resident aliens. Generally speaking, S-Corporations are also required to have only individual shareholders; and their fiscal year must track with the calendar year. Finally, if a corporation elects to be an S-Corporation, the only differences permitted between different classes of stock are differences in voting rights.
So, forming an S-Corporation is often preferable for small businesses, because the requirements with which an S-Corporation must comply force their tax reporting to track more closely with individual reporting than a C-Corporation’s reporting forces it to do. Put another way, the S-Corporation’s tax reporting is more likely to feel familiar to a small-business-person who may not be as sophisticated or may not have as many licensed professionals (accountants, attorneys, etc.) on staff to handle regulatory and tax compliance.
The above two paragraphs are really more properly described as “Why to consider an S-Corporation,” rather than Why To Form a Corporation at all. In my opinion, if you are forming a corporation solely to limit your liability, you are likely making a hasty decision. For many small- or -medium-sized-businesses, an LLC will achieve an adequate liability limitation threshold at a lower operating cost than a corporation is likely to have. Choosing a corporation, in my opinion, should be done only when the corporate structure strongly appeals to the incorporator (or group of incorporators) and when the incorporator needs to raise large amounts of capital quickly.
Other Considerations When Forming a Corporation
An S-Corporation can be a good choice over an LLC, just as a C-Corporation can be a good choice over an S-Corporation. Each company, each incorporator (or organizer) must weigh a complex set of variables, costs, and benefits in choosing the type of entity to create, and that choice primarily should be based on the tax liabilities and the appeal (or lack thereof) of the business structure to the involved parties, which are going to have long-term impacts on the business’s bottom line. If you are going to elect to form an S-Corporation, you should be aware that the accounting rules they are required to follow are complicated enough that converting from a C-Corporation to an S-Corporation can be difficult, and, therefore, expensive. For example, if an S-Corporation was a C-Corporation, and if it elected “S status” within the previous 10 years, it may face corporate tax (double taxation). Filing for S-Corporation election within 75 days of initially forming the corporation can enable you to avoid some of these complicated rules and reduce the cost of running your company; remember, you can always switch back to a C-Corporation, later.
Claiming business losses on his personal tax return might appeal to a small-business-person, and that’s not possible with a C-Corporation, but it is possible with a pass-through S-Corporation. Also, the double taxation that attends C-Corporations can quickly wipe out profit margins for small businesses. However, these concerns–very real, very valid concerns–do not necessarily weigh in favor of the S-Corporation form for all incorporators.
Finally, every business–corporation, LLC, what-have-you–is going to have a strong interest in establishing a powerful brand in their market. That is not inexpensive. So, when you invest in building your brand, you will want to protect it. That means having an attorney who can handle a broad spectrum of business legal issues, including intellectual property concerns. Corporations also have specific legal needs pertaining to securities regulation compliance. Corporations absolutely must have legal counsel and an accountant. That does not mean they must hire an attorney and an accountant as employees, but a corporation that does not hire both an attorney and an accountant, at least, on a contract basis is taking an irresponsible risk about which its shareholders should be deeply concerned.
Having both an accountant and a business lawyer as part of your team are essential, even if you cannot afford to put either on your payroll. An attorney who serves as “general counsel” is the chief lawyer for a business; if that lawyer is independently contracted, and not on the business’s payroll, he is said to be “outside general counsel” for the business. Outside general counsel services are crucial to a business’s success, because legal services are necessary for every business, and are one area where cutting corners will usually result in expensive problems later. Taking a proactive, preventive approach to your legal issues can seem costly, but the preventive approach is often far less expensive than the alternative—litigation. Obviously, unless you’re a CPA, you also need an accountant for similar reasons. It’s better to pay a little for bookkeeping services in advance than pay a lot when you get audited, later.
In addition to reiterating the need for having both outside general counsel and a CPA on your team, is the necessity of a written business plan. A business without a written business plan is like an ancient sailing ship on the high seas without a map. It might be a sunny day with wind in your sails when you start out, but a storm is coming, and you’re going to get tossed around a bit. You better have a way to figure out where you are when that happens. A well-written, thorough business plan will keep you oriented on your priorities and help you stay on track, come what may.
Winding-Up the Business Formation Series
This is the last article in the Business Formation Series of articles from Executive Legal Professionals, but we hope you will bookmark www.ExecutiveLP.com and come back often for additional, helpful resources that will help you make wise business decisions. I have enjoyed writing these articles, and I hope, if you need a business attorney, you’ll contact us.
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