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Corporations are the most common form of business entity because, for a reasonable cost, the owner(s) of the business are afforded personal liability protection. A corporation is a business entity totally separate and distinct from its individual members. In a partnership, individual ownership may be established in a partnership agreement by setting forth a person’s percentage ownership interest in the partnership, and management is usually more informal. In a corporation, ownership is designated by how many shares of the corporation a person owns, and management is centralized in a governing body elected by shareholders. A corporation is much more formal than either a sole proprietorship or a partnership, and to ensure liability protection, all the corporate formalities must be strictly complied with. A corporation is formed by filing “Articles of Incorporation” with the Secretary of State in the state where the corporation is located. Once the Articles of Incorporation are approved by the Secretary of State, they must be recorded (placed on record) in the county where the corporation has its owners and a person must be appointed as a registered agent to receive legal notices on behalf of the corporation. The corporation must also obtain a federal tax identification number or FEIN.
After these preliminary steps are completed, a corporation must have an organizational meeting to complete the corporate book. In the corporate book, accurate details of the organization are set forth. These details, called minutes, include the initial set-up details, formal rules or bylaws of the corporation, the election of a board of directors to manage the company, the election of officers to carry out the board’s directives, and the stock certificates indicating individual ownership in the corporation. Each year, an annual report is completed. In addition, the shareholders and directors of the corporation should meet to conduct new elections and to update the minutes in the corporate book.
The main advantage of a corporation is the protection from individual liability. This means that if the corporation is properly established and is maintained on a continual basis, the owners (shareholders) are protected from personal liability in the same way that limited partners are protected in a limited partnership. While the corporation’s assets may be at risk, the shareholders’ personal assets are totally protected from creditors. This liability protection comes at a cost, both in terms of time and money. As discussed, the corporate formalities, even in a single shareholder company, are elaborate and require professional assistance. Taxes also become complicated because a corporation must file a tax return; however, unlike a partnership, a corporation may be individually taxed depending on the type of corporation it is.
All corporations are separate taxpaying entities (sometimes referred to as C corporations) unless an election is made (and documents filed) to treat the corporation as a subchapter S corporation. In a C corporation, any retained earnings the company has each year are taxed at a corporate rate. When the shareholders or employees of the company are paid or receive compensation from the corporation, they must also pay tax individually. The result is double taxation. To avoid this apparent pitfall, smaller corporations may elect sub-S treatment. In a sub-S corporation, like a partnership, the corporation files a return, however, all income or loss is passed through to the individual employees or shareholder(s). The decision to elect subchapter S treatment may be complicated based on the type of business and the tax deductions that are available to the company. It is important to discuss these issues with your business professionals prior to making this decision. Employees of a profitable C or sub-S corporation may receive a reasonable salary, as opposed to taking compensation totally as dividends.
Additionally, in any corporation of two or more persons, it is imperative that the shareholders enter into a shareholder agreement (sometimes called a buy-sell agreement). This agreement sets forth important rights and obligations of the shareholders to one another. The agreement places an annually updated value on the company and sets forth the rights and procedures for the sale of and purchase by another shareholder. The agreement, among other issues, also clarifies the procedure and costs of shareholder death or disability. Clearly, there are many important efficiency, liability, and tax issues that must be considered when electing to do business as a corporation.
The information above is a review of the most common features of privately owned corporations. The mere fact that a corporation requires more organization should not deter you from choosing a corporate structure, however, you must be prepared to consult with corporate and tax attorneys or accountants prior to establishing the new business entity.
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