Business Types Series-Part Three; The "C" Corporation

C Corporation

A legal form of business entity that may have an unlimited number of shareholders, which may include shareholders who are foreign citizens;

Shareholders are protected from the corporation's liabilities. "Double taxation" frequently occurs, because the corporation is taxed on its profits, and shareholders are also taxed on the distributions they receive, such as profit sharing payments or dividends.

A C Corporation may be public – one in which shares are offered for sale to the public, or privately held – one in which shares are not sold to the public. Usually shares are held by the founders (often a family), by board members and by private investors, such as venture capitalists, who may or may not sit on the board of directors.

While public C corporations have far more stringent reporting requirements than privately held corporations, both must have annual shareholder meetings and minutes of those meetings must be recorded.

When a small business incorporates, it is automatically a C corporation, also called a regular corporation. The most basic characteristic of the corporation is that it is legally viewed as an individual entity, separate from its owners, who are now shareholders. This means that when the corporation is sued, shareholders are only liable to the extent of their investments in the corporation. Their personal assets are not on the line, as they would be if the business was a partnership or sole proprietorship. Any debts that the corporation may acquire are also viewed as the corporation's responsibility. In other words, once the business is incorporated, shareholders are protected by the corporate veil, or limited liability.

Because the corporation is a separate entity, the Internal Revenue Service also views it as an individual taxpayer. As a result, corporations are subject to double taxation, which means that the profits are taxed once on the corporate level and a second time when they are distributed as dividends to the shareholders. (If a business is eligible, it may elect S corporation status to avoid this negative characteristic of C corporations.)

ADVANTAGES

LIMITED LIABILITY Most small businesses that consider incorporating do so for the limited liability that corporate status affords. The greatest fear of the sole proprietor or partner—that their life's savings could be jeopardized by a law suit against their business or by sudden overwhelming debts—disappears once the business becomes a corporation. Although the shareholders are liable up to the amount they have invested in the corporation, their personal assets cannot be touched. Rather than purchase expensive liability insurance, then, many small business owners choose to incorporate to protect themselves.

RAISING CAPITAL It can be much easier for a corporation to raise capital than it is for a partnership or sole proprietorship, because the corporation has stocks to sell. Investors can be lured with the prospect of dividends if the corporation makes a profit, avoiding the necessity of taking out loans and paying high interest rates in order to secure capital.

ATTRACTING TOP-NOTCH EMPLOYEES

Corporations may find it easier to attract the best employees, who may be lured by stock options and fringe benefits.

FRINGE BENEFITS One advantage C corporations have over unincorporated businesses and S corporations is that they may deduct fringe benefits (such as group term life insurance, health and disability insurance, death benefits payments to $5,000, and employee medical expenses not paid by insurance) from their taxes as a business expense. In addition, shareholder-employees are also exempt from paying taxes on the fringe benefits they receive. To be eligible for this tax break, though, the corporation must not design a plan that benefits only the shareholders/owners. A good portion of the employees (usually 70 percent) must also be able to take advantage of the benefits. For many small businesses, the expense of providing fringe benefits for all employees is too expensive, so the tax break may not be considered an advantage.

CONTINUANCE OF EXISTENCE Transfer of stock or death of an owner does not alter the corporation, which exists perpetually, regardless of owners, until it is dissolved. While this is usually considered an advantage, Fred Steingold argues in The Legal Guide for Starting and Running a Small Business that, in reality, "You don't need to incorporate to ensure that your business will continue after your death. A sole proprietor can use a living trust or will to transfer the business to heirs. Partners frequently have insurance-funded buy-sell agreements that allow the remaining partners to continue the business."

DISADVANTAGES

DOUBLE TAXATION After they deduct all business expenses, such as salaries, fringe benefits, and interest payments, C corporations pay a tax on their profits at the corporate level. If any of those profits are then distributed as dividends to the shareholders, those individuals must also pay a tax on the money when they file their personal tax returns. For companies that expect to reinvest much of the profits back into the business, double taxation may not affect them enough to be a serious drawback. In the case of the small business, most if not all of the company's profits are used to pay salaries and fringe benefits, which are deductible, and double taxation may be avoided because no money is left over for distributing dividends

BUREAUCRACY AND EXPENSE: state and federal statutes govern Corporations, which means that they have to abide by sometimes-intricate corporate laws. Therefore, lawyers and tax preparers will need to be hired, and regular stockholder and board of directors meetings will have to be held, and detailed minutes of those meetings must be taken. The directors, who can limit the ability of the corporation to take quick action on pressing matters, must approve all of the corporation’s actions. Corporations have to pay fees, which vary by state, when they file the articles of incorporation. And in order to bring up a case in small claims court, the corporation is required to be represented by a lawyer, whereas sole proprietors or partners can represent themselves. In addition, if the corporation does interstate business, it is subject to taxes in other states.

RULES GOVERNING DIVIDEND DISTRIBUTION A corporation's profits are divided on the basis of stockholdings, whereas a partnership may divide its profits on the basis of capital investment or employment in the firm. In other words, if a stockholder owns 10 percent of the corporation's stock, she may only receive 10 percent of the profits. However, if that same person was a partner in an unincorporated firm to which she had contributed 10 percent of the company's capital, she might be eligible to receive more than 10 percent of the business's profits if such an agreement had been made with the other partners. Strict rules, though, govern the way corporations’ divide their profits, even to the point, in some states, of determining how much can be distributed in dividends. Usually, all past operations must be paid for before the corporation’s directors can declare a dividend. If this is not done, and the corporation's financial stability is put in jeopardy by the payment of dividends, the directors can, in most states, be held personally liable to creditors.

STRUCTURE OF A CORPORATION

In small businesses, the owners often hold more than one or all of the following positions, which are required of all corporations:

•    Shareholders: They own the company's stock and are responsible for electing the directors, amending the bylaws and articles of incorporation, and approving major actions taken by the corporation like mergers and the sale of corporate assets. They alone are allowed to dissolve the corporation.

•    Directors: They manage the corporation and are responsible for issuing stock, electing officers, and making the corporation's major decisions.

•    Officers: The Corporation must have a president, secretary, and treasurer. These officers are responsible for making the day-to-day decisions that govern the corporation's operation.

•    Employees: They receive a salary in return for their work for the corporation.

FINANCING A CORPORATION

Financing the operations of a corporation may involve selling stock (equity financing), taking out loans (debt financing), or reinvesting profits for growth.

EQUITY This is cash, property, or services exchanged for stock in the company. Generally, each stock is equivalent to one dollar of investment. If the small business owner is planning to exchange property to the corporation for stock, then a tax advisor should be consulted; if the property has appreciated, taxes may be due on the exchange.

DEBT This is money lent by banks or shareholders. In the former case, a personal guarantee by the corporation's principals is usually required, which makes an exception to the limited liability rule. The owner of a corporation who personally guarantees a loan is also personally responsible for paying it back if the corporation goes under. Many corporations have preferred to fund the corporation with shareholder money in exchange for promissory notes because unlike dividends, the repayment of debts is not taxable. The Internal Revenue Service monitors such debt closely, though, to make sure it is not excessive and that adequate interest is paid.

PAYING C CORPORATION TAXES

After the C Corporation deducts all business expenses, such as salaries, fringe benefits, and interest payments, it pays a tax on its profits at the corporate level. Then dividends may be distributed to the shareholders, who must pay a tax on the money when they file their personal tax returns. In the case of the small business, though, double taxation may not be a consideration, because most, if not all of the company's profits are reinvested in the business or go to pay salaries and fringe benefits, which are deductible, and no money is left over for distributing dividends.

To avoid double taxation, corporations sometimes pay their shareholder-employees higher salaries instead of distributing income as dividends. But the IRS looks out for this trick and often audits corporations, claiming that executive salaries are not "reasonable" compensation. To prevent this charge, then, the corporation should consider the duties performed, the experience and/or special abilities of the employee, and how much other corporations pay for similar positions before determining "reasonable" compensation. In How to Run a Small Business, the J.K. Lasser Institute also advises that a corporation keep salaries somewhat consistent: "Fluctuating salaries, high salaries in high earning years and low salaries in lean years, will attract a review of salary payments by the Internal Revenue Service. A charge might be made, for example, that the high salary payments were in fact dividend payments."

RUNNING A CORPORATION

Once a small business has been incorporated, the day-to-day management of business affairs should not be that much different than it was beforehand. It is important, though, that the business is treated like a corporation. The courts have been known on occasion to overlook a business's corporate status and find the shareholders/owners liable because the business was run as if it were still a sole proprietorship or partner-ship. Simply filing the articles of incorporation does not guarantee limited liability. In order to maintain corporate status in the law's eyes, these guidelines should be followed:

ACT LIKE A CORPORATION Before doing business, stock certificates should be issued to all stockholders, and a corporate record book should be established to hold the articles of incorporation, records of stock holdings, the corporation's bylaws, and the minutes of board and shareholder meetings. In addition, such meetings should be held regularly (once a year is the minimum requirement). In this way, the corporation can record all-important actions taken and show that such actions were approved by a vote. It is also important to treat the corporation like the separate entity it is by keeping personal and corporate accounts separate. Whereas a small business owner may have previously used one account to pay the company's accounts and personal expenses, as a corporate shareholder, he now needs to receive a regular salary from the corporation, deposit it in a separate account, and pay his personal expenses from that account. In all respects, the corporation and owner must be treated as distinct individuals. Fred Steingold advises, "Document all transactions as if you were strangers. If the corporation leases property to you, sign a lease." In addition, the corporation's full name (which should indicate the company's corporate status through use of "Inc." or an equivalent) must be used on all correspondence, stationary, advertising, phone listings, and signs.

ACT LIKE A CORPORATE OFFICER When the corporation's owner signs her name to checks, contracts, or correspondence for the corporation, she must always indicate that she is the president to show that she is not acting on her own but as an agent of the corporation.

ADEQUATE CAPITAL INVESTMENT AND INSURANCE COVERAGE It is important to protect the corporation against failure due to debts and lawsuits. In other words, simply trying to protect the owners' assets by becoming a corporation and neglecting to fortify the business can be viewed as reason to disregard a business's corporate status in a lawsuit. Therefore, enough capital should be invested in the corporation to handle all business activities. Likewise, if business activities pose a risk to employees or customers and reasonably priced insurance is available to protect against such risks, such coverage should be secured.

 Next week we will discuss the "LLC" and "LLP" Business Models.

Business Types Series-Part Two; The S Corporation

An S Corporation is initially formed in the same manner as a C Corporation, by filing incorporation documents with the state of incorporation. Once the business has incorporated, the owners may decide to file as an S Corporation, within approximately 75 days of incorporating. To do so, they need to file an IRS Form 2553. This does not create a separate type of corporation, but does change the corporation's tax structure.

The S Corporation has shareholders and is taxed like a sole proprietorship or a partnership rather than like a C Corporation, which is taxed as a separate business entity. Income is passed through to the shareholders, who report their pro rata income, or losses, on their individual tax returns. The corporation still files a federal tax return (Form 1120S) and possibly a state return as well, if required by individual state law. The S Corporation shows profits and losses as they pass through to the shareholders, and the corporation does not pay federal income tax as a separate entity. Some states, however, do tax S Corporations in the same manner as C Corporations. Check your state tax laws before electing S Corporation status.

Advantages of an S Corporation

Corporate losses can be passed through to the shareholders, and as the owner (and shareholder), you may be able to take the loss against income that appears on your personal return.

•                You can have the protection of limited personal liability without having to pay corporate taxes.

•                You can minimize self-employment tax and FICA tax. Your profits, as a shareholder, are not taxed in this manner.

•                It's easier to raise capital as a corporation than as a sole proprietorship or partnership.

Disadvantages of an S Corporation

•                Numerous regulations and requirements must be upheld by an S Corporation, including a limit on the number of shareholders (see list below).

•                Like a C Corporation, it can be costly to set up and follow corporate formalities.

•                Close scrutiny by the IRS of shareholder-employees, who must receive reasonable compensation (subject to employment taxes) before any nonwage distributions may be made to that shareholder-employee.

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Other regulations imposed on S Corporations

•                All shareholders must be U.S. citizens.

•                All shareholders must vote in favor of the S Corporation.

•                Benefits, such as health or accident insurance for employee shareholders (with at least a 2 percent partnership), may not be deducted by the corporation.

A corporation that plans to pass through dividends regularly to shareholders may want to elect S Corporation tax status. Also, a business owner who may want to take business losses on his or her own personal tax return, possibly to offset income earned by his or her spouse, may opt for this type of corporation. If you do set up an S Corporation and later decide that there's a better alternative for your business, you can vote to drop S Corporation status.

Like other corporations, the S Corporation can limit the personal liability of the owners. Creditors can go after the assets of the corporation and not the owners, if there are outstanding debts. It is important, however, that the owner keeps his or her personal financial records and those of the S Corporation completely separate, to avoid legal entanglements.

Next week we will discuss the "C" Corporation.

Business Types Series-Part One; The Sole Proprietorship

The Sole Proprietorship is the simplest business form under which one can operate a business. The sole proprietorship is not a legal entity. It simply refers to a person who owns the business and is personally responsible for its debts. A sole proprietorship can operate under the name of its owner or it can do business under a fictitious name, such as Janet’s Hair Salon. The fictitious name is simply a trade name--it does not create a legal entity separate from the sole proprietor owner.

The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. A distinct disadvantage, however, is that the owner of a sole proprietorship remains personally liable for all the business's debts. So, if a sole proprietor business runs into financial trouble, creditors can bring lawsuits against the business owner. If such suits are successful, the owner will have to pay the business debts with his or her own money.

The owner of a sole proprietorship typically signs contracts in his or her own name, because the sole proprietorship has no separate identity under the law. The sole proprietor owner will typically have customers write checks in the owner's name, even if the business uses a fictitious name. Sole proprietor owners can, and often do, commingle personal and business property and funds, something that partnerships, LLCs and corporations cannot do. Sole proprietorships often have their bank accounts in the name of the owner. Sole proprietors need not observe formalities such as voting and meetings associated with the more complex business forms. Sole proprietorships can bring lawsuits (and can be sued) using the name of the sole proprietor owner. Many businesses begin as sole proprietorships and graduate to more complex business forms as the business develops.

Tax Implications

Because a sole proprietorship is indistinguishable from its owner, sole proprietorship taxation is quite simple. The income earned by a sole proprietorship is income earned by its owner. A sole proprietor reports the sole proprietorship income and/or losses and expenses by filling out and filing a Schedule C, along with the standard Form 1040. Your profits and losses are first recorded on a tax form called Schedule C, which is filed along with your 1040. Then the "bottom-line amount" from Schedule C is transferred to your personal tax return. This aspect is attractive because business losses you suffer may offset income earned from other sources.

As a sole proprietor, you must also file a Schedule SE with Form 1040. You use Schedule SE to calculate how much self-employment tax you owe. You need not pay unemployment tax on yourself, although you must pay unemployment tax on any employees of the business. Of course, you won't enjoy unemployment benefits should the business suffer.

Suing and Being Sued

Sole proprietors are personally liable for all debts of a sole proprietorship business. Let's examine this more closely because the potential liability can be alarming. Assume that a sole proprietor borrows money to operate but the business loses its major customer, goes out of business, and is unable to repay the loan. The sole proprietor is liable for the amount of the loan, which can potentially consume all her personal assets.

Imagine an even worse scenario: the sole proprietor (or even one her employees) is involved in a business-related accident in which someone is injured or killed. The resulting negligence case can be brought against the sole proprietor owner and against her personal assets, such as her bank account, her retirement accounts, and even her home.

Consider the preceding paragraphs carefully before selecting a sole proprietorship as your business form. Accidents do happen, and businesses go out of business all the time. Any sole proprietorship that suffers such an unfortunate circumstance is likely to quickly become a nightmare for its owner.

If another party wrongs a sole proprietor, he can bring a lawsuit in his own name. Conversely, if another party wrongs a corporation or LLC, the entity must bring its claim under the name of the company.

Advantages of a Sole Proprietorship

•                Owners can establish a sole proprietorship instantly, easily and inexpensively.

•                Sole proprietorships carry little, if any, ongoing formalities.

•                A sole proprietor need not pay unemployment tax on himself or herself (although he     or she must pay unemployment tax on employees).

•                Owners may freely mix business or personal assets.

Disadvantages of a Sole Proprietorship

•                Owners are subject to unlimited personal liability for the debts, losses and liabilities of the business.

•                Owners cannot raise capital by selling an interest in the business.

•                Sole proprietorships rarely survive the death or incapacity of their owners and so do not retain value.

Forming a Sole Proprietorship

You may already be operating a sole proprietorship. One of the great features of a sole proprietorship is the simplicity of formation. Little more than buying and selling goods or services is needed. In fact, no formal filing or event is required to form a sole proprietorship; it is a status that arises automatically from one's business activity.

Next week in Part Two, we will discuss the "S" Corporation.