One of the best-known and most widely used business entity forms is the corporation. One of the main advantages of forming a business as a corporation is the liability protection it provides its shareholders. Liability is limited because the corporation is a legal entity separate from its shareholder owners.
To form a corporation, articles of incorporation must be filed with the secretary of state's office in the state in which the corporation is being organized.
In this article, we answer the question “What is a corporation?”, explore the pros and cons of a corporation, list the steps required to start a corporation, and answer important FAQs.
What is a corporation?
A corporation is a legal business entity. Importantly, a corporation is separate and distinct from its owners (known as shareholders).
Traditionally, corporations are viewed as having four identifying characteristics:
- Continuity of life
- Centralization of management
- Limited liability
- Free transferability of interests
As a separate legal entity, the corporation has a perpetual life. This means that it can continue as an entity indefinitely until the shareholders/owners choose to dissolve it. A corporation continues to exist even after the death, incapacity, or withdrawal of shareholders, directors, or officers.
Furthermore, as a separate legal entity, the corporation is liable for its own debts and can only be held liable to the extent of the corporation’s assets. Even though shareholders can profit from the corporation through dividends and stock appreciation, they can’t be held personally liable for the business’s debts. The assets of a shareholder (owners) are personal assets that cannot be reached by corporate creditors, unless the "veil" of corporate limited liability is "pierced." The corporate veil is pierced when the required corporate formalities, such as having annual directors' and shareholders' meetings, etc., aren't followed.
Although the corporate form generally results in limited liability, lenders usually require the shareholders of small, closely held corporations to personally guarantee corporate loans. If you personally guarantee the loans, you will have to pay the lender if the corporation is unable to pay.
C corporation vs. S corporation
A C corporation is the default form of a corporation under IRS rules. An S corporation is still a corporation, but it has elected a special tax status and has certain tax advantages.
A C corporation and S corporation are named after the IRS code that they are taxed under. C corporations are taxed under Subchapter C, while S corporations are taxed under Subchapter S.
When you form a corporation with your state, your corporation will be taxed under IRS Subchapter C, unless you are eligible and elect to be taxed under Subchapter S. To elect Subchapter S status when starting a corporation, you must file Form 2553 with the IRS and ensure that all S Corporation guidelines are met.
There are many advantages to choosing a corporation as your business structure. These include the following:
- Limited liability. As an owner/corporate shareholder, you are generally not liable for the debts and obligations of your company.
- Tax planning advantages. There are many tax strategies that can only be employed by a corporation. In addition, a corporation provides opportunities to retain or pass along earnings in ways that are not allowed in partnerships, sole proprietorships, or even LLCs.
- Earnings can be retained. A corporation can reinvest or pay down debt once all dividends have been paid to shareholders.
- Unlimited life. The corporation will continue to exist even if the owner is disabled or passes away.
- Ability to raise capital. Corporations can raise capital by selling shares of stock.
- Credibility. Corporations are often perceived as more professional or legitimate than non-incorporated businesses like sole proprietorships and general partnerships.
Every form of business also has disadvantages. Some of those for corporations include:
- Formalities required. A corporation must follow certain formalities dictated by law to maintain its corporate status.
- Administration. The administration of a corporation is complicated since certain federal and state tax procedures are necessary and some accounting methods may not be available.
- Cost. The cost to incorporate an entity can be considerable. There are also annual filing fees that must be paid in most states. Furthermore, the administrative costs of accounting and tax preparation may be expensive due to the complexity of complying with corporate laws.
- More complicated tax compliance. A corporation is a separate taxable entity. Sound tax advice is needed to minimize the impact of double taxation of your revenue — at the corporate level and when it is passed only to you as dividends or salaries.
Steps to forming a corporation
There are several steps to forming a corporation. These must be completed before and after you file incorporation paperwork with the Secretary of State in the formation state. Although actual requirements can vary depending on the state, they typically involve the following:
- Select a state of incorporation. A corporation typically incorporates in the state where it conducts business. If you choose to transact business in another state, you must qualify as a foreign corporation in that state. Many corporations that do business in multiple states choose to incorporate in the state where they are headquartered.
- Choose a business name. Corporate statutes impose guidelines for a corporation’s choice of name. A corporation must include a word, phrase, or abbreviation that indicates that the business is a corporation, such as Corporation, Incorporated, Limited, Corp., Inc., or Ltd. Words that may mislead are also prohibited. Lastly, the corporation’s name must be different from other names on the state filing office’s records.
- File incorporation paperwork. Depending on the state, a corporation’s formation document is called Articles of Incorporation or Certificate of Incorporation. These documents are generally filed with the Secretary of State’s office.
- Appoint a registered agent. A corporation must appoint and maintain a registered agent. The agent acts on behalf of the corporation and receives important tax and legal documents. This includes mail sent by the state, state tax documents, and service of process.
- Prepare corporate bylaws. Bylaws stipulate how you must operate your corporation. Initial bylaws are adopted after the articles of incorporation are filed at an organization meeting.
- Draft a shareholders’ agreement. This is an optional document that outlines shareholders’ rights and obligations. It is most helpful if your corporation has only a small number of owners/shareholders.
- Hold the first board meeting. Once articles of incorporation are filed, you must hold an organization meeting. During this meeting, corporation directors are elected (if not already listed in the articles). Meeting minutes are filed in the corporation minutes book.
- Get an EIN. Issued by the IRS, an Employer Identification Number (EIN) identifies your company and is used on all federal income tax filings.
- Select a tax election. You can elect that your corporation is taxed federally as an S corporation or C corporation. The decision can have tax impacts and should be discussed with a tax professional. To file as an S Corp you must file Form 2553 with the IRS. No filing is needed to elect C corporation status.
- Register a DBA. If conducting business under a name that’s different than your company’s legal name, you will need to make a DBA filing (“doing business as”) with your local or county clerk’s office, with a state agency, or both.
- Comply with other tax and regulatory requirements. These typically involve obtaining a sales tax ID and the appropriate licenses, permits, and insurance.
Once the secretary of state's office accepts the articles of incorporation, it will send a certificate of incorporation. Many states require that a copy of the certificate of incorporation be recorded in the local recorder's office where the corporation resides.
As mentioned in step 1, a corporation does not have to be organized in the state in which it is going to do business. It can be organized in any state. Many corporations organize in Delaware or Nevada to take advantage of favorable corporate laws. (Read: Key Issues in Selecting Formation State for more information.)
If your desired corporate name is already in use by another corporation, the incorporation documents will be rejected. Save time and effort by determining whether the proposed corporate name is available before filing the incorporation documents. Contact your state's secretary of state's office and ask them to reserve the name for you. If the name already exists, they'll tell you.
Corporation frequently asked questions
How do corporations operate?
A corporation is owned by its shareholders, but the shareholders don't have any control over the day-to-day operations of the business directly. Instead, the shareholders are responsible for electing directors of the corporation who oversee the operation of the corporation and make major corporate decisions, such as appointing officers. The directors meet at least annually to assess the past performance of the corporation and to plan for the future. The officers of the corporation are responsible for the day-to-day operations of the company.
Once directors are elected and corporate officers are appointed, the corporation can begin to operate. It is important that the corporation observe all the formalities of being a corporation. The formalities include:
- Adopting bylaws
- Issuing stock certificates to the shareholders
- Holding annual meetings--and complying with meeting notice provisions
- Electing directors or ratifying the status of existing directors
- Recording meeting minutes in the corporate register
Observing all the corporate formalities provides evidence that the corporation is a separate legal entity rather than an extension of the shareholders. The reason it is necessary to enforce the notion that the corporation is a separate legal entity is to protect the limited liability of the shareholders.
In small, closely held corporations, take extra precautions to see that all corporate formalities are observed. If the corporate formalities are not observed, someone suing the corporation may be able to show that the corporation is not a separate entity from its shareholders. The shareholders will then be liable for the corporation's debts.
Do corporate bylaws need to be filed with the state?
While corporate bylaws do not need to be filed with the state Secretary of State’s office, they are an essential element in insuring that your corporation is respected as a separate entity for both tax and asset protection purposes. Corporate bylaws must be tailored to meet the specific needs of your business. One size truly does not fit all. Your documentation burden does not stop once your bylaws are adopted. To avoid the risk of having your corporation disregarded, you must document shareholder and director meetings.
You must also document financial dealings between the corporation and its shareholders, directors and officers. For example, a loan made to or from the corporation should be evidenced by a corporate resolution.
How are corporations taxed?
In general, corporations are separate taxable entities that are subject to federal and state taxation. Corporate income is taxed at the corporate level. When that income is passed on to the shareholders as a distribution or dividend, it is taxed again on the shareholder's individual tax return. Double taxation may be partially or completely avoided in a small business by paying a salary to the employee shareholder. However, the tax laws governing this area are complex and should be discussed with your accountant or attorney.
Also, be aware of the tax consequences upon dissolution of a corporation. With all forms of business entity except a C corporation, dissolution and distribution of the business's assets to the owners is, at worst, a single taxable event. In a C corporation, a double tax may be due; the corporation may owe a capital gains tax on liquidation and the individual shareholders also must recognize a gain upon the transfer of proceeds from the corporate entity to the individual recipient. Consequently, dissolving a C corporation can have serious tax ramifications, so think carefully about incorporating in this form if you anticipate a short-term business opportunity.
What are some ways to maintain corporate business continuity?
A corporation with two or more shareholders may require the efforts of all the shareholders to succeed, especially in the early life of the business. If one shareholder withdraws or dies, the existence of the corporation may be threatened. To protect the corporation and the remaining shareholders, consider buy/sell agreements and key person life insurance policies for the shareholders.
A buy/sell agreement specifies how the value of a shareholder's interest will be determined if a shareholder wants to leave the corporation. The agreement minimizes disputes over the company value and facilitates the purchase of the withdrawing shareholder's interest by the corporation or other shareholders.
Key person life insurance is a life insurance policy on the life of key members of an organization to provide cash in the event of the death of a key member. The beneficiaries of a key person policy are the organization or the organization members. In a corporation, key person life insurance can be purchased on the life of all shareholders or on some designated class such as corporate officers. The life insurance proceeds can be used by the corporation to keep the business going in the absence of a key shareholder or officer. The proceeds can also be used to buy out a deceased shareholder's interest pursuant to a buy/sell agreement.
What is a close corporation?
Some states allow a type of corporation called a close corporation, which may appeal to small business owners. A close corporation is one that is managed by its shareholders. Directors do not have to be elected and officers do not have to be appointed. In addition to these formalities being eliminated, the laws usually streamline some of the other meeting and voting requirements. The intent is to relieve some of the administrative burdens to the small corporation owner. If a close corporation appeals to you, consult an attorney in the state you are incorporating in to determine if a close corporation statute exists.
What is a professional corporation?
The corporate form can also be used for professional service providers. The main advantage of incorporating is that professionals in the corporation are not liable for the malpractice of others in the corporation, but they still remain liable for their own individual acts. Incorporating a professional corporation is essentially the same as incorporating any other corporation. A professional corporation, however, must identify itself as such by including the following in its name: P.C., P.A., chartered, or incorporated.
Once created, only professionals can own shares of the corporation. The corporation can only provide one form of service, i.e., a professional corporation of lawyers who are also accountants can provide legal services but not accounting services. There are many other aspects of professional corporations that should be addressed before you venture into this form of entity. Your attorney or accountant can advise you as to whether the professional corporation is right for your situation.