Corporations are probably the most widely talked about business types in the United States – if not the world at large – and yet, also the most complex and yet easily misunderstood. Many new business owners who would otherwise be in sole proprietorships or even partnerships believe that the first thing they must do when forming a business is to incorporate – and this likely may not be the case early on; at the same time, there are those who believe that incorporating is for Fortune 500 companies and that there are no benefits for small businesses – and that may also not be true.
In order to determine whether forming a corporation is appropriate, it’s necessary to ask three questions:
- Do you have assets that need to be protected?
- Are you staying in business for the foreseeable future?
- Are you going to be (or willing to down the road) giving up/selling ownership stake in your company as a means of capital gain?
If the answer to any or all of these is yes, you should form a corporation.
A corporation is a business entity that is legally separate from its owners. It has the right to enter into contracts, take legal action against others, give and receive loans, own assets, hire workers and pay taxes.
One of the most significant things about a corporation is its limited liability. That is, shareholders have the right to participate in the profits through stocks and paid dividends but are not held personally accountable for the company’s debts or legal issues that may arise.
There are two types of corporations – S Corporations and C Corps – to be discussed here:
An S Corporation is a business entity that is federally taxed in a certain way. It is taxed as a pass-through entity by the IRS. This means that the S Corporation gives out stock to shareholders they are protected from liability just as they would be if they had an incorporated business. That means that if something bad happens to the business, the shareholder’s personal bank accounts cannot be tapped.
Each shareholder is subject to their own tax rates on their shares, on individual returns.
It is necessary to point out that the IRS does have a list of requirements to meet S Corporation status:
- Be US-based
- Have only allowable shareholders including individuals, certain trusts, and estates and may not include partnerships, corporations or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not be a company such as a financial institution, insurance company or do any international sales.
There are a lot of advantages to S corporations, especially if you change structure or transfer ownership.
On the other hand, if you make a simple mistake with your taxes, it can cause you to lose your S corps status. Additionally, the IRS pays more attention to S corps to make sure that everything is properly reported. There are several tax obligations that can make S corps tricky – as such any navigation through the formation of this type of business entity should not be undertaken without a professional advisor such as Dunham Tax Professionals.
The other type of corporation is C Corporation. A C corporation is a business entity that is taxed separately from its owners. Businesses are incorporated differently in all 50 states. All C corps are required to issue financial statements.
Whereas S-Corporations tax shareholders individually, in C Corporations the business and owners are taxed completely separately.
Key features of the C Corporation are:
- Limited liability – if something bad happens to the business, it’s seen as a separate entity from its owners and founders. This can protect business owners, so they are not liable if things go wrong.
- Easier to raise capital – C corps are attractive to employees because of stock options. These options can help lure in top notch employees, especially when the business is first starting out and there aren’t a ton of funds for giant salaries.
C Corps have different requirements than other business entities. You must fill out more paperwork. In fact, you’re required to hold formal shareholder meetings and take notes on them. You need to spend more time dealing with taxes and nitty-gritty details than for other business entities. The corporate tax forms can be so difficult to fill out that you may need to get a business accountant, though this is a good idea no matter what kind of business you have.
As always, it’s best to consult a professional like those at Dunham Tax Professionals. Make an appointment today.