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The Attributes of Corporations
by Mark Minassian, CPA

The corporation is the most widely used form of business in the world. And while the biggest businesses in the world operate as corporations, corporations may be formed and operated by one person on a small scale. A corporation is a separate legal entity from its owners.

Corporations provide tax breaks and liability protection that are unavailable to sole proprietors and partnerships. But while they offer significant advantages, there are also complex rules that must be followed when forming and operating a corporation.

There are two main types of corporations: C-Corporations and S-Corporations. They are named after the chapters of the tax code that govern them. And while they share many similar characteristics, they are taxed in completely different manners.


Formation   •   Key Personnel   •   C-Corporations   •   S-Corporations   •   Liability Protection   •   Dissolution

Formation

A corporation is a legal entity that is formed under state law. Each state has its own requirements and fees for filing articles of incorporation. In addition, each state requires annual fees and annual reports to be filed to maintain the corporation in good standing with the state.

The following steps should be followed to form a corporation.

  1. Pick a Name for Your Corporation. Your corporation’s name must include the words or abbreviations Corporation (Corp.), Incorporated (Inc.) or in some states, Limited (Ltd.). Examples include ABC Corporation, Joe’s Auto Repair, Inc, Main Street Flower Corp., and Electronics Warehouse Ltd.

    Your state’s Secretary of State office must approve your corporate name. If it is too similar to another corporation already in existence, you must either choose a different name or get permission from the existing corporation to use the name. Some states are more lenient than others. Also, most states will let you reserve your name for a nominal fee.

  2. Appoint the Corporation’s Directors. The next step is for the initial shareholders of the corporation to appoint directors. The directors make the major policy and financial decisions of the corporation, including appointing the initial corporate officers, authorizing the issuance of stock and deciding how the business will be financed.

    For most small businesses, the shareholders will appoint themselves as directors (especially if there is only one shareholder). However, some states require at least two directors, and anyone can be appointed as a director. Shareholders will often appoint spouses, family members, attorneys or other business advisors as directors. However, being a director carries serious authority and serious responsibilities. Be absolutely sure that the directors of your corporation are well qualified, trustworthy and have the best interest of your corporation in mind.

  3. File the Articles of Incorporation. Corporations are organized under state law, and must file Articles of Incorporation (also called Articles of Organization, a Certificate of Formation, or a Corporate Charter) with their state’s Secretary of State office. While each state’s requirements vary, the articles will typically include the name and business address of the entity, the business’s purpose, the names of the shareholders, members and/or directors, the name of the registered agent (the person who will be served with any legal correspondence on behalf of the company), and the number of shares of stock authorized.

    Filing fees vary by state and can run anywhere from $50 to $500 depending on the state. In addition, there are many companies that will incorporate your business for you. For a fee, they will prepare and file all of the legal paperwork with your state and obtain an EIN from the IRS.

    C-Corporations may have an unlimited number of owners, and may also have only one owner. In addition, there are no restrictions on who may own a corporation. Corporations may be owned by individuals, partnerships, LLCs, other corporations and even trusts and estates.

  4. Draft the Corporate Bylaws. The corporate bylaws are the rules that govern the operation of the corporation. They will specify such things as the names of the directors and corporate officers, the location, time and procedure for director and shareholder meetings, how the books and corporate records will be maintained and who will maintain them and how any future changes to the bylaws will be accomplished.

    The bigger the business, the more in-depth the bylaws will be. Blank templates for drafting bylaws are readily available in libraries, bookstores and on the internet. Your bylaws are not filed with any government agency. They are for the corporation’s internal use only.

  5. Issue the Corporate Stock. Owners of corporations are called shareholders (or stockholders) because they own the shares of stock of the corporation. All for-profit corporations, no matter how big or small, must issue corporate stock. Typically, the board of directors authorizes an initial number of shares of stock to be issued, and then issues the shares of stock (in the form of stock certificates) to the initial shareholders.

  6. Obtain an employer identification number (EIN). All corporations must obtain an EIN from the Internal Revenue Service. The form will ask for basic information about the corporation and may be filed by any officer or director of the company. You may also authorize another person, such as a CPA or attorney, to obtain the number for you. This number will be used to identify the corporation on all tax forms, the corporation’s bank accounts and on many legal forms as well.

  7. Open Corporate Bank Accounts. Once you have your corporation’s EIN, you may open the company’s bank account. Corporations are required to have their own bank accounts and must keep a separate and specific set of books and records. You may also obtain corporate credit cards as well.

  8. Obtain the Necessary Licenses and Permits. Depending on the industry your corporation operates in, you may have to obtain certain licenses and permits from your city, county, state or even the federal government. Such licenses include liquor licenses, occupancy licenses and tobacco licenses.

Key Personnel

The key personnel in a corporation are the directors, officers, shareholders and employees.

  • Directors. The directors establish and maintain the policies and procedures of the corporation. The board of directors must meet on a regular basis (at least annually and often more frequently) to review the corporation’s operations, discuss any legal issues and create or amend corporate policies. Directors are elected by the shareholders and may serve on fixed terms as specified in the corporate bylaws. Directors do not participate in the management or the day-to-day operations of the corporation. Directors are usually compensated for the roles and receive a director’s fee which is paid by the corporation.

  • Corporate officers. The corporate officers control the day-to-day operations of the company. Large corporations may have hundreds of officers, while one person may hold all of the officer positions in a small corporation. Common officers include the president, vice-president, secretary, treasurer, CFO, and CEO. Most states require at least a president, secretary (sometime referred to as a clerk) and a treasurer. Officers usually serve fixed terms and are elected by the Board of Directors. The responsibilities and authority of the officers are described in the corporate bylaws and may be further documented in job descriptions or employee contacts.



  • Shareholders. The shareholders are the owners of the corporation. Many small corporations have only one shareholder, while large international corporations may have thousands of them. In small corporations, the shareholder(s) are also the officers and directors. The shareholders have a right to receive a distribution of any profit the corporation makes, usually in the form of a dividend. Most states require shareholders meetings to be held at least once a year. In addition to the right to receive dividends, shareholders also have the right to elect and remove directors, approve mergers, reorganizations and dissolutions, and amend the articles of incorporations and bylaws.



  • Employees. As in any business, the employees perform the work. In a partnership or sole-proprietorship, the owners are not considered employees even if they work in the business. However, in a corporation, if an owner (shareholder) works in the business, he or she is considered an employee under common law. And as with any business, corporations must obey the legal and tax rules for operating with employees.

C-Corporations

A C-Corporation is a separate taxpaying entity and must file IRS Form 1120 each year. If the business has taxable income at the end of the year, the corporation must pay a tax on it. The current corporate tax rates range from 15% (on the first $50,000 of taxable income) to 38%.

Once a corporation has paid the tax on its taxable income, it may decide to distribute those profits to its shareholders in the form of a dividend. The shareholders must pay taxes on the dividends they receive (special rules apply to C-Corporations that are shareholders of other C-Corporations) and the dividends are not deductible by the corporation. Thus, C-Corporations face double taxation since the corporation pays tax on its profit and the shareholders pay tax on the dividends. Any profits that are not distributed to the shareholders are known as retained earnings.

In reality though, small C-Corporations very rarely pay dividends. Since most shareholders of small C-Corporations also work for the corporation and draw salaries, they will usually take any profit out of the corporation in the form of extra salary or a bonus. By doing this, they can eliminate the tax at the corporate level because they can reduce the corporation’s taxable income to (or below) zero.

If a C-Corporation has a loss for the year, the shareholders do not get any personal benefit of the loss. The loss stays with the corporation and can be used to offset future taxable income of the corporation. The loss may also be carried back to previous years when the corporation had taxable income and paid a tax. In this case the corporation can actually get the tax money they paid refunded to them. Certain restrictions apply and must be followed closely.

S-Corporations

S-Corporations are legal corporations that are taxed like partnerships. All corporations start out as C-Corporations by default. If the shareholders want the corporation to be taxed as an S-Corporation, they must apply for S-Corp status from the IRS.

Certain requirements must be met for a corporation to operate as an S-Corp:

  1. The corporation must be a domestic (U.S.) corporation.
  2. There may be no more than 100 shareholders.
  3. There may only be one class of stock.
  4. The shareholders must be either individuals who are U.S. citizens or U.S. resident aliens (green card), estates, certain types of trusts or certain types of charitable organizations.
  5. The corporation may not be an ineligible type of corporation (generally financial institutions, mortgage pools, insurance companies and domestic international sales corporations).

If the corporation meets these requirements, then it can file Form 2553 with the IRS. The form must be filed by the 15th day of the third month of the company's tax year of the year the election is to take effect.

While an S-Corporation is a separate legal entity, it is not a separate taxpaying entity. An S-Corp does not generally pay federal income tax (unless certain special situations apply). Any profit or loss from the S-Corp is passed though to the shareholders who report the profit or loss on their individual tax returns. If there is a profit, the corporation can then distribute to profits to the shareholders without the shareholders paying additional taxes on those distributions. Thus, S-Corps avoid the double taxation that C-Corps are subject to when they distribute their profits to the shareholders. However, an S-Corp shareholder must still pay taxes on his or her share of the profit even if they do not receive any profit distribution. This is common if the corporation decides (or needs) to keep cash in the business for operating funds or expansion.

S-Corporation profits taxed to the individual shareholders are not subject to self-employment taxes. However, shareholders who work in the business are considered employees and must take a reasonable salary in return for their services.

S-Corporations are required to file Form 1120S annually with the IRS and must issue K-1s to the shareholders detailing their share of the corporation's income and expenses.

Liability Protection

One of the biggest benefits of a corporation is its ability to protect the shareholders from personal liability. Since a corporation is treated as a separate legal entity from its shareholders, it can own its own assets, incur its own debts and enter into its own contracts. The shareholders are generally not responsible for the debts and taxes of the corporation. If someone sues your corporation, they can only go after the corporation’s assets and not the shareholders’ personal assets. However, this limited liability is not absolute and certain exceptions do apply.

Corporate formalities must be followed and failure to do so may jeopardize the entity’s liability protection. This is known as “piercing the corporate veil” and once this happens, creditors may attach the personal assets of the shareholders.

Some of the corporate formalities that should be followed include:

  • Holding annual shareholders’ meetings
  • Holding an annual Board of Directors’ meeting
  • Keeping written minutes of the meeting
  • Maintaining separate and accurate financial and legal records of the corporation’s activities
  • Maintaining separate bank accounts for the corporation
  • Filing corporate tax returns with the IRS and your state
  • Filing annual reports with your state's Secretary of State office
  • Titling assets in the corporation’s name

A shareholder is always liable for his or her own actions even if they are doing so with or on corporate property. If a shareholder gets sued individually, creditors may go after the shares of the corporation. This can also happen if the corporate veil is pierced and shareholders are held liable for the corporation’s debts. In addition, professionals such as doctors, lawyers and accountants cannot hide behind the corporate liability shield if they commit malpractice.

Dissolution

If a shareholder of a corporation dies, his stock in the corporation will be passed on to his heirs (or to whomever he designates in his or her will). The ability to pass on the stock allows a C-Corporation to have a perpetual life.

If the shareholders of the corporation want to end the corporation, it must be formally dissolved. The shareholders must vote for the dissolution as per the rules in the corporate bylaws. Special papers called Articles of Dissolution must be filed with the Secretary of State office in the corporation’s home state and any remaining assets and liabilities must be distributed to the shareholders. When a corporation dissolves, there are usually tax consequences for both the corporation and the shareholder. A tax professional should be consulted if you decide to dissolve your corporation.

Disclaimer:  Any tax advice contained in this article is not intended or written to be used, and cannot be used, to avoid penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions.

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