Back to Business Basics: Corporations 101
Business owners use business entities to protect their personal assets from business debts and creditors, to separate management of the enterprise from ownership, and to enable outside investment into the business. A properly created, structured, and operated business entity can limit the risk to an owner’s personal assets.
It can be difficult to decide which business entity is right for you. The differences in taxation, corporate structure, or compliance rules between these business entities range from minor to meteoric, and to the uninitiated, deciphering these differences can be a Sisyphean task.
One of the most commonly used business entities is a Corporation, which comes in two varieties: “S” Corporation and “C” Corporation. These types differ primarily in tax structure.
Before we look at “S” and “C” Corporations more in depth, let’s get a better idea of how the corporation functions as a legal entity, who runs it, and how it’s formed.
What Is a “Corporation”?
A corporation is separate and distinct from its owners, who are known as shareholders or stockholders. In fact, as far as the law is concerned, the owners and the corporation are separate persons. Yes, persons.
Just like a person, a corporation can enter contracts, sue and be sued, own property, or incur criminal punishment (even give money to elections!). It has the rights and obligations of a person, but—importantly—those obligations are not the rights and obligations of its shareholders.
There are three key groups of people involved in a corporation: shareholders, directors, and officers.
Shareholders are the owners of the corporation. There can be one shareholder, a few shareholders, or thousands of shareholders.
Each shareholder has rights to do some or all of the following:
- Receive dividends and distributions (profits),
- Vote for directors and other matters requiring shareholder votes, and
- Receive the assets left over after the corporation is liquidated.
Shareholders can also have other rights and “preferences.” Preferences give one group of shareholders the ability to get ahead of other shareholders. For example, when the corporation is dissolved, one group of shareholders might get its money out before another group. These preferences apply to classes and series of stock. All of this—the classes and series of stock and the rights of each shareholder—is described exactly in the articles of incorporation.
The Board of Directors is elected by the shareholders (at the annual shareholder meeting) to serve terms of, typically, one to three years. The directors are the people who establish broad policies for the corporation and set strategic plans for the company.
Depending on the size of the company, the Board usually has between one and nine members. Any more and it becomes too large to be effective. Also, there are usually an odd number of directors, to protect against tied votes.
The Board of Directors has regular meetings to review the business of the corporation, its financial results, and to make important business decisions. The Board of Directors also elects the officers of the corporation.
The officers of the corporation manage the day-to-day business of the corporation.
Officer positions will vary from company to company as per their bylaws, but typical roles include:
- Chief executive officer (CEO)
- Chief operating officer (COO)
- Chief financial officer (CFO)
- Chief technology officer (CTO)
No particular officers are required to be appointed by the Board of Directors of a Florida corporation. But, because the corporation can only act through the officers, there needs to be at least one for the corporation to be able to operate its business.
Each officer has the responsibilities described in the bylaws. Either the president or chief executive officer is the highest-ranking officer in the corporation and reports to the Board of Directors. He or she has ultimate responsibility for the company’s activities and financial performance.
The COO oversees the daily operations of the company. The CFO and CTO are in charge of their respective areas, finance or technology.
Most often, the secretary keeps corporate documents and records and detailed minutes from both shareholders and Board of Directors meetings.
In small business corporations (sometimes referred to as closely held corporations or close corporations), a few people (or one) may fill all of the roles. One, two, or three people could be the sole shareholders, directors, officers, and employees of the corporation. This is entirely permissible and doesn’t result in a loss of the limited liability benefit.
And, as discussed above, because management (officers and directors) is separated from ownership (stockholders), a corporation can have “investor” shareholders who do not take part in the daily operation of the business, but who benefit from the increase in value of the corporation’s business and properties.
Before you actually file any paperwork, you must choose a name for your corporation. This comes with certain requirements, and it’s best to take the time to consider them up front. All formation paperwork (and future business-related paperwork) must use the precise company name or you might risk losing your asset protection.
For example, here is Florida, the Department of State requires a corporation name to be “distinguishable in the records.” What does that mean? It means that the name of your corporation has to be unique from the name of every other existing business in the Department of State’s database. There are additional state requirements, however, and you should take the time to familiarize yourself with them.
Forming a corporation begins (but does not end) with the filing of articles of incorporation with the secretary of state by an incorporator. The incorporator, the person who forms the corporation, signs the articles of incorporation and files them (usually through an attorney).
An incorporator can also use the online service at www.sunbiz.org. However, this method uses the most basic articles of incorporation and does not contain certain protective provisions that I would normally include in the articles of incorporation, such as indemnification of the directors and officers for lawsuits arising from the corporation.
In Florida, the base filing fee (as of 2018) for the articles and statement identifying the registered agent and registered office of the corporation is $70.00.
Once the articles are filed, the corporation is technically formed. But, if you do nothing more, it’s like building a house without putting up interior walls. You won’t get rained on, but it isn’t a great place to live.
Whether you form online or through an experienced business attorney, it is, therefore, important to completely form the corporation. Make sure that you:
- Have an initial meeting of the board of directors,
- Transfer assets to the corporation (e.g. cash for the bank account),
- Adopt bylaws,
- Issue stock and stock certificates,
- File the appropriate tax forms with the IRS and Florida Department of Revenue, and
- Sign a shareholders agreement (if applicable)
Frankly, I’m surprised how often these steps aren’t done properly or at all. Failing to do any of these steps can cause massive disruption to your new company or even weaken your liability protections.
S Corp or C Corp: What Are They and What’s the Difference?
From a legal and corporate perspective, “S” corporations and “C” corporations are identical: They are distinct entities from their owners; they have stockholders, directors, and officers. However, all corporations are treated as “C” corporations by default.
To be treated as an “S” corporation requires an election on behalf of the shareholders. First, all of the shareholders of the corporation must qualify to be “S” corporation shareholders. One restriction here is that all investors must be U.S. citizens or legal residents (i.e. hold a citizen card). Second, the corporation can have only one class of stock. Finally, IRS Form 2553 must be signed by the required people and be filed with the IRS in a timely fashion.
Since the election is made with the IRS, the difference lies in their tax structures.
Generally, a “C” corporation has a two-tiered tax structure: The entity itself pays taxes on its net income, and the shareholders pay tax on the dividends they receive. An “S” corporation, on the other hand, has a single-tiered tax structure. The corporation itself doesn’t pay tax. Instead it passes the obligation of the net income through to its shareholders, who have to pay the taxes themselves. As such, “S” corporations are generally known as “pass through” entities.
The election to be taxed as an “S” corporation is made by filing IRS Form 2553 with the IRS. Once that is properly completed, the corporation is taxed as a pass through entity. That means the “S” corporation almost never pays taxes itself.
Instead, the “S” corporation files its tax return (on IRS Form 1120S) with the IRS and issues all of the shareholders K-1 statements. The K-1 statement shows the portion of the net income of the corporation for which that shareholder will be taxed.
For example, if a shareholder owns 25% of the issued and outstanding stock of an “S” corporation, and the corporation’s total net income for the year is $200,000, then that shareholder’s K-1 statement will show $50,000 allocated to that shareholder.
It’s important to note the income passes to the shareholders whether or not any of them actually get the cash from the corporation. In other words, the K-1 doesn’t necessarily come with a check.
Rather, the allocated income is “phantom” income to the shareholder. The income is recognized by the IRS, but it is unlikely that the shareholder received all or any of it.
Why? Well, the net profit of a corporation will almost never be present in the corporation’s bank account at the end of the year. Instead, that money is used to continue or grow the business operations.
Further, in the absence of a shareholders agreement, the Board of Directors is not compelled to, and can refuse to, distribute profits to the shareholders.
The benefit of this arrangement is that only the shareholders pay taxes on the corporate income. The big drawback with an “S” corporation, though, is that the shareholders have to include their share of the corporate income on their tax returns and pay tax on that money.
If the corporation distributes cash to the shareholders, this may not be a problem. But, there are instances when a corporation may not distribute its cash to the shareholders.
First, cash and net income (or profit) are quite different. The corporation may have a net income, but not have the cash in its bank account. Or, if the corporation is controlled by other shareholders, it may decide not to distribute cash to its shareholders.
However, even if the shareholder never receives any money from the corporation, he must pay the tax on his share of the corporation’s net income. The shareholder could have to pay those taxes by dipping into savings or selling other assets.
(Related: New 20% QBI Deduction)
Of course, if the corporation has losses, the shareholder may be able to offset those losses against other income. The shareholder must, however, have “basis” in the shares in order to do this. In other words, the shareholder needs to have money at risk in the corporation, from a tax perspective.
A “C” corporation itself pays taxes on its net income. It files form 1120 with the IRS (as its tax return) and pays federal (and possibly state) taxes based on its net income. The maximum corporate rate used to be 35%, but this was lowered to flat 21% by the Tax Cuts and Jobs Act for 2018 and beyond.
In addition, when a “C” corporation distributes profits to the shareholders through dividends, the shareholders pay income taxes on the dividends at a rate of approximately 15%. This results in a double taxation, with a maximum tax rate as high as 32.85%.
To avoid the double taxation, the shareholders of a closely held “C” corporation will “bonus out” the profits of the corporation so that the net profit shown on the corporation’s tax return is zero and no corporate taxes are paid. Of course, the bonus, as earned income, is subject to FICA taxes (up to the FICA maximum), Medicare taxes, and income taxes.
The “bonus out” arrangement works only so long as the profit of the corporation is not too large (that is, the bonus is “reasonable”). If the profit is too large, the IRS will ignore the bonus and treat it as profit, subject to the double tax.
The exact costs vary from state to state. In Florida, there is an annual corporate fee of $150.00, if paid on or before May 1st of each year. In addition to the fee, you’ll have accountant’s fees for preparation of the corporate tax return, costs of a bank account, and attorney’s fees for the annual corporate housekeeping. Those costs will depend on the activities of the corporation.
Despite the costs associated with operating a corporation, there are undoubtedly benefits to business owners, which quite often will outweigh the costs.
The most basic advantage is the personal liability protection afforded by the corporate shield. However, this protection isn’t unique to corporations and is offered by other business entities, such as the limited liability company (LLC), which is cheaper to form and maintain.
If the company plans to secure outside professional investment or go public, however, C corporations are the preferred structure.
Corporations have a leg up in raising capital because they can raise funds by selling stock and other securities. This also means that a corporation allows for easy transfer of stock when a shareholder wants to leave a business, without any disruption to the day-to-day operation of the business.
However, many of these benefits can be belied by an improperly executed (or non-existent) shareholders agreement. So, be sure to enlist a qualified and experienced business attorney to draft a comprehensive shareholders agreement.
As the Grail Knight in Indian Jones and the Last Crusade says, you must choose wisely. You won’t suddenly age and wither into dust like Walter Donovan, but it can be very costly and ruinous to your business venture.
Plan ahead of time with your business partners and your business attorney. Consider each of the founders’ goals and expectations for the company and use that conversation to guide the choice of business entity.
When you’ve chosen, have an experienced attorney handle the formation of your business entity and the creation of your key business documents. Using a business lawyer to form your business entity and its foundation documents ensures it will be done correctly and fully completed. You can rest assured that your assets are protected to the fullest extent possible and you won’t have unpleasant surprises.
This process requires skill and attention to detail. Business owners only find out that they haven’t properly formed a corporation (read: don’t have liability protection in place) too late, after a claim has been made against their company.
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