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C-Corporation

Description

The ultimate goal of many small businesses is to operate under the corporate form of ownership. We will discuss the reasons for this, but first let’s understand exactly what a corporation is.

Unlike most other forms of business ownership, a corporation is a separate legal entity, chartered under state (not federal) laws, with a perpetual existence independent of its owners, directors, and managers. Among other activities, a corporation can incur debts, enter into agreements with vendors and customers, employ people, and pay taxes. A corporation is owned by shareholders, controlled by directors, and operated by officers. Normally, small business owner(s) hold all these positions. They are at the same time shareholders, directors, and officers. Another important characteristic of corporations is that they are taxed as separate entities. This allows corporate owners (the stockholders) a good deal of flexibility in minimizing or deferring taxes (more on this later).

Included under the “corporate umbrella” form of business ownership are C- Corps., S-Corps., and Personal Service Corporations. All have many similarities, but a few important differences will be discussed shortly.

With this in mind, here are the main characteristics--good and bad--of incorporating a small business:

Limited Liability

Â Perhaps the most important reason for incorporating is to shield owners from problems that may occur in the business. Specifically, if a small business runs into troubled waters and cannot pay its debts or other liabilities, the assets of the business may be lost, but personal assets are not in peril. Owners, directors, and officers stand to lose any investment (including retained earnings) they may have in the small business. But homes, bank and investment accounts, retirement savings, automobiles, etc., not held in the name of the small business are difficult to seize.

There are at least three possible exceptions to this rule:

1. Piercing the Corporate Veil

When troubles arise and your small business runs into legal trouble, plaintiffs will routinely charge that

â€¦if the small business is, in fact, a corporation, such a corporation is in mere form only, having no existence, and that there existed a unity of interest and ownership between the small business and its owners (the Defendants), such that any individuality and separateness between the small business and its owners (the Defendants) have ceased, and the small business owners are the alter ego of the small business.

The plaintiff here is charging that your corporation is a sham--which will happen any time troubles arise--and you had better be ready to defend yourself and win on this issue. This is where entrepreneurs need to prove that the small business is indeed a separate entity, demonstrated by the bookkeeping system, the shareholders and directors’ meeting minutes, and other evidence. It is possible to lose on this issue if there is too much hanky-panky between the small business owners and the business, or if poor records are kept. In this case, plaintiffs can indeed seize the personal assets of the small business owner.

2. Personal Guarantee

In many cases, lenders or vendors will request the personal guarantee of small business owners before advancing funds or credit. Others understand that it is easy for small business owners to “sell” or otherwise transfer assets out of the corporation and into the names of the owners. They also understand that small business owners sometimes retain little value in the business, but transfer assets out of the company. The intent of a personal guarantee is for the lender to have access to personal assets, which transcends the benefits of limited liability.

3. The Feds

Limited liability is not recognized by taxing authorities when a small business has failed to pay income, payroll, or other taxes. Further, these obligations survive bankruptcy, and both federal authorities and their state-government colleagues will pursue “responsible employees” for amounts due plus interest and penalties.

Tax Planning

Another important benefit of organizing the small business as a corporation is reaping the rewards of tax planning, also known as tax minimization and/or tax deferral. A corporation is an independent and separate tax-paying entity from its owners, so significant tax-minimization and tax-deferral opportunities may be available.

For now, let’s just say that incorporated small business owners, unlike sole proprietorships or partnerships, may distribute income earned by the small business between their corporate and individual income tax returns, rather than report all business income in the year in which it is earned. Further, small business owners may deduct some expenses unavailable to non-corporate business owners, such as certain types of insurance, vacation, and sick pay.

Charitable and Political Contributions

In addition, the IRS allows corporations to make tax-deductible charitable contributions. Other forms of business ownership are not allowed this deduction. Small business owners, of course, may take income from the corporation and donate it personally to a charity, but note that although payroll taxes must be paid on any amounts transferred from business to owner, these amounts also reduce corporate income taxes, since taxable income is reduced. Since the small business is owned by the same person making the tax contribution, he or she can devise the best overall plan. Other businesses do not have this flexibility and cannot deduct such contributions as a business expense.