Setting up a Corporation
By Bryan at 29 August, 2010, 11:40 pm
Warning. I have to do this post about corporations.I remember when I set up my first corporation and the feeling was great. I felt like this was real and I actually had a business, instead of a sole proprietorship that anyone can have immediately. It was a proud day in my affiliate marketing career and my life in general, as I always wanted to own my own business since I was a kid seriously. So, how do you know if it is worth it to you? What is the purpose of a corporation?
Running your own business entails more then just selling products or making products. It involves accounting, collections, secretarial work, customer service and so much more. If you don’t have any employees, you will quickly see that the mundane aspects of your business can take up almost half your day if you are not organized properly. Even if you are organized, they will take lots of your time. And it is very important that you have your business in order for many reasons, such as taxes and if you ever decide to sell your business.
But enough about that. We want to talk about setting up a corporation and if it is really necessary for you. First, let me kinda define what a corporation is. A corporation basically is a business that is governed under certain tax laws and is treated as a single entity. What I mean by single entity is that the corporation is basically a person, equipped with its’ own EIN number, which is just like your social security number. A sole proprietership or a partnership is not treated as a separate entity.
Why is that important though? It is a huge advantage and a main reason why people incorporate. Since the corporation is a single entity not related to you, it protects you from liability in terms of being sued and also through bankruptcy. Incorporating is a great thing to do with any business venture simply because of this, because without it, you leave yourself open to litigation personally, even if it is through your business. Say you have an employee who is driving a company vehicle and they kill someone. If you are not incorporated, the family of the person who was killed can come after your business and you since you are not incorporated. That is an extreme case of course, but it shows how you are liable for your actions if you are not incorporated.
Also, with a corporation, it is much easier if you have partners or want to raise some funds as well for your corporation. If you wish to add someone later to your business and give them a small portion of ownership, it is easy to give them shares and much easier to prove in court if there is ever a dispute about it. Then, there are taxes.
Taxes play a huge part. As a sole proprietor, every piece of income is considered your income, so you will be taxed on that whole amount minus deductions. However, in a corporation, you can deduct items and expenses much easier. Plus, you treat yourself as an employee, meaning you pay yourself a salary. Pay yourself a smaller salary and invest the rest into your company with assets to help out with a tax burden.
So what are the different types of corporations and what are the differences between them? Well, there are four major types of corporations, LLC, S-Corp, Close Corporation and a General Corporation. Here is the pros and cons of them:
General Corporation
This is the most common corporate structure. The corporation is a separate legal entity that is owned by stockholders. A general corporation may have an unlimited number of stockholders that, due to the separate legal nature of the corporation, are protected from the creditors of the business. A stockholder’s personal liability is usually limited to the amount of investment in the corporation and no more.
Advantages
- Owners’ personal assets are protected from business debt and liability
- Corporations have unlimited life extending beyond the illness or death of the owners
- Tax free benefits such as insurance, travel, and retirement plan deductions
- Transfer of ownership facilitated by sale of stock
- Change of ownership need not affect management
- Easier to raise capital through sale of stocks and bonds
Disadvantages
- More expensive to form than proprietorship or partnerships
- More legal formality
- More state and federal rules and regulations
Close Corporation
There are a few minor, but significant, differences between general corporations and close corporations. In most states where they are recognized, close corporations are limited to 30 to 50 stockholders. In addition, many close corporation statutes require that the directors of a close corporation must first offer the shares to existing stockholders before selling to new shareholders.
This type of corporation is particularly well suited for a group of individuals who will own the corporation with some members actively involved in the management and other members only involved on a limited or indirect level.
S Corporation
With the Tax Reform Act of 1986, the S Corporation became a highly desirable entity for corporate tax purposes. An S Corporation is not really a different type of corporation. It is a special tax designation applied for and granted by the IRS to corporations that have already been formed. Many entrepreneurs and small business owners are partial to the S Corporation because it combines many of the advantages of a sole proprietorship, partnership and the corporate forms of business structure.
S Corporations have the same basic advantages and disadvantages of general or close corporation with the added benefit of the S Corporation special tax provisions. When a standard corporation (general, close or professional) makes a profit, it pays a federal corporate income tax on the profit. If the company declares a dividend, the shareholders must report the dividend as personal income and pay more taxes.
S Corporations avoid this “double taxation” (once at the corporate level and again at the personal level) because all income or loss is reported only once on the personal tax returns of the shareholders. However, like standard corporations (and unlike some partnerships), the S Corporation shareholders are exempt from personal liability for business debt.
S Corporation Restrictions
To elect S Corporation status, your corporation must meet specific guidelines. As a result of the 1996 Tax Law, which became effective January 1, 1997, many of these qualifying guidelines have been changed. A few of these changes are noted below:
- Prior to the 1996 Tax Law, the maximum number of shareholders was 35. The maximum number of shareholders for an S Corporation has been increased to 75.
- Previously, S Corporation ownership was limited to individuals, estates, and certain trusts. Under the new law, stock of an S Corporation may be held by a new “electing small business trust.” All beneficiaries of the trust must be individuals or estates, except that charitable organizations may hold limited interests. Interests in the trust must be acquired by gift or bequest — not by purchase. Each potential current beneficiary of the trust is counted towards the 75 shareholder limit on S Corporation shareholders.
- S Corporations are now allowed to own 80 percent or more of the stock of a regular C corporation, which may elect to file a consolidated return with other affiliated regular C corporations. The S Corporation itself may not join in that election. In addition, an S Corporation is now allowed to own a “qualified subchapter S subsidiary.” The parent S Corporation must own 100 percent of the stock of the subsidiary.
- Qualified retirement plans or Section 501(c)(3) charitable organizations may now be shareholders in S Corporations.
- All S Corporations must have shareholders who are citizens or residents of the United States. Nonresident aliens cannot be shareholders.
- S Corporations may only issue one class of stock.
- No more than 25 percent of the gross corporate income may be derived from passive income.
- An S Corporation can generally provide employee benefits and deferred compensation plans.
- S Corporations eliminate the problems faced by standard corporations whose shareholder-employees might be subject to IRS claims of excessive compensation.
- Not all domestic general business corporations are eligible for S Corporation status. These exclusions include:
- A financial institution that is a bank;
- An insurance company taxed under Subchapter L;
- A Domestic International Sales Corporation (DISC); or
- Certain affiliated groups of corporations.
Keep in mind, these lists of qualifying S Corporation aspects are not all-inclusive. In addition, there are specific circumstances in which an S Corporation may owe income tax. For more detailed information about these changes and other aspects regarding S Corporation status, contact your accountant, attorney or local IRS office.
How to File as an S Corporation
To become an S Corporation, you must know the mechanics of filing for this special tax status. Your first step is to form a general, close or professional corporation in the state of your choice. Second, you must obtain the formal consent of the corporation’s shareholders. This consent should be noted in the corporation’s minutes. Once the filing is approved, your company must complete Form 2553, Election by a Small Business Corporation. This form must be filed with the appropriate IRS office for your region. Please consult the IRS’ instructions for Form 2553 to determine your proper deadline for completing and submitting this form.
The Company Corporation can assist you in preparing and submitting the IRS Form 2553 as part of your incorporating process. Please see our online order form for additional details.
Limited Liability Company (LLC)
LLCs have long been a traditional form of business structure in Europe and Latin America. LLCs were first introduced in the United States by the state of Wyoming in 1977 and authorized for pass- through taxation (similar to partnerships and S Corporations) by the IRS in 1988. With the recent inclusion of Hawaii, all 50 states and Washington, D.C. have now adopted some form of LLC legislation for both domestic and foreign (out of state) limited liability companies.
Many business professionals believe LLCs present a superior alternative to corporations and partnerships because LLCs combine many of the advantages of both. With an LLC, the owners can have the corporate liability protection for their personal assets from business debt as well as the tax advantages of partnerships or S Corporations. It is similar to an S Corporation without the IRS’ restrictions.
Advantages
- Protection of personal assets from business debt
- Profits/losses pass through to personal income tax returns of the owners
- Great flexibility in management and organization of the business
- LLCs do not have the ownership restrictions of S Corporations making them ideal business structures for foreign investors
Disadvantages
LLCs often have a limited life (not to exceed 30 years in many states) Some states require at least 2 members to form an LLC, and LLCs are not corporations and therefore do not have stock — and the benefits of stock ownership and sales.
As with the S Corporation listing, these lists are not inclusive. For more detailed information, please be sure to speak with a qualified legal and/or financial advisor.
Important Note Regarding the Federal Taxation of LLCs:
Before January 1, 1997, the Internal Revenue Service determined whether a limited liability company would be taxed “like a partnership” or “like a corporation” by analyzing its legal structure or by requiring the members to elect the tax status on a special form. Effective January 1, 1997, the IRS has simplified this process.
Pursuant to these new IRS regulations, if a limited liability company has satisfied IRS requirements, it can be treated as a partnership for federal tax purposes. As such, LLCs are required to file the same federal tax forms as partnerships and take advantage of the same benefits. However, this is still a highly technical area, and if you require further information, it is recommended that you communicate with the Internal Revenue Service or consult a competent professional such as a qualified tax accountant or attorney.
(Thanks to http://www.morebusiness.com/getting_started/incorporating/d934832501.brc for the great info!)
Ton of information here to digest, I know. But, reading over this and making the choice as to which one you want to do for your business is important and will save you money. Most affiliates seem to go with an S-Corp or an LLC, as those are my preferred ones as well. Generally, they will work for almost any business, just that if you ever go big, incorporating then to a general corporation can get a little sticky, but hey, that is why you hire accountants, right? Anyways, this was the boring post that built the foundation, and unfortunately, it is boring stuff that you need to know. However, knowing it will make you a smarter business person in the long run.
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