There’s inherent risk in any business enterprise, but there are many ways to minimize that risk. One of the most effective can be through the way you choose to legally structure your business. With the proper legal form, you can transfer personal liability to a separate legal entity. Forming a corporation is one way to do that.
This page discusses only corporations, but when deciding how to structure your business, there are other options to consider, including the limited liability company and partnership. A business lawyer can help you decide which form is right for you.
A corporation is a separate legal entity, established under state law, that has the rights to own, purchase, sell, and lease real and personal property. In many respects, a corporation has the rights of a person, to hold, purchase, sell, own, and lease property and to conduct business.
The corporate form provides an incentive for individuals to take risks and form commercial enterprises, allowing for a reasonable risk that often accompanies a new venture without the risk of total loss of personal wealth or net worth. Forming as a corporation also allows a business to establish responsibility under contracts and provides a convenient mechanism for funding economic ventures.
Corporations afford their owners a number of important benefits, including the limitation of personal liability, business continuity, and built-in methods for raising operating capital:
The law governing corporations includes a vast body of state laws that:
Most laws related to corporations are in the form of state statutes, written laws enacted by legislative bodies, with some degree of variation from state-to-state. Federal law, primarily the Securities Act of 1933 and the Securities and Exchange Act of 1934 (and their amendments), govern minimum standards for corporate governance rights and trading corporate stock.
Most corporations are formed under either Subchapter C or Subchapter S of the Internal Revenue Code.
A C corporation differs primarily from other corporations in that the corporation’s income is subject to a separate “corporate tax,” in addition to any tax its shareholders must pay on distributions of income. Any corporation that is publicly traded on a stock exchange, such as the New York Stock Exchange, is a C corporation.
An S corporation is typically formed in the same manner as a C corporation, under the applicable laws of the state of incorporation; however, S corporations are not subject to taxation at the corporate level. All income passes through to shareholders and is taxed only as part of their personal income. To be eligible for Subchapter S status, a corporation must meet the requirements established in the Internal Revenue Code and must affirmatively elect to be treated as an S corporation by filing IRS Form 2553.
Both C and S corporations issue shares of stock as documents of ownership, and both limit the liability of shareholders to the full amount of any investment in the company. In addition, both can pass income to shareholders, which is then recognized by the shareholder as personal income on their tax return.
There are no limits on the number of shareholders for a C corporation, but an S corporation may have only one class of stock and no more than 100 shareholders. Nonresident aliens and most partnerships and corporations are prohibited from owning S corporation stock. A corporation may acquire S status only if it has been incorporated in the United States. All income of an S corporation “passes through” the entity and is recognized as personal income by shareholders. There is no tax on S corporations at the corporate level.
A C corporation may have an unlimited number of shareholders, and there’s no requirement that all shareholders be American citizens. The distributions made by corporations to shareholders will be considered personal income to the shareholders. In addition, C corporations are subject to a separate “corporate tax,” a percentage levied on corporate earnings.
Setting up a C corporation can provide the following advantages:
The most obvious disadvantage of a C corporation is its exposure to double taxation—at the corporate level and then again at the shareholder level (if there are distributions).
Subchapter S corporations enjoy the same general benefits and disadvantages as C corporations, allowing business owners to protect personal net worth by setting up a separate legal entity. However, an S corporation avoids double taxation because it is not subject to the corporate tax. Also, an S corporation may find it harder to raise initial or working capital because its stock cannot be traded on a public exchange.
A C corporation is established by preparing and filing Articles of Incorporation with the appropriate state agency. Other essential components in the establishment of a C corporation include the preparation of corporate bylaws and the registration of the entity with state and federal tax agencies.
An S corporation is set up the same way as a C corporation, with an additional step taken once the corporation is legally formed. A C corporation will be converted to an S corporation when the entity successfully files Form 2553 with the Internal Revenue Service.
One of the key considerations for choosing between a C corporation and an S corporation is the need to raise initial capital. If you don’t have sufficient investors set up, or you cannot secure bank or venture capital funding, you might choose to set up a C corporation so that you can raise funds through an initial public offering. However, if you already have sufficient capital and want to minimize the tax consequences, as well as the complexity of compliance, an S corporation is a better choice.
Setting up a corporation can help you effectively manage risk in a new business enterprise. Based on a number of factors, including the number of shareholders and your strategy for raising initial capital, you may elect to establish a C corporation or an S corporation. Consult with an experienced business law attorney before you make any commitments.
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