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HOW TO INCORPORATE

Corporations Defined

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The following information deals primarily with the small, privately owned corporation. It assumes that all of the corporate stock is owned by one person or a few people, and that all shareholders are actively involved in the management of the business -- with the possible exception of friends and relatives who have provided seed money in exchange for stock. Because there are many complexities involved in selling stock to the public, this article does not discuss public corporations.

The most important feature of a corporation is that, legally, it's a separate entity from the individuals who own or operate it. You may own all the stock of your corporation, and you may be its only employee, but -- if you follow sensible organizational and operating procedures -- you and your corporation are separate legal entities.

All states but Arizona have adopted legislation that permits a corporation to be formed by a single incorporator. All states permit a corporate board that has a single director, although the ability to set up a one-person board may depend on the number of shareholders. In addition, many states have streamlined the procedures for operating a small corporation to permit decisions to be made quickly and without needless formalities. For example, in most states, shareholders and directors can take action by unanimous written consent rather than by holding formal meetings, and directors' meetings can be held by telephone.

Limited Personal Liability
One of the main advantages of incorporating is that, in most circumstances, it limits your personal liability. If a court judgment is entered against the corporation, you stand to lose only the money that you've invested. Generally, as long as you've acted in your corporate capacity (as an employee, officer, or director) and without the intent to defraud creditors, your home and personal bank accounts and other valuable property can't be touched by a creditor who has won a lawsuit against the corporation.

Example
Andrea is the sole shareholder, director, and officer of Market Basket Corp., which runs a food store. Ronald, a Market Basket employee, drops a case of canned food on a customer's foot. The customer sues and wins a judgment against the business. Only corporate assets are available to pay the damages. Andrea is not personally liable.

Caution: Liability for your own acts. If Andrea herself had dropped the case of cans, the fact that she is a shareholder, officer, and director of the corporation wouldn't protect her from personal liability. She would still be personally liable for the wrongs (called torts, in legal lingo) that she personally commits.

So much for theory. In practice, incorporating may not actually give you broad legal protection. In the real world, banks and some major corporate creditors often require the personal guarantee of individuals within the corporation. So the limited liability gained from incorporating isn't always as valuable a legal shield as it first seems.

Example
Market Basket Corp. borrows $75,000 from a bank. Andrea signs the promissory note as president of the corporation, but the bank also requires her to guarantee the note personally. The corporation runs into financial difficulties and can't repay the debt. The bank sues and wins a judgment against the business for the unpaid principal plus interest. In collecting on the judgment, the bank can go after Andrea's assets as well as the corporation's property. Incorporation offers no advantage over a sole proprietorship.

Liability insurance can protect against many of the risks of doing business. But if you operate a high-risk business -- child care center, chemical supply house, asbestos removal service, or college town bar -- and you can't get (or can't afford) liability insurance for some risks that you're concerned about, incorporation may be the wisest choice.

Example
Loren is afraid that a clerk at his After Hours beverage store might inadvertently sell liquor to an underaged customer or one who has had too much to drink. If that customer got drunk and hurt someone in a car accident, there might be a lawsuit against the business.

Loren contacts his insurance agent to arrange for coverage, but learns that his liquor store can afford only $50,000 worth of liability insurance. Loren buys the $50,000 worth of insurance, but also forms a corporation -- After Hours Inc. -- to run the business. Now if an injured person wins a large verdict, at least Loren won't be personally liable for the portion not covered by his insurance.

The lesson of these examples is clear: Before you decide to incorporate your business primarily to limit your personal liability, analyze what your exposure will be if you simply do business as a sole proprietor (or partner).

The limited liability feature of corporations can be valuable, protecting you from personal liability for:

  • Debts that you haven't personally guaranteed, including most routine bills for supplies and small items of equipment.
  • Injuries suffered by people who are injured by business activities not covered adequately by insurance.

Also, for a business with more than one owner, incorporating can offer a great deal of protection from the misdeeds or bad judgment of your co-owners. In a partnership, as noted above, each partner is personally liable for the business-related activities of the other partners.

Example
Ted, Mona, and Maureen are partners in Mercury Enterprises. Mona writes a nasty letter about Harold, a former employee, which causes Harold to lose the chance of a good new job. Harold sues for defamation and wins a $60,000 judgment against the partnership. Ted and Maureen are each personally liable to pay the judgment even though Mona wrote the letter.

If Mercury Enterprises had been a corporation, Mona and the corporation would have been liable for the judgment, but Ted and Maureen would not. Ted and Maureen would lose money if the assets of the corporation were seized to pay the judgment, but their own personal assets would be safe.

Note: Payroll taxes. Limited liability doesn't protect you if you fail to deposit taxes withheld from employees' wages -- especially if you have anything to do with making decisions about what bills the corporation pays first. Because this debt can't be discharged in bankruptcy (most others are), you want to pay it first.

Income Taxes
Federal taxation of corporations is a very complicated topic. This section deals only with basic concepts.

The federal tax laws distinguish between two types of corporations. A regular corporation (sometimes called a C corporation) is treated as a tax-paying entity separate from its investors and must pay corporate federal income tax. By contrast, a corporation that chooses S corporation status doesn't pay federal income tax; instead, income taxes are paid by the corporation's owners.

1. S corporations. Electing to do business as an S corporation lets you have the limited liability of a corporate shareholder but pay income taxes on the same basis as a sole proprietor or a partner. Among other things, this means that as long as you actively participate in the business of the S corporation, business losses can be used as an offset against your other income -- reducing, maybe even eliminating, your tax burden. The corporation itself doesn't pay taxes but files an informational tax return telling what each shareholder's portion of the corporate income is.

Example
Paul decides to start an environmental cleanup business. Because insurance isn't available to cover all of the risks of this business, he forms a corporation called Ecology Action Inc. This limits Paul's personal liability if there's a lawsuit against the corporation for an act not covered by insurance.

Paul is also concerned about taxes. He expects his company to lose money during its first few years; he'd like to claim those losses on his personal tax return to offset income he'll be receiving from consulting and teaching work. He registers with the IRS as an S corporation. Unless he changes that tax status later, his corporation won't pay any federal income tax. Paul will report the corporation's income loss on his own Form 1040 and will be able to use it as an offset against income from other sources.

For many years, if you wanted to limit the personal liability of all owners of your business and have the income and losses reported only on the owners' income tax returns, you would have no choice but to create an S corporation. Today you can accomplish the same goal by creating a limited liability company (LLC). Because, in addition, an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, it's generally better to structure your business as an LLC than as an S corporation. (But there are some situations when it might be better to create a corporation.)

Should You Elect S Corporation Status?

For federal tax purposes, it's often best for a start-up company to elect to be an S corporation rather than a regular corporation. This is so even though recent changes in tax rates have made this decision a bit more complex. Still, to make sure an S corporation is best for you, speak to a knowledgeable accountant or other tax adviser. Also keep in mind that an LLC may be an even better choice than either type of corporation.

Starting as an S corporation rather than a regular corporation may be wise for several reasons:
  • Because income from an S corporation is taxed at only one level rather than two, your total tax bill will likely be less. (But be aware that the two-tier tax structure for regular corporations can sometimes be an advantage. See the discussion below on how a regular corporation can achieve tax savings through income splitting.)
  • Your business may have an operating loss the first year. With an S corporation, you generally can pass that loss through to your personal income tax return, using it to offset income that you (and your spouse, if you're married) may have from other sources. Of course, if you're expecting a profit rather than a loss -- because, for example, you're converting a profitable sole proprietorship or partnership to a corporation -- this pass-through for losses won't be an advantage to you.
  • Interest you incur to buy S corporation stock is potentially deductible as an investment interest expense.
  • When you sell your S corporation business, your taxable gain on the sale of the business can be less than if you operated the business as a regular corporation.
  • Your decision to elect to be an S corporation isn't permanent. If you later find there are tax advantages to being a regular corporation, you can easily drop your S corporation status, but timing is important.


Caution: Limits on deductions. You can deduct S corporation losses on your personal return only to the extent of your " basis" -- the IRS term for the money you put into the corporation and the corporate debts that you personally guarantee. Also, if you don't work actively in the S corporation, there are potential problems with claiming losses from passive activities. For the most part, you can only use losses from passive activities to offset income from passive activities. See your tax adviser for technical details.


To be treated as an S corporation, all shareholders must sign and file IRS Form 2553. Shareholders pay income tax on their share of the corporation's income regardless of whether they actually received the money or not. If the corporation suffered a loss, shareholders can claim their share of that loss.

Example
Assume the same facts as above except that there are two other shareholders in Ecology Action Inc. Paul owns 50% of the stock, and Ellen and Ted each own 25%. Paul would report 50% of the corporation's income or loss on his personal tax return, and Ellen and Ted would each report 25% on theirs.

Most states follow the federal pattern in taxing S corporations: They don't impose a corporate tax, choosing instead to tax the shareholders for corporate income. About half a dozen states, however, do tax an S corporation the same as a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

2. Regular corporations. Under federal income tax laws, a regular corporation is a separate entity from its shareholders. This means that the corporation pays taxes on any income that's left after business expenses have been paid.

A sole proprietorship doesn't pay federal income tax as a separate entity; the owner simply reports the business's income or loss on Schedule C and adds it to (or, in the case of a loss, subtracts it from) the owner's other income. Similarly, a partnership doesn't pay federal income tax; rather, the partnership annually files a form with the IRS to report each partner's share of yearly profit or loss from the partnership business. Each partner then adds his or her share of partnership income to other income reported on his or her personal tax return (the familiar Form 1040) or deducts his or her share of loss. And an S corporation is treated as a sole proprietorship or partnership for federal income tax purposes.

A regular corporation is different. It reports its income on Form 1120 and pays tax on that income. In addition, if the income is distributed to shareholders in the form of dividends, the shareholders pay tax on the dividends they receive.

In practice, however, a regular corporation may not have to pay any income tax even though it is a separate taxable entity. In most incorporated small businesses, the owners are also employees. They receive salaries and bonuses as compensation for the services they perform for the corporation. The corporation then deducts this "reasonable" compensation as a business expense. In many small corporations, compensation to owner-employees eats up all the corporate profits, so there's no taxable income left for the corporation to pay taxes on.

Example
Jody forms a one-person catering corporation, Jody Enterprises Ltd. She owns all the stock and is the main person running the business. The corporation hires her as an employee, with the title of president. The corporation pays her a salary plus bonuses that consume all of the corporation's profits. Jody's salary and bonuses are tax deductible as a corporate business expense. There are no corporate profits to tax. Jody simply pays tax on the income that she receives from the corporation, the same as any other corporate employee.

Copyright © 2000 Nolo.com Inc.

Last updated: May 12, 2000




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