A great way to build some legal protection into your business is to incorporate. Many people incorporate to gain limited liability to protect personal assets from company liabilities such as lawsuits or creditors. Incorporating also can reduce a business' taxes if it earns a lot of revenue, make it easier to seek venture capital or other outside investment, and in some cases provides more flexibility for your business.
For federal income tax purposes, corporations are governed by the Internal Revenue Code and there are different types of corporate structures to consider. The basic type of American corporation is governed under Subchapter C of the Internal Revenue Code, so they are called C corporations. S corporations start out as C corporations but make a special tax election to have income, deductions, etc. taxed directly to shareholders (S corporations are governed by Subchapter S).
From a legal standpoint, C corporations are separate entities that can sue and be sued. From a tax standpoint, they are separate taxpayers, paying tax at special corporate tax rates that differ from those applicable to individuals. Whether you are in business by yourself or with one or many other co-owner and want to set up a C corporation, be sure to follow certain legal and practical steps to help ensure success.
The following sections will review what a C corporation is, the pros and cons of structuring your business as a C corporation, and how to go about setting up a C corporation.
Forming a C Corporation
Among the different types of business structures available in the U.S., almost all larger corporations with more than 100 shareholders and virtually all publicly traded companies are C corporations. All companies that are considering going public, seeking venture capital, or taking on equity investors are also usually C corporations. That doesn't mean, however, that a small business or a sole proprietor is barred from becoming a C corporation.
"A C corporation can consist of one person, anybody over the age of majority. There is no restriction," says Cliff Ennico, an attorney and nationally syndicated small business columnist and author of Small Business Survival Guide (Adams Media 2005). "The law recognizes that you can form a corporation for the sole purpose of limiting your personal liability for business debts, agreements and lawsuits, and, as long as you follow the rules regarding corporations, it should be there to protect you."
Many smaller businesses, however, choose to start off as a limited liability company (LLC) or an S corporation. There are several reasons. LLCs don't require formal meetings and generally have less paperwork involved. Both LLCs and S corporations are "pass-through" entities for the purpose of taxation, meaning that the business isn't taxed but profits or losses pass through to the shareholders to include on individual tax returns. That is significant if the business isn't making a lot of money or incurs a loss because individuals may take that loss against other income on their tax returns. S corporations are limited to 100 or fewer shareholders, but about 97 percent of S corporations have three or fewer shareholders, according to Barbara Weltman, a tax and business attorney and author of such books as J.K. Lasser's Small Business Taxes (Wiley 2009).
Most start-ups register first as an LLC or S corporation because they can always file to become a C corporation at a later date. "Very commonly what people do is form an S corporation during the early years of their business, when they are losing money, so that the losses flow through to owners. Then, as soon as the business becomes profitable, they switch it to a C corporation to shelter some of the profits from taxes," Ennico says. Once an S corporation becomes a C corporation, however, it may have to wait a few years before it can elect to be taxed as an S corporation again. Also, Ennico points out that it may be extremely difficult to convert a C corporation into an LLC without adverse tax consequences.
Benefits of using C corporation format
There are a few key reasons for opting to create a C corporation, as opposed to the other business structures, according to Weltman. These include the following:
- The opportunity to use a medical reimbursement plan. "This enables the corporation to deduct all medical payments up to a fixed dollar amount (set by the corporation, not tax law) while shareholders-employees enjoy this benefit on a tax-free basis," Weltman says.
- The need for venture capital. A business that needs substantial start-up and/or expansion capital (more than $5 million) may turn to venture capitalists for help. "Usually, such financiers are interested providing money for businesses organized as C corporations because there is more flexibility in making ownership arrangements," Weltman adds.
- The intention to take the company public. If there is the potential for growing the business to such a level that it can attract financing by becoming a public company traded on a national exchange (such as the New York Stock Exchange), the business must be a C corporation, Weltman says.
- Tax considerations: Besides the opportunity for shareholder-employees to obtain tax-free fringe benefits, there is another key tax edge for C corporations: The ability to accumulate earnings for future expansion at a lower tax cost than other types of entities.
Drawbacks of Using C Corporation Format
There are also several reasons that argue against forming a C corporation if your business has the option to form under a different legal structure. These include the following:
- The potential for "double taxation." The chief drawback of a C corporation is the so-called "double taxation" potential. "Profits are first taxed to the corporation," Weltman says. "Then, when they are distributed to shareholders in the form of dividends, they are taxed again; the corporation cannot deduct dividend distributions." However, the threat of a double tax can sometimes be mitigated for following certain strategies.
- The requirement to file more paperwork. Corporations are required to hold formal board and shareholder meetings and keep accurate minutes of these meetings. In addition, there are a series of tax forms that may need to be filed with federal, state, and even local officials, including corporate taxes (IRS Form 1120), taxes on salaries and other employee compensation (W-2s), and profit distribution to shareholders (Form 1099-DIV). "A C corporation complicates your life," Ennico says. "Most entrepreneurs I work with want to spend their time making or selling their products. They don't want to stay up until 3 a.m. doing paperwork."
- Filing corporate tax forms may require an accountant. The tax forms for corporations can be complicated and may require you to get some help from an accountant. In addition, corporations have to pay federal taxes by March 15 -- a full month before the individual federal tax filing deadline.
How to Set Up a C Corporation
Once you have an idea for a company, whether this means selling a product or a service, and you decide to set it up as a C corporation be prepared to devote time, use business methods, and get set up properly so you can make more money, minimize taxes, and generally avoid potential problems.
1. Choose a state in which to form your C corporation.
A C corporation is a creature of state law. It is formed under state law in accordance with the rules of each state. You can complete the set-up steps yourself or use an attorney for this purpose. Either way, there are state filing fees for incorporation that can range from $50 to $500 depending on state law.
Usually it is advisable to set up the corporation in the state in which you are based, rather than in another state that is considered to have laws more favorable to corporations, for example, Delaware or Nevada. For a small corporation, starting out and operating from a single state is less costly, avoiding the need to register to do business and, in some cases, pay additional taxes in multiple states. "If you form a corporation in Delaware or Nevada but are not actually doing business there, you will need to register your corporation as a 'foreign corporation' in the state where you are actually, physically, located, and pay taxes there" Ennico cautions, adding that "if you don't, you will be viewed as operating an illegal business in your state, and it will be only a matter of time before you receive a nasty letter from your state tax authority inviting you to come down for a chat."
2. Decide whether to incorporate on your own or get help.
There are many legal websites these days that enable you to incorporate a business on your own over the Internet. These services charge fees ranging from less than $100 to nearly $500 for do-it-yourself instructions, forms, and sometimes CD-Roms. These services include such sites as LegalZoom, The Company Corporation, and BizFilings.com, among other services. "Some of them are not bad. They tend to do a good job in completing the most important steps in incorporating a business such as filing the Certificate of Incorporation and getting your federal tax ID number (EIN) from the IRS," says Ennico. But Ennico cautions that "none of the do-it-yourself incorporation websites I'm familiar with complete all the steps, such as registering your corporation for state sales, payroll and other important taxes. The better websites will tell you where to go to complete these steps, but they leave it up to you to finish the job. If you're not disciplined enough to follow through, you may not have completed the incorporation process and that may cause problems for you down the road."
Ennico advises that businesses enlist an attorney or CPA to help them form a C corporation. The cost, he says, will usually range from $1,000 to $2,000 and is a good idea, because "that way, you know the job will be done 100% correctly, and if it isn't, you've got someone you can sue for any damages you may incur. The last time I looked, you cannot sue yourself for your own malpractice."
3. Write articles of incorporation.
Articles of incorporation act as a charter to create a corporation. "It's like the birth certificate of the corporation," Ennico says. "It's going to be a matter of public record." Each state dictates what must be included in order to form a corporation in that jurisdiction, Weltman says. Some states require several filings at different times so be sure to check your state's rules. Usually, Weltman says, the information must include the following
- The name and business address of the corporation. The corporation needs a name to describe the business. "The name cannot be one that confuses the company with another business and cannot be one that is barred by state law -- for example, one that is obscene," Weltman says. You also want to coordinate your corporate name with a domain name if you plan to create a website. Your corporate name must be followed by the abbreviation for corporation, incorporated, or limited (corp., inc., or ltd.). For example, if you are starting up a landscaping business, your corporate name might be Lush Landscapers, Inc. (assuming the name is not already in use in your state).
- The nature of the corporation's business. This can be a general description of conducting any legal business activity or it can be restricted to a particular activity.
- The designation of a registered agent in most states. This is a person authorized to receive legal notices from the state or third parties, such as service of process to start a lawsuit, Weltman says. The registered agent can be a corporate officer or a professional registered agent.
- Information about stock. This includes the number of initial shares being authorized, whether there is more than one class of stock, and the value of each share.
The articles of incorporation name the incorporator, who is the person or company responsible for filing required forms with the state, Weltman says. The articles of incorporation may also name the initial directors of the corporation -- the people taking control once the corporation comes into existence, she adds.
4. Write by-laws and a shareholder agreement.
To operate a corporation, there must be by-laws and other written guidance as dictated by the law in the state you incorporate in and dictated by good business practices.
By-laws are the governing rules for the corporation. "They stay in existence for as long as the corporation does, although they can and usually are amended from time to time," Weltman says. State law may outline many required rules; corporations can in some cases create their own rules. Weltman advises to include in the by-laws such information as:
- The time and place for meetings of officers, directors, and shareholders.
- How many directors there will be and how long they will serve (state law may dictate this).
- The compensation of officers (which can be amended from time to time).
- The business year of the corporation (which can be a calendar year or a fiscal year in some cases).
- Rules for adopting and amending by-laws.
- Rules for approving contracts, loans and other actions of the corporation (e.g., whether an officer can act on behalf of the corporation or there must be agreement among shareholders).
- The location for inspection of corporate records.
"It is also advisable to create a shareholder agreement -- also referred to as buy-sell or buyout agreements -- to specify what happens to ownership interests in case of death, disability, retirement, bankruptcy or other contingency involving a shareholder," Weltman says. "For example, will a deceased-shareholder's shares be bought back ("redeemed") by the corporation or purchased by the remaining shareholders?"
5. Pay your taxes.
A C corporation is a separate taxpayer for federal income tax purposes. It files a return, IRS Form 1120, to report its income and expenses. There is a separate tax rate schedule for corporations, with rates ranging from 15 percent to 35 percent.
Shareholders of C corporations only pay tax when and to the extent they receive distributions from the corporation, Weltman says. These distributions can include:
- Salary and bonuses. These are taxed to shareholder-employees at their personal tax rates. Payments are also subject to payroll taxes, including Social Security and Medicare taxes, FICA, paid by both the corporation and shareholder-employee. Compensation and the corporation's share of payroll taxes are fully deductible by the corporation.
- Dividends. These are taxed to shareholders at a maximum rate of 15 percent (this rate may be increased in the future for higher-income shareholders). The corporation cannot deduct these payments, but they are exempt from payroll taxes.
- Fringe benefits. Many of these are tax-free to shareholders. Assuming the benefits meet tax law requirements (usually they must be provided to all employees on a nondiscriminatory basis and not just to shareholder-employees), then the corporation can deduct them and, in most cases, the benefits are exempt from payroll taxes, Weltman says.
There may also be state-level income taxes on C corporations in the states in which they do business. Usually there is a minimum payment required to do business in a state; this is sometimes called "a franchise tax" even though there is no franchise involved.
6. Attend to other details.
Make sure to deal with various other business matters before your begin operations:
- Obtain a federal employer identification number. A new C corporation must obtain a federal employer identification number (EIN). Obtaining an EIN can be done instantaneously and at no cost from the IRS. Any principal officer, such as the corporate president, can do this on behalf of the corporation.
- Pay other taxes. Check with your state tax authority to learn about sales, use, payroll and other taxes that may apply to the corporation's business. The corporation may be required to collect sales taxes on the goods and services sold and to turn over collections to the state, as well as to report on collections on sales tax returns. To find your state tax authority's website, go to this website. Once there, click on the "Forms and Publications" link and download the form businesses are required to file to register for state taxes. Certain cities and municipalities require you to register for their taxes as well -- check with a local accountant to make sure you haven't overlooked any taxing jurisdiction where your corporation is located.
- Obtain licenses and permits. Depending on your type of business, the corporation and/or each owner-employee may be required to have a license or permit to operate legally.
- Obtain insurance. While the corporation affords shareholders personal liability protection, in order to safeguard business assets be sure to carry adequate insurance for the unexpected. Discuss these and other types of coverage with an insurance agent.
- Business.gov: Link to your location to find applicable requirements for registering your business.
- Internal Revenue Service: IRS Publication 542, Corporations, explains how C corporations are taxed; it also provides guidance on recordkeeping and other tax-related information.
- U.S., Small Business Administration: How to choose a business structure.
- Legal Zoom: Help choosing a business structure.