Essentials to Forming a Corporation - Business Tip # 7

Forming a corporation is by far the most complicated alternative of the legal business structures. It is also the structure that provides you with the most control and minimizes exposure to risk most effectively. Unless specific advantages for your business can only be attained by choosing another legal form or your business cannot yet absorb the cost of incorporating, you are most likely to incorporate your business. Establishing a corporation means creating a distinct legal entity that is completely independent of its owners in a legal sense, just like an individual, a corporation has rights and responsibilities in the eyes of the law, and it is liable for its own actions. A corporation must file its own tax return independently of its owners, and it must maintain certain paperwork regarding its activities. Think of a corporation as an individual that comes to life as soon as approval for incorporation is obtained from the secretary of state.

Corporation versus Other Legal Business Structures

The corporation is a unique type of legal structure for a business to take, because a corporation is a separate legal entity from its owners. Unlike a sole proprietorship or a partnership, a corporation must be established by filing articles of incorporation with the secretary of state. A corporation is a much more formal business form than the sole proprietorship or partnership, and a corporation must keep accurate records of nearly all its activities. Starting a sole proprietorship or a partnership can be done with as little as a verbal agreement, but a corporation requires many expensive formalities.

Corporations can be divided into two broad categories: public and closely held. Public corporations are the most elaborate to form and are partially owned by stockholders within the general public.

Reasons for Starting a Corporation:

Any legal business structure serves to protect a business and its owners, but the corporation is a particularly powerful and effective way to obtain a potent set of legal benefits. The advantages of running a corporation include limited liability for the owners, easy transfer of ownership, a corporate tax rate, ability to retain earnings for expansion, and use of fringe benefits at a marginally lower cost.

Since a corporation is a separate entity from its owners, any business obligations or debts must be paid off using only the business's assets. The owners don't have any personal liability for the corporation. In theory creditors and plaintiffs can only go after the corporation's property when they seek the payment of a business debt or obligation and cannot touch the personal assets of its owners. While this may sound like a perfect solution to all your liability problems, you are still vulnerable to some extent. Even though the corporation's liability shield protects your personal assets from business obligations and debts, you must still worry about personal liability and negligence. If a client wins a suit for damages you have incurred or a creditor sues for payment you neglected to make, the corporation's liability shield is of little use to you. You are still personally liable for your own actions.

Ownership in a corporation is easily transferred between people, unless the stockholder's agreement restricts a transfer since the value of each owner's share is known. Unlike a partnership or limited liability company, however, the transfer of a share of a corporation from one person to another does not affect the term of the corporation's existence. The corporation is still an independent entity with a life span of its own, and the dissociation of one of its owners does not change that.

Another reason for choosing to incorporate is the possibility to retain earnings at a lower tax rate for expanding the business. Profits made by a sole proprietorship, a partnership, or a limited liability company must be distributed in the same year in which they were earned. Once the profits are distributed, the individual recipients are required to declare them on their individual income tax returns. The partnership itself is not a separate entity and cannot retain some of the earnings. Since a corporation is a separate entity from its owners and files its own tax return, a corporation has the ability to retain some of its earnings for expansion or other uses.

Taxation:

Reading over all of the benefits incorporation brings to your company, you must have been wondering about the drawbacks. A punishing tax rate is one of the most significant problems owners of a corporation face. By forming a corporation, you are creating a separate entity resembling an artificial person. As such, the corporation must file its own tax return and pay taxes on all of its income. Once the corporation has paid its taxes, the remaining profits are distributed among the owners, who pay taxes on the same money again. This double taxation takes a tremendous toll on the net figure you see in your personal savings account at the end of a fiscal year. There are ways to minimize the effect of double taxation. One possibility is declaring your corporation an S corporation. Another option is paying salaries, rather than dividend distributions, to the owner-employees. Spend a little money on an accountant to help with this. The return on that money, in the form of tax savings, will likely be large.