For a small business, the
available forms of business enterprise include the individual or sole
proprietorship, the general partnership (including the limited liability
partnership), the limited partnership (including the limited liability
limited partnership), the limited liability company, and the business
corporation. Each of these forms of business enterprise is adaptable to the
small business venture.
What is a corporation?
A corporation is an
artificial legal entity that must be created under the specific laws of a
state or of the United States. A corporation may, with some exceptions, be
owned by one or more people, by other legal entities, or by people and legal
entities. Once created, a corporation is considered to have an existence
separate and distinct from that of its owners or its employees. A
corporation can buy, own, and sell property. In a legal sense, a
corporation can do everything that a person can do.
What are shareholders?
The corporation's owners
are called shareholders. Their rights are set forth in the laws under which
the corporation is formed and in a document called the Articles of
Incorporation. While the shareholders own the corporation, they do not act
for it unless they are also officers or employees of the corporation.
The ownership of a
corporation is usually evidenced by stock certificates. Unless restricted
in the corporation's Articles of Incorporation, in the corporation's Bylaws,
or in a separate agreement such as a buy-sell agreement, a stockholder can
sell or give away his or her stock without notice to or approval from the
corporation or the other stockholders. A stockholder can also, without
notice or prior approval, pledge his or her stock as security for a loan or
other obligation. If the corporation or its stockholders wish to control
the ownership or transfer of the corporation's stock, this can easily be
solved with a buy-sell agreement or with a stockholders' agreement.
What are incorporators?
During start-up, the
incorporators control the corporation. The incorporators elect and appoint
the initial Board of Directors, who control the corporation during their
initial term and are primarily responsible for all management decisions.
The initial Board of Directors also oversees the issuance of the
corporation's stock to its initial shareholders. The statutes that govern
corporations require the Board of Directors to consult the shareholders on
major corporate changes. The corporation's officers are appointed by the
Board of Directors and perform the duties delegated to them by the
Directors. The officers are responsible for the day-to-day operation of the
corporation's business.
How do I create a
corporation?
The Colorado Secretary of
State accepts and files the Articles of Incorporation for new corporations
formed in Colorado. The fee for filing the Articles of Incorporation is
$50.00. The Secretary of State will soon offer electronic filing for
Articles of Incorporation, but as of August 31, 2004 Articles of
Incorporation must be filed in paper format.
A corporation must file an
annual report with the Colorado Secretary of State in order to remain in
good standing and to retain its authority to engage in business in the
state. The annual report consists of the name and street address of the
corporation's registered agent, the address of the corporation's principal
office, and the name and address of the individual completing the report.
The report is due on or before the last day of the month during which the
corporation filed its Articles of Incorporation (the anniversary month) each
year, and the filing fee for a report submitted on paper is $25.00. A
corporation may file its annual report electronically beginning two months
prior to its anniversary month, and the fee for electronic filing is
currently only $0.99.
How long can a corporation
exist?
The corporation's Articles
of Incorporation can provide for perpetual existence. If this is the case,
the corporation continues to exist even if the stockholders, directors, or
officers and employees die, quit, or withdraw. If a stockholder dies, the
corporation is not divided among stockholder's heirs. The shares of stock
are transferred to the deceased stockholder's heirs and the corporation
continues in existence as if the original stockholder were still alive. If
the corporation or the stockholders wish to end the corporation's life, the
corporation may be dissolved by agreement of the stockholders.
Why should I consider
incorporating my business?
Probably the most
attractive feature of a corporation is the limit on the personal liability
of the stockholders. A properly formed corporation that observes the
statutory corporate formalities and is properly capitalized will shield all
of its stockholders from personal responsibility for the corporation's
obligations. However, in some situations where a corporation is newly
formed and has not established a credit and business record, a bank, lender,
landlord, or vendor may require the main stockholders to personally
guarantee the corporation's debts.
How is a corporation
taxed? How can I minimize taxes?
In general, a corporation
must pay federal and state taxes in its own right, separate from the taxes
that its shareholders, officers, directors, and employees pay.
Unless a corporation elects
to be taxed as a "flow-thru" entity, the corporation's income is taxed
according to the corporate tax rates. The highest corporate rate currently
in effect is 35%. The profits left after taxes are available to be
distributed as dividends, which are subject to tax again on the
stockholder's personal income tax return.
This double taxation is
recognized as a distinct disadvantage of the corporate form, as compared
with other forms of business enterprise. Larger corporations with many
shareholders simply accept the disadvantage, but in smaller, closely held
corporations double taxation must be minimized. There are several ways to
accomplish this, including:
a.
Salaries. Whenever shareholders are officers or employees of a
corporation, as is frequently the case in smaller organizations, they may be
paid salaries that are deductible as a corporate expense. By taking
salaries, the stockholder-officers are compensated in a manner other than
through dividend distributions.
b. Loans.
The small corporation may be structured so that a significant portion of
its capital comes from loans to the business rather than from shareholder
investments. Having established sufficient equity capital, the remaining
funds needed for the business may be raised through interest-bearing loans.
The interest is deductible to the corporation as an expense. Interest paid
to the stockholder-lender is individual income to him, but it substitutes
for dividends and is not subject to double taxation.
c.
Subchapter S Election. The small business corporation may elect not to
be taxed at the corporate level, but may have its income (whether
distributed or not) passed through and taxed pro rata to its shareholders.
This choice of taxation, called a “flow-thru entity, generally causes the
corporation to be taxed as a sole proprietorship or a partnership. It also
takes advantage of potential losses in the early stages of the business.
All shareholders must consent to the election by signing a separate
statement of consent, which is submitted with the application electing
taxation under Subchapter S. The following requirements must also be met
for a corporation to qualify for the Subchapter S election:
d. Employee
Benefit Plans. The corporate structure permits the corporation to offer
certain benefit plans to its employees. Qualified stock option plans,
qualified pension and profit-sharing plans, and life, health, and accident
insurance plans are all available as corporate benefits.
Qualified
profit-sharing plans permit a corporate deduction for profits accumulated
for employees under the plan, and the employees are not taxed until they
receive payment. Qualified pension plans are treated similarly for tax
purposes.
Insurance plans
may provide a direct economic benefit to employees, who may also be
shareholders. The corporation may deduct the expense of paying insurance
premiums as an ordinary business expense. Hospital, accident, health, and
disability insurance plans may be maintained by the corporation with very
few limitations. Group life insurance, with a maximum limitation of $50,000
per employee, may be maintained by the corporation with the premiums treated
as an expense to the corporation but not taxable to the employee.
What other tax
disadvantages exist?
There are
certain tax disadvantages and pitfalls in utilizing a corporate form:
(1) If the
character of the income of a partnership or a sole proprietorship is tax
exempt, such income retains its tax-exempt status in the returns of the
partners or the individual proprietor. However, if the corporation form is
used, such income does not preserve its tax-exempt status when paid out in
the form of salaries or dividends to the shareholders, although that income
is exempted from the corporation’s taxable income. Similarly, a dividend
traceable to the capital gain income of a corporation is, nevertheless,
ordinary income to the shareholders (except in the case of a Subchapter S
corporation).
(2) The
liquidation of a corporation is normally a taxable event, unlike a similar
situation in a partnership or a proprietorship. Moreover, a sale of stock
or a liquidation at a loss may only give the shareholder a capital loss,
whereas there is an ordinary loss upon the abandonment of a sole
proprietorship or a partnership. The same is true if stock becomes
worthless before it is sold. This disadvantage can be avoided in the small
business by utilizing Section 1244 of the Internal Revenue Code.
(3) The
Internal Revenue Code places a penalty tax on a corporation’s earnings
accumulated beyond the reasonable needs of the corporation. This tax,
called the accumulated earnings tax, is on earnings accumulated for the
purpose of avoiding income taxes on the shareholders. The tax is aimed at
forcing corporations to pay out taxable dividends. However, for the small
corporation that is not a professional services corporation it may well not
be a problem, as a surplus of $250,000 can be accumulated without incurring
this tax.
(4) Salaries
are only deductible by the corporation if they are reasonable in amount.
Consequently, the excessive portion of a salary paid to a
shareholder-employee will be disallowed as a deduction by the corporation,
while the shareholder-employee will be taxed on the full amount received as
either salary or dividend income.
(5) A
corporation, in some circumstances, may be taxed as a personal holding
company. Generally speaking, when a large portion of the income of a
corporation is derived from passive or non-operating sources, such as
dividends, interest, annuities, amounts received from personal service
contracts, rents, and royalties, the corporation may be subject to a 50
percent tax on its undistributed income. Such corporations are not subject
to the accumulated earnings tax. Speaking broadly, a corporation will be
treated as a personal holding company if more than 50 percent of the value
of its outstanding stock is owned by fewer than six individuals and if at
least 60 percent of its ordinary gross income is from passive or
non-operating sources. The provisions of the Internal Revenue Code and
regulations must be examined carefully if the income of the business is
likely to be of this passive nature.
