Should You Incorporate Your Small Business?
One of the first decisions to make when starting your business is how to structure it. This decision will have an impact on many aspects of your business, from the way that your business is taxed to who will have liability for business debts. Each state operates under its own business corporation laws, and each has different filing fees to establish various types of business entities, as well as different reporting requirements for each type of entity. It is critical that the structure you choose makes sense for your company. This article provides information on corporations and how the different corporate structures work.
A corporation is a completely independent legal and tax entity, entirely separate from those who own, control, and manage it. As a result, corporations pay their own taxes on corporate profits, and owners pay personal income tax only on salaries and bonuses paid to them from the corporation.
A corporation typically provides the greatest protection for business owners who have potentially significant liabilities, incur substantial business debts, and/or want to ensure they protect their personal assets. Because of the separate status of a corporation, the personal assets of the business owners should not become exposed in the event of a lawsuit or default on a business debt.
Starting a Corporation
Corporations must file Articles of Incorporation or Certificate of Incorporation to begin operations, signed by the incorporator and incorporators. Individual states have specific requirements about what information needs to be included, but typically, the Articles of Incorporation include basic information about the company, including the official name and address of the business, corporate purpose, name and address of the registered agent, stock information (including the number of shares of stock authorized and the par value of those shares), and the names and addresses of the corporation’s Officers and Directors.
Some states also require corporations to maintain and adhere to bylaws, which define the company’s structure, individual roles and governance, voting rights, and responsibilities of directors, and also, to hold and document periodic meetings to discuss corporate business.
There are two main types of corporations to consider when starting a new business: S corporations and C corporations.
S corporations are typically referred to as “closely held corporations” and are usually used for small businesses, since an S corporation can generally have no more than 100 shareholders by law. Officers and shareholders of an S corporation are not personally responsible for the debts and liabilities of the corporation, and there is no self-employment tax imposed on each person’s share of the business’s net income, but shareholders must file a form with their personal tax return called a K-1 form.
The K-1 form reports each shareholder's share of income, losses, deductions and credits from the corporation. This same information is used to fill out the individual shareholders’ tax returns. Shareholders in an S corporation can take a reasonable salary from the corporation in combination with a portion of the profits as a distribution, which is treated as net income under the K-1. Shareholders pay self-employment tax only on their salary, but they may be liable for regular income taxes on their portion of the corporation’s income, even if that income was not distributed.
C corporations are generally used for larger businesses, and should be used if you want to raise capital for your business, take on multiple investors, and/or intend to make shares of your corporation available to the public on the open market.
Income from a C corporation is taxed twice; once at the corporation level, when the corporation pays taxes on its profits at a corporate rate, and again on the individual shareholder level, when the shareholders pay taxes on distributions based on the individual’s tax rate.
C corporations allow for many more tax-related deductions than S corporations, but in order to obtain those deductions, the corporation must meet specific requirements. Some benefits that may be deductible on a corporation’s tax return include the costs of health plans, life insurance, cafeteria plans, and assistance with educational expenses. In some cases, in order to be eligible for deduction, the corporation must offer the same benefits to all employees and cannot provide special benefits to some employees while excluding others.
C corporations can also offer a lower tax rate, but a tax and accounting professional should be consulted to determine if that is the case for your particular business.
If you are starting a new business and have questions about which type of business entity is right for your business, visit Legal Services Link, post a short summary of your legal needs, and let the perfect business lawyer come to you!
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