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When Should You form a Corporation
What is a corporation and what is its purpose?
Corporations exist to allow companies to operate as an entity separate from the people who run the entity. This allows owners, officers, managers and operators of the corporation to be free from legal liability in the event that the corporation is sued. It also allows the corporation to employ people, have bank accounts, own assets, have credit, create credit lines, and all number of things that individuals would do on their own in the normal course of business operations.
A business owner may decide at some point that his company is too large, is open to legal action, needs a larger structure, or he/she wants to distance himself from the company itself for a number of reasons. A company can begin as a corporation, or become a corporation at any point.
There are several ways to incorporate; public, private, llc, S-Corp, and professional are a few types. The type that needs to be used, the tax consequences, and how to set them up is what this article is about. For the purposes of discussing the different types of corporations we will generally refer to all types as corporations.
Corporations are entities that exist for tax and credit purposes outside of an individual. The corporation has the right to own property and must file a tax return. A corporation can have one stockholder or many, it can be publically traded on the stock market, or closely held (private). It can be gigantic and have investors all over the world, or it can have just one investor who is the businesses creator. They are very versatile. It is important to understand what they are, why they exist, and when it is the right time to use one.
A corporation is considered a separate entity from the investors for tax purposes. It has an employer identification number (EIN), which is a 9 digit code that identifies it to the IRS, similar to an individuals social security number. It has a state corporation number, that links it to the people that formed it and identifies it to the state. It exists on its own, but must have officers to run it since it is not actually alive.
If you have questions about how to form a corporation you can visit the Bowen Accounting Resources page.
Why should you form a corporation?
The main reasons that people form corporations is to avoid legal liability, create a structure that exists outside of their normal operations, and to allow the corporation to setup its own credit accounts.
Avoiding legal liability is one of the original purposes that corporation law even exists. While corporations can be as small as one person operating a business, most people think of corporations as huge entities that have their hands in many different businesses and industries. When multiple people wanted to join together to undertake a business opportunity, they did not want their personal assets subject to being lost if the venture was a failure. Thus, the investors, would form a corporation to undertake a combined business venture. Each investor would invest money into the corporation, and the profits of the corporation would go to pay dividends to the investors (also known as shareholders). If the venture was a failure, the investors would only lose what they had invested and would not be personally liable for the corporations losses. This illustrates the concept of limited liability. None of this has changed. People who want to work together commonly create corporations so that their liability is limited to their capital investment. Later we will discuss under what circumstances the shareholders and officers can be held liable for a corporations liabilities.
Since a corporation can exist as a separate entity it has the right to have bank accounts, own property/vehicles/equipment, employ people, and have credit accounts. When a corporation is first formed, or is very small, it may have problems establishing credit, just as a teenager might. In this case credit accounts may require an officer or shareholder of the corporation to be personally liable for the debts associated with the account. While this defeats the purpose of limited liability, the individual is acting as a consignor for a time to allow the corporation to build its credit rating, which will eventually lead to the corporation being allowed to have credit lines without an individual signor.
What does 'piercing the corporate veil mean'?
Since one of the most important application of the corporation is to give the shareholders limited liability, it is important to not jeopardize that. When a corporation is sued, and it's assets cannot support the legal judgment (for example: if a corporation only has 100k in assets, and the lawsuit judgment against them is for 1 million), it is commonly place for the plaintiff to attempt to 'pierce the corporate veil'. Basically, this means holding the shareholders directly liable for the corporations legal liabilities.
The laws regarding this are different in every state, but generally, it is important for the corporation to act officially as a separate entity.
- The corporation needs to have regular board meetings, where shareholders set the agenda of the company and give direction to the officers (operator and employees) of the company.
- Any major activities of the corporation need to be ordered using official channels, or corporate directives.
- The entity must maintain a firm separation from the shareholders. It should not co-mingle owner funds with company funds, pay personal bills, give company assets to shareholders through improper channels.
- The corporation must maintain its own interest and the interest of the shareholders, above the interests of specific shareholders and/or officers.
That sure sounds legal and official, but the main point is the corporation must live and act separate from the shareholders. In the case of a corporation with a single shareholder, who is also the managing officer of the corporation (very common in startups and small corporations), the officer must be very careful to keep his personal affairs separate from the corporation.
If you don't have a lot of personal assets to protect outside of the corporation, you might not see the point of trying to protect yourself, but legal judgments levied against corporations go partially paid all the time. Even having the corporation close its doors or declare bankruptcy to avoid paying a judgment is preferable to the liability being attached to the shareholders (owners/officers).
Double Taxation
The concept of double taxation can be simplified with this explanation; since the corporation is a separate entity, its profits (less distributions to shareholders), are taxed. If money is left in the corporation and then distributed to shareholders in the preceding year, these will essentially be taxed again.
The key to understanding double taxation is understanding the relationship of the shareholder to the corporation. They are completely separate. The profits of the company are taxed. Distributions made to shareholders are a deduction to the corporation for the purposes of taxation. The money that the shareholders receive are taxed at the individual level. At the end of a tax year, if the corporation has not distributed everything to the shareholders, it will have profits leftover to tax. If that money (money that has already been taxed) is distributed in the following year, it will be taxed at again at the individual level.
I am sure no one has to tell you that paying tax on the same money twice is a bad idea. Corporations may have the necessity to keep funds on hand at the end of the year. This may be required by credit restrictions, bank issues, or for operating cash. This cash profit will be double taxed at the time it is distributed. You cannot always avoid double taxation, but if you have a corporation it is a good idea to speak to a tax professional quarterly to avoid this and many other tax related issues if possible.
Understanding Flow-Through Rules
When incorporating it is important to discuss this with your CPA, tax preparer, and/or a lawyer. Many members of the financial industry can help you with incorporating, and discuss tax issues related to the change. One of the main issues that needs to be discussed is whether the entity will be a flow through entity. Almost all of the entity types mentioned have the ability to be a flow through entity. This means that while the entity will exist on its own and will have to file its own tax returns, the net profits from the company will not be taxed individually. Instead, the net profits will 'flow through' to the shareholders' personal tax return. This is a nice benefit to the incorporation rules that allows the shareholders to avoid double taxation. All of the money and profits are only taxed one time at the individual level.
The corporation will be no different than a normal corporation, it will only be distinguished as an S-Corp (Small Corporation) for tax purposes. This election can be removed later if your plans for the entity change, but can generally only be elected at the formation of the corporation, or at the beginning of a fiscal year.
When is it right to form a corporation?
Finally, after understanding what a corporation is, why they exist, how they are helpful, and how they are taxed, it is time to discuss when it is right to use one. Well the answer is very simple and very complicated at the same time. Since there are a multitude of different types of businesses and shareholder structures, it is important to remember that this is a general guideline and is not intended as specific advice for anyone who wants to form a corporation. Please consult a lawyer, tax preparer, and/or CPA before making major business structure changes.
The simple answer to 'when is the right time' is;
- When you need protection from liability. If you are in a business that is open to lawsuits, deals with the public on a large scale, provides a product that may open the doors to litigation, or you have a lot of personal assets that need to be protected, it is a good time to use a corporation.
- When the organization needs to have credit and financials that are not tied to you directly. Since you have your own personal debts and obligations, you may not want the debts and the obligations of the company affecting what you do in your personal life. Having too many credit lines in your personal name can adversely affect your credit score, and might stop you from buying a new home, car, or rental properties. The corporation can get credit, and bank accounts in it's own name and you can operate separate from it.
- When you need an organization that has its own structure. A corporation can have officers that run it (not always shareholders, usually employees), have its own bank accounts, assets, tax returns, and everything that an individual operating a business can. But when it is within the corporation it is separate from the shareholders. Even if you are out of the country or ill, the organization that you are a shareholder for can continue to operate without you.
- A general rule is that you probably need a corporation if you make over $500,000 per year in gross profits.
That might have seemed a little anticlimactic, since we have already discussed all of those things. The point is, not every business needs a corporation. If you don't need one, and set one up, it could cost you a lot of organizational setup fees, and ongoing taxes for years to come.