Corporations FAQ

What is a corporation?

A corporation is a type of business structure created and regulated by state or federal law. A corporation is an independent legal entity, separate from the people who own, control and manage it.  Corporation and tax laws view the corporation as a legal "person," which means the corporation can enter into contracts, incur debts and pay taxes apart from its owners.  A corporation does not dissolve when its owners (shareholders) change or die, and the owners of a corporation are not personally responsible for the corporation's debts.  This is called limited liability.

To learn more about corporations, please read the free legal tutorial entitled  Small Business Legal Structure found in the Lean Law Library.

What is "limited liability" and why is it important?

Limited liability means the business owner is not personally responsible for business debts and obligations of the corporation. In other words, if the corporation is sued, only the assets of the business are at risk, not the owners' personal assets, such as their houses or cars. Corporate owners must comply with certain corporate formalities and keep up with paperwork to maintain this limited liability privilege.

Limited liability has traditionally been associated with corporations, and is the main reason that most people consider incorporating.  Sole proprietorships and general partnerships do not offer the protection of limited liability.

How are corporations different from partnerships and sole proprietorships?

Partnerships and sole proprietorships do not provide limited personal liability for business debts. Creditors of these businesses can go after the owners' personal assets to collect  business debts.  Organizing and operating a partnership or sole proprietorship is much easier than forming a corporation because there is little formal paperwork required.

Corporations also differ from other business structures in the way they are taxed. The corporation itself must pay corporate income taxes on profits.  Partnerships and sole proprietorships are not taxed on business profits.  Instead, the profits "pass through" the business to the owners who then report business income or losses on their personal tax returns.

For more information on sole proprietorships, partnerships and corporations, read the free legal tutorial entitled  Small Business Legal Structure found in the Lean Law Library.

How do I form a corporation?

There are several steps required to legally create a corporation. The first is filing a document called "articles of incorporation" with the corporations division of your state or federal government. (Some states refer to this organizational document as a "certificate of incorporation," "articles of organization," "letters patent", "certificate of formation" or "charter.")  The filing fees to file this document vary from state to state. Articles of incorporation contain:

• the name of your corporation

• the registered office of your corporation

• the names and addresses of the corporation's directors

• the names and addresses of the incorporators

• the classes and restrictions on issuance of shares

When forming your corporation, you must also prepare corporate by-laws, a lengthy document which sets out the rules that govern your corporation, including necessary decision-making procedures and voting rights.

You must hold an initial meeting of your board of directors to take care of some formalities, and you need to issue shares of stock to the initial owners (shareholders).

For more information on how to form a corporation, read the free legal tutorial entitled  Small Business Legal Structure found in the Lean Law Library.

Who should incorporate?

Because of the expense and formalities involved in setting up a corporation and issuing shares, you should only form a corporation if you have a valid reason for doing so, for example:

• Your business needs the ability to issue shares to attract key employees or outside investment capital.

• Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year.

• You own a family business and you want to begin making gifts of ownership or shares to your family as part of your financial or estate planning or to plan for the next generation of owners. With a corporation you can easily make gifts of shares in your company without necessarily giving up management control.

• Others insist that you incorporate your business. For example, if you are an independent contractor, the companies you want to work for may require that you are incorporated before they will sign contracts for your services. This is may be because the Internal Revenue Service is more likely to view you as an independent contractor -- not an employee -- and because it is less risky for those who want to hire you.

Does  a corporation involve a lot more paperwork than other businesses?

Definitely.  Corporations must comply with statutory rules that don't apply to partnerships and sole proprietorships. Corporation must hold annual directors and shareholders meetings and record them by way of resolution or minutes.  Corporations must also document any major decisions or actions taken by its directors, e.g. entering into contracts, selling shares, issuing dividends, etc.   Corporations must also file a separate corporate tax return.

For more information on corporate documentation, please read the free legal tutorial entitled Small Business Legal Structure found in the Lean Law Library.

How is corporate income taxed?

Unlike sole proprietors and partnerships, a corporation's owners do not pay individual taxes on business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses and dividends. (Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings").

For more information on corporate documentation and taxing, please read the free legal tutorial entitled Small Business Legal Structure found in the Lean Law Library.

Is corporate income taxed twice?

Many people believe that corporate income is taxed twice: once to the corporation itself and again when earnings are paid out to the corporation's owners (shareholders).   This is true only for earnings paid out to shareholders in the form of dividends (profits paid by large corporations to their shareholders in return for their investment in the company).

Double taxation seldom occurs in a small corporation because the shareholders don't usually pay themselves dividends.  They usually pay themselves salaries and bonuses.   Because the corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay corporate tax on them.  (Dividends, on the other hand, are not a tax-deductible corporate expense, so both the corporation and the shareholder must pay tax.) As long as you work for your corporation, even on a part-time or consulting capacity, you can take home profits in the form of a salary and bonuses, avoiding double taxation.

What is a professional corporation?

A professional corporation is a special kind of corporation for members of certain professions, e.g. lawyers, accountants, or doctors.  A professional corporation allows these professionals to limit their personal liability for the malpractice of their associates.

Do I need to worry about securities laws when I issue stock in my corporation?

Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to follow certain guidelines before accepting investments in exchange for shares (the "securities"). Technically, a corporation is required to register the sale of shares with its state or federal  securities agency before granting stock to the initial shareholders. This registration takes time and typically involves extra legal and accounting fees.

Fortunately, many small corporations get to skip the registration process because of exemptions provided by both federal and state laws.  If you are setting up a corporation that you will actively manage, you will no doubt qualify for an exemption, and you will not have to file any paperwork.

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