Small Business Tutorial - Corporations

A corporation is a legal entity that has a "perpetual existence" separate from the individual(s) who create, own and run the corporation. A company can be a state or federal corporation.  Federal incorporation is used if business will be conducted in more than one state or outside the U.S.  State incorporation is used if all business will be conducted in one state. The owners of a corporation are its shareholders, who buy into the corporation by providing money, goods or services to the corporation in exchange for shares. Shareholders do not own the assets of the corporation and generally are not responsible for any of its debts of liabilities. If a corporation has financial difficulties, its shares may lose their value, but creditors of the corporation cannot normally look to the shareholders to pay off corporate debts or liabilities.

Advantages of Incorporating: The traditional advantages cited in support of incorporation are: limited liability, ease of raising capital, ease of transferring an interest in the business and tax advantages. [Note: Before you jump onto the incorporation bandwagon, please be cautioned that these reasons may sound good on first blush but may not have any real value or meaning to you in the early stages of your business. Read the comments below and remember, you can always change the status of your business to suit your changing needs.]

Limited Liability: Incorporating a business does protect the personal assets of the individual(s) who create, own and run the business. However, most lenders will require a personal guarantee from the owners before loaning money to a (new) corporation without assets. Suppliers may also want such personal guarantees. The directors and officers of a corporation are not completely protected from liability for acts of the corporation. A director could be held personally liable for: unpaid wages of employees if the corporation became insolvent; employee source deductions should the corporation fail to remit same to the I.R.S., or other breaches of tax statutes or legislation.

Raising Capital: A private corporation [unlike a publicly traded corporation] will usually be forced to raise capital by borrowing it and will have little advantage over a sole proprietorship or a partnership when a lender demands a personal guarantee.

Transferring Interest: It is not, in fact, easy to transfer an interest in a private corporation by transferring shares. This normally requires the consent of the majority of shareholders or directors and there is a limited market for anything less than 100 % of the shares of most private corporations.

Tax Advantages: Because corporations are taxed on profits at a flat rate [as compared to an increasing tax rate on individuals as personal income goes up], some of the tax advantages of incorporation can be real.

There are additional corporation tax reductions in connection with capital gains taxes, postponed taxation of gains on shares, and tax-free rollovers of capital gains on qualified investments from one small business to another. Additionally, if you incorporate your business you can control when you receive income for tax purposes by choosing the date of the corporation's year-end, deciding when to pay yourself and deciding when to declare a dividend for shareholders. However, if your business operates at a loss in its early stages, you would be better off operating as a sole proprietor and deducting those losses from your personal income. If you have incorporated, you won't be able to deduct those losses. If your business makes a small profit and you don't have much other personal income, you may pay less tax as a sole proprietor than you would if you were incorporated.

If your business is really just you providing services to a third party (where you would be the third party's employee if it weren't for the corporation), the I.R.S. may consider your business to be a personal services corporation. As such, your corporation would not be allowed to claim a small business deduction. If you think your business may be a personal services corporation, be sure to check with the I.R.S. before you incorporate.

Other Advantages of Incorporating: An incorporated business may give the impression of more stability and longevity to your clients and customers. The owners (shareholders) are not responsible for the acts or omissions of other owners the way partners are liable in partnerships. You may take advantage of offering profit sharing to employees and you can use your corporation for estate planning and the passing of assets to family members while minimizing taxable capital gains on your death.

DO-IT-YOURSELF INCORPORATION

It is not recommended that you attempt a do-it-yourself incorporation unless your company will be a closely-held corporation The definition of a closely held corporation is a corporation whose voting shares are held by a single shareholder or a closely-knit group of shareholders (like you and your family) who are in control of corporate policy and stand to benefit personally from such policy. Representing yourself in an incorporation or any other legal matter is called "pro se" which is a Latin phrase meaning "for [him]self" or "in [his] own behalf" rather than hiring a lawyer to represent you. If you are intending to incorporate with a partner, it is recommended that you have in a place a shareholders' agreement to set out each shareholder's mutual rights and obligations. For more information on this subject, see subsection Shareholders' Agreements.

General rules about names: the name can't be confusingly similar to an existing corporation or business, it cannot be obscene or contain words to suggest any connection with the government like "federal" or "state," it can't contain words like "university," "bank," or "stock exchange," it can't contain the name of a specific person unless that person is involved in the business or has agreed to the use of his or her name or has been dead for more than 30 years. The corporation's name must include one of the following words at the end which indicates that it is a corporation: Limited, Ltd., Incorporate., Inc. Corporation, Corp.

Types or "Classes" of shares:
There are two kinds of shares: "Common" or "Preference" (sometimes called preferred, pref or special shares). Common shares can give a shareholder a right to vote at shareholders' meetings and elect directors, to receive a share of the corporation's property if the corporation shuts down, or to receive a portion of the corporation's profits in the form of dividends. Holders of Preference shares may or may not have the right to vote at shareholders' meetings, but do have the right to receive dividends before common shareholders. If you don't want all shareholders to have the same rights to vote or receive dividends, you will need more than one class of shares. You must define the rights attached to the different classes of shares in the "Articles of Incorporation", including the following:

• Voting rights
  
• Right to receive dividends, or receive dividends before other shareholders
  
• Right to receive a share in the assets of the corporation if it shuts down
  
• Right to demand that the corporation buy back (redeem) shares, or the obligation to sell back shares to the corporation on demand
  
• Right to convert shares into shares of another class.

Restrictions on the Right to Transfer Shares: Most small business owners want to set restrictions on the transfer of shares by the shareholders of their corporation. In this way, the business owner maintains control over a fellow shareholder selling shares to a third party without his/her consent. In all likelihood, you will want to restrict the transfer of all classes of shares.

Shareholders' Agreements: If the owners of the corporation are partners, there should be a shareholders' agreement setting out their mutual rights and obligations and dealing with the election of directors, resolution of deadlock votes, agreements among all the shareholders (unanimous shareholders' agreement), a buy-sell clause that allows shareholders to buy out a co-owner's shares or be bought out, or what happens if a owner-shareholder dies. The shareholders' agreements are prepared separately from the incorporating documents and are not filed with the government.

Directors of the Corporation: Every corporation must have at least one director to manage the affairs of the corporation. A director of a corporation must be a person (rather than another corporation), at least 18 years of age, not bankrupt and of sound mind. In many businesses, the directors and shareholders are the same. A director has certain legal duties to the corporation and its shareholders. A director must be reasonably careful and must exercise reasonable skill and must act honestly and in good faith with a view to the best interest of this corporation (call fiduciary duty). This protects the corporation from a director participating in activities which may present a conflict-of-interest from which a director could benefit or profit at the expense of the corporation. In such a situation, a director would have to pay back to the corporation any such benefit or profits. Directors can be liable for the following debts of a corporation:

• Employees' wages if the corporation can't pay them
  
• Income tax, sales tax, employment insurance and Social Security which the corporation does not pay

A director can also be held responsible for any illegal actions or activities of the corporation and can be convicted of an offense if the director authorized or participated in any criminal or state offense by the corporation.

COMPLETING ARTICLES OF INCORPORATION

Name of Corporation: state the full name of the corporation. Don't forget to include "Inc." "Ltd." "Corporation" or other indicators of a corporation as discussed in the subsection Naming a Corporation (above).

Address of Corporation: this must be a registered office (street address, not post office box) within the state. This address does not have to be the address where business is carried on.

Number of Directors: "minimum of one (1) director and a maximum of ten (10) directors" is a standard which allows for future expansion or growth of your company.

Classes and Maximum number of shares that the corporation is authorized to issue: Two classes of common shares (one voting and one non-voting) and two classes of preference shares (one voting and one non-voting) will provide flexibility when expanding a business to include issuing shares to a spouse or children in the future without having to amend the articles of incorporation.  An example would look as follows:

• An unlimited number of Class A Common Shares (voting)
  
• An unlimited number of Class B Common Shares
  
• An unlimited number of Class A Preference Shares
  
• An unlimited number of Class B Preference Shares (voting)

Restrictions, if any, on business the corporation may carry on: 
It is not wise to restrict the type of business in case you want to change the nature of the business in the future.

Incorporators: All incorporators must be listed with their full street address (post office box is insufficient) and they must sign the form.