What is a corporation? How they work and how to incorporate

KEY TAKEAWAYS

• A corporation is a business entity that is legally separate from its owners. Corporations retain many of the same rights and responsibilities as individuals.
• The most common types of corporations are C Corps and S Corps. In some states, you can form a benefit corporation (B Corp).
• Corporations offer many benefits such as limited liability, credibility, infinite life, and transferable ownership.

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Starting a new small business as an entrepreneur is an exciting endeavor. But it also comes with many new responsibilities and to-dos. One of the first and most important things you’ll have to do is decide how to structure your business. Business structure options include sole proprietorships, partnerships, limited liability companies (LLCs), and corporations. Each type of structure has pros and cons, and the business formation decision is not one you should take lightly.

Corporations are often seen as a complex and highly regulated type of business structure. But don’t let this intimidate you. Despite the complexity of forming a corporation, there are some upsides (more on that below!).

Your business structure sets the framework for your future operations. There are many factors to consider, so let’s cover the pros and cons of corporations. Then, we’ll share how to start one if you decide a corporation is the best option for you.

What is a corporation?

A corporation is a business that is considered a legal entity separate from its owners, who are called shareholders. Therefore, under the law, corporations possess many of the same rights and responsibilities as individuals. They have a board of directors, issue stock to shareholders and investors, pay taxes, and hire employees.

To become a corporation, you must follow your state’s legal requirements. This generally entails creating corporate bylaws and filing articles of incorporation. Working alone, preparing all the information required to file these articles takes some small business owners significant time and effort. But once the paperwork is filed your business will officially be recognized as a corporation.

If you’re a new small business owner, or you’ve just started considering becoming a corporation, it’s wise to seek direction from an attorney and a tax professional. Block Advisors also has information and tools to help you prepare yourself to make this important decision for your company.

Benefits of incorporating

There are several advantages to becoming a corporation. These include limiting liability, increasing credibility, accessing transferable ownership, and securing tax benefits. Below, we’ll look at each in detail:

Limited liability

One of the most well-known advantages of forming a corporation is that they offer personal liability protection to shareholders. This means that owners are generally only liable for the amount that they’ve invested in the company. Shareholders’ personal assets are generally protected.

 Credibility

By registering your small business as a corporation, you may appear more credible to potential customers, partners, employees, vendors, and investors. Furthermore, having a corporation status can reassure potential investors who may be interested in funding your small business.

 Unlimited life and transferable ownership

Corporations have an unlimited life and transferable ownership. If an owner passes away or decides to sell their share of the company, the business will continue to exist. With the option of transferable ownership (with some restrictions for S Corps), owners can sell or pass shares to another person or business.

Tax benefits

Some corporation types (C Corps) are subject to double taxation. But, other corporation structures come with many tax advantages. For example, for many corporations, owner-paid health insurance premiums are tax-deductible. Another benefit is that corporate shareholders are not subject to self-employment tax on income they pay tax on. This can result in significant savings as compared to other entity types.

The disadvantages of forming a corporation

Despite the many benefits of corporations, this business structure is not for everyone. Before diving into the process of becoming a corporation, there are some potential considerations to be aware of.

Application process

There is a lengthy application process to become a corporation. The extensive paperwork may require you to sort through minute details of the organization and ownership. Though filing your articles of incorporation can be quick, the entire process is often prolonged. There is also a cost associated. Corporation registration fees vary by state. They are often around a couple of hundred dollars.

Double taxation

While we discussed the tax benefits of certain types of corporations above, it’s important to note that C Corps face double taxation. This means that the business income is taxed both at the entity level and shareholder level, to the extent dividends are paid to shareholders.

Rigid formalities and protocols

Properly maintaining and complying with the legal requirements can involve a lot of time and energy. To keep your corporation status, you must follow several formalities. These administrative tasks include writing and following bylaws, holding meetings, maintaining a board of directors, and creating annual reports.

Types of corporations: which is the best option for you?

Your business’s goals and ownership structure help determine which type of corporation is your best option. Different types of corporations include:

·      C Corporation (C Corp)

A C Corp pays corporate income taxes. This is a common type of corporation. It can have an unlimited number of shareholders. Ownership is divided based on stocks. Large, publicly traded companies are often structured as C Corps.

·      S Corporation (S Corp)

S Corps differ from C Corps in that they have the option to select a pass-through tax structure. This means they can avoid double taxation. To form an S Corp you must first form a corporation. Then you file IRS Form 2553 to elect S Corp taxation. There are certain criteria you must meet to be an S Corp. These include having no more than 100 shareholders and having only one class of stock. Additionally, none of the shareholders can be nonresident taxpayers.

(NOTE: Want to avoid the formalities discussed above? Consider forming an LLC and electing S Corp status instead!)

·      B Corporation (B Corp)

A certified benefit corporation, or B Corp, is a for-profit business that has a social mission in addition to its profit generation goals. This management structure of this entity type balances the financial interests of shareholders and the well-being of stakeholders impacted by the company. Because of the social impact component, B Corps may be subject to additional reporting requirements. These requirements may ask the B Corp to provide evidence that its social mission is being advanced to retain its unique corporate status.

The business structure you choose affects your tax obligations, ability to raise funds, and share distributions. Find out more about business entity formation with help from Block Advisors small business tax professionals.

How to start a corporation

As mentioned, the process of forming a corporation can be lengthy. Each state has slightly different requirements. Below are common steps you may need to take in your state to form a corporation for your small business.

1.    Choose a name for your corporation

The first step to forming a corporation is choosing a name. It may seem like a small detail, but choosing the right name is important. Start by searching for similar names. Check to make sure yours is available. The name of your corporation cannot match or be too similar to one that already exists. The name also must contain certain identifiers such as Incorporated (Inc.), Limited Corporation (Ltd.), or Company (Co.).

2.    Appoint a board of directors

The board of directors is responsible for overseeing the business operations and protecting the interests of shareholders and investors. To begin incorporating, you’ll need to appoint an initial board. Once the corporation has been formed, however, you can replace the initial directors with more permanent members. Keep in mind that different states have different obligations for the number of directors that will need to be appointed.

3.    draft and file articles of incorporation

Articles of incorporation often include:

• Corporation name
• Principal place of business
• Corporation purpose
• Name and address of the agent – i.e., the person who accepts legal papers on the corporation’s behalf
• Names and addresses of the incorporators and/or the initial board members

After drafting your articles of incorporation, you will need to file them with your state’s secretary of state. These articles serve as the corporation’s official charter. They are required to document the corporation’s formation.

4.    Create your corporate bylaws

Not all states require that corporations draft corporate bylaws. But you may consider creating them regardless. Bylaws define the rules and regulations of how the corporation will operate. They also inform the rights and duties of the shareholders, directors, and officers.

5.    Hold the first board of directors meeting

Next, after your corporation has been officially formed, hold a meeting of the initial board of directors. This meeting’s purpose is multifold. It is often the time when you appoint a permanent board, approve the drafted bylaws, appoint officers, and authorize the issuance of shares of stock. The minutes of this meeting, and all board meetings, should be recorded. Get in the habit of having good record-keeping from the start.

6.    Issue stock

Prepare and execute stock certificates next. This is one of the first formal corporate actions you can take after forming your corporation. Be sure to make a record of the shares issued to each shareholder and the price paid. Again, keeping clear and timely records is always a good idea!

7.    Draft a shareholders’ agreement

This step is optional. But like the corporate bylaws, a shareholders’ agreement may contribute to the long-term success of your business. This agreement serves as a contract between the owners of a small business. It determines how ownership will be handled if a shareholder dies, retires, or leaves the company.

8.    Secure an employer identification number

An Employer Identification Number (EIN) essentially acts as the corporation’s taxpayer identification number (similar to a Social Security Number for individuals). Your company EIN is the number the IRS uses to identify your business for tax purposes. You’ll need it to open a bank account, set up payroll, and file taxes.

9.    Get business permits, licenses, and DBAs

Many businesses have licensing or permitting requirements. These requirements may be at a city, state, and/or national level. The rules depend on your location and industry. Contact your state and local governments to inquire about the licenses and permits you need to operate.

Next steps for corporation business formation

The process of forming a corporation may feel complicated. But keep in mind, there may be benefits for you and your company if you put in the effort. Choose carefully when deciding which structure is right for you and your specific business needs.

If you’re still feeling overwhelmed by the idea of choosing a business structure and forming a corporation, don’t worry. Block Advisors has the resources to help you make a more informed decision. Speak with a Block Advisors certified small business tax pro about your options.

This article is for informational purposes only and should not be construed as legal advice. You may want to seek the advice of an attorney to evaluate all relevant considerations. 

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