How should I form my business?

The choice of the best type of entity for any particular business involves an analysis of many business and legal considerations. Among the most important factors are:

• the cost and formality of organization
• transferability of ownership interests
• expected life of the enterprise
• who will manage and control the enterprise
• the need to obtain capital and credit
• method of participation in profits
• vulnerability to liability, and
• the manner and extent to which the enterprise is taxed

For a small business, the available forms of business enterprise include the individual or sole proprietorship, the general partnership (including the limited liability partnership), the limited partnership (including the limited liability limited partnership), the limited liability company, and the business corporation. Each of these forms of business enterprise is adaptable to the small business venture.

What is a corporation?

A corporation is an artificial legal entity that must be created under the specific laws of a state or of the United States. A corporation may, with some exceptions, be owned by one or more people, by other legal entities, or by people and legal entities. Once created, a corporation is considered to have an existence separate and distinct from that of its owners or its employees. A corporation can buy, own, and sell property. In a legal sense, a corporation can do everything that a person can do.

What are shareholders?

The corporation’s owners are called shareholders. Their rights are set forth in the laws under which the corporation is formed and in a document called the Articles of Incorporation. While the shareholders own the corporation, they do not act for it unless they are also officers or employees of the corporation.

The ownership of a corporation is usually evidenced by stock certificates. Unless restricted in the corporation’s Articles of Incorporation, in the corporation’s Bylaws, or in a separate agreement such as a buy-sell agreement, a stockholder can sell or give away his or her stock without notice to or approval from the corporation or the other stockholders. A stockholder can also, without notice or prior approval, pledge his or her stock as security for a loan or other obligation. If the corporation or its stockholders wish to control the ownership or transfer of the corporation’s stock, this can easily be solved with a buy-sell agreement or with a stockholders’ agreement.

What are incorporators?

During start-up, the incorporators control the corporation. The incorporators elect and appoint the initial Board of Directors, who control the corporation during their initial term and are primarily responsible for all management decisions. The initial Board of Directors also oversees the issuance of the corporation’s stock to its initial shareholders. The statutes that govern corporations require the Board of Directors to consult the shareholders on major corporate changes. The corporation’s officers are appointed by the Board of Directors and perform the duties delegated to them by the Directors. The officers are responsible for the day-to-day operation of the corporation’s business.

How do I create a corporation?

The Colorado Secretary of State accepts and files the Articles of Incorporation for new corporations formed in Colorado. The fee for filing the Articles of Incorporation is $50.00. The Secretary of State will soon offer electronic filing for Articles of Incorporation, but as of August 31, 2004 Articles of Incorporation must be filed in paper format.

A corporation must file an annual report with the Colorado Secretary of State in order to remain in good standing and to retain its authority to engage in business in the state. The annual report consists of the name and street address of the corporation’s registered agent, the address of the corporation’s principal office, and the name and address of the individual completing the report. The report is due on or before the last day of the month during which the corporation filed its Articles of Incorporation (the anniversary month) each year, and the filing fee for a report submitted on paper is $25.00. A corporation may file its annual report electronically beginning two months prior to its anniversary month, and the fee for electronic filing is currently only $0.99.

How long can a corporation exist?

The corporation’s Articles of Incorporation can provide for perpetual existence. If this is the case, the corporation continues to exist even if the stockholders, directors, or officers and employees die, quit, or withdraw. If a stockholder dies, the corporation is not divided among stockholder’s heirs. The shares of stock are transferred to the deceased stockholder’s heirs and the corporation continues in existence as if the original stockholder were still alive. If the corporation or the stockholders wish to end the corporation’s life, the corporation may be dissolved by agreement of the stockholders.

Why should I consider incorporating my business?

Probably the most attractive feature of a corporation is the limit on the personal liability of the stockholders. A properly formed corporation that observes the statutory corporate formalities and is properly capitalized will shield all of its stockholders from personal responsibility for the corporation’s obligations. However, in some situations where a corporation is newly formed and has not established a credit and business record, a bank, lender, landlord, or vendor may require the main stockholders to personally guarantee the corporation’s debts.

How is a corporation taxed? How can I minimize taxes?

In general, a corporation must pay federal and state taxes in its own right, separate from the taxes that its shareholders, officers, directors, and employees pay.

Unless a corporation elects to be taxed as a “flow-thru” entity, the corporation’s income is taxed according to the corporate tax rates. The highest corporate rate currently in effect is 35%. The profits left after taxes are available to be distributed as dividends, which are subject to tax again on the stockholder’s personal income tax return.

This double taxation is recognized as a distinct disadvantage of the corporate form, as compared with other forms of business enterprise. Larger corporations with many shareholders simply accept the disadvantage, but in smaller, closely held corporations double taxation must be minimized. There are several ways to accomplish this, including:

1. Salaries. Whenever shareholders are officers or employees of a corporation, as is frequently the case in smaller organizations, they may be paid salaries that are deductible as a corporate expense. By taking salaries, the stockholder-officers are compensated in a manner other than through dividend distributions.
2. Loans. The small corporation may be structured so that a significant portion of its capital comes from loans to the business rather than from shareholder investments. Having established sufficient equity capital, the remaining funds needed for the business may be raised through interest-bearing loans. The interest is deductible to the corporation as an expense. Interest paid to the stockholder-lender is individual income to him, but it substitutes for dividends and is not subject to double taxation.
3. Subchapter S Election. The small business corporation may elect not to be taxed at the corporate level, but may have its income (whether distributed or not) passed through and taxed pro rata to its shareholders. This choice of taxation, called a “flow-thru entity, generally causes the corporation to be taxed as a sole proprietorship or a partnership. It also takes advantage of potential losses in the early stages of the business. All shareholders must consent to the election by signing a separate statement of consent, which is submitted with the application electing taxation under Subchapter S. The following requirements must also be met for a corporation to qualify for the Subchapter S election:
   • There may be no more than seventy-five (75) shareholders.
   • Shareholders must be natural persons, and cannot be another corporation or partnership, although estates and certain trusts may own shares.
   • The corporation has limitations on different classes of stock (they may vary only with respect to voting rights), and may not be a member of an affiliated group.
   • The corporation cannot have a non-resident alien as a shareholder.
   • The corporation’s foreign income and passive investment income may not exceed certain limitations.
4. Employee Benefit Plans. The corporate structure permits the corporation to offer certain benefit plans to its employees. Qualified stock option plans, qualified pension and profit-sharing plans, and life, health, and accident insurance plans are all available as corporate benefits.Qualified profit-sharing plans permit a corporate deduction for profits accumulated for employees under the plan, and the employees are not taxed until they receive payment. Qualified pension plans are treated similarly for tax purposes.Insurance plans may provide a direct economic benefit to employees, who may also be shareholders. The corporation may deduct the expense of paying insurance premiums as an ordinary business expense. Hospital, accident, health, and disability insurance plans may be maintained by the corporation with very few limitations. Group life insurance, with a maximum limitation of $50,000 per employee, may be maintained by the corporation with the premiums treated as an expense to the corporation but not taxable to the employee.

What other tax disadvantages exist?

There are certain tax disadvantages and pitfalls in utilizing a corporate form:

(1) If the character of the income of a partnership or a sole proprietorship is tax exempt, such income retains its tax-exempt status in the returns of the partners or the individual proprietor. However, if the corporation form is used, such income does not preserve its tax-exempt status when paid out in the form of salaries or dividends to the shareholders, although that income is exempted from the corporation’s taxable income. Similarly, a dividend traceable to the capital gain income of a corporation is, nevertheless, ordinary income to the shareholders (except in the case of a Subchapter S corporation).

(2) The liquidation of a corporation is normally a taxable event, unlike a similar situation in a partnership or a proprietorship. Moreover, a sale of stock or a liquidation at a loss may only give the shareholder a capital loss, whereas there is an ordinary loss upon the abandonment of a sole proprietorship or a partnership. The same is true if stock becomes worthless before it is sold. This disadvantage can be avoided in the small business by utilizing Section 1244 of the Internal Revenue Code.

(3) The Internal Revenue Code places a penalty tax on a corporation’s earnings accumulated beyond the reasonable needs of the corporation. This tax, called the accumulated earnings tax, is on earnings accumulated for the purpose of avoiding income taxes on the shareholders. The tax is aimed at forcing corporations to pay out taxable dividends. However, for the small corporation that is not a professional services corporation it may well not be a problem, as a surplus of $250,000 can be accumulated without incurring this tax.

(4) Salaries are only deductible by the corporation if they are reasonable in amount. Consequently, the excessive portion of a salary paid to a shareholder-employee will be disallowed as a deduction by the corporation, while the shareholder-employee will be taxed on the full amount received as either salary or dividend income.

(5) A corporation, in some circumstances, may be taxed as a personal holding company. Generally speaking, when a large portion of the income of a corporation is derived from passive or non-operating sources, such as dividends, interest, annuities, amounts received from personal service contracts, rents, and royalties, the corporation may be subject to a 50 percent tax on its undistributed income. Such corporations are not subject to the accumulated earnings tax. Speaking broadly, a corporation will be treated as a personal holding company if more than 50 percent of the value of its outstanding stock is owned by fewer than six individuals and if at least 60 percent of its ordinary gross income is from passive or non-operating sources. The provisions of the Internal Revenue Code and regulations must be examined carefully if the income of the business is likely to be of this passive nature.