Cor­po­ra­tions

As an en­tre­pre­neur, you have to decide which business structure your new company should have. Among the many different legal struc­tures, you can choose to form a cor­po­ra­tion. This can have many benefits for your future business, but also comes with unique dis­ad­van­tages. To make the decision, you must un­der­stand exactly what a cor­po­ra­tion is and the different types of cor­po­ra­tions.

A popular al­ter­na­tive to this is a part­ner­ship. But what’s the dif­fer­ence between a cor­po­ra­tion and a part­ner­ship?

The term “cor­po­ra­tion” includes a full catalog of legal struc­tures. What they all have in common is that their existence is based on assets that are provided by their share­hold­ers. Two key char­ac­ter­is­tics stand out for cor­po­ra­tions: Firstly, they are rec­og­nized as a separate legal entity with detached ac­count­abil­i­ty. Secondly: Share­hold­ers in a cor­po­ra­tion aren’t per­son­al­ly liable for any company debts or claims against the business: they are only liable for what they have per­son­al­ly invested.

These are the different kinds of cor­po­ra­tions found in the United States:

• C cor­po­ra­tion: The C cor­po­ra­tion is the most common legal structure in the United States. It can have an unlimited number of share­hold­ers who are protected from personal liability. The cor­po­ra­tion is taxed on its profits, and a second time when dividends are paid to share­hold­ers. One major dis­ad­van­tage is that share­hold­ers face the pos­si­bil­i­ty of double taxation if corporate income is dis­trib­uted to business owners as dividends.
• S cor­po­ra­tion: The S cor­po­ra­tion is designed to avoid the double taxation that comes with being a regular C cor­po­ra­tion. This means that profits can be trans­ferred to owners without being subject to corporate tax rates. To become an S corp, busi­ness­es must file with the IRS for S corp status. A drawback is that S corps cannot have more than 100 share­hold­ers, and they all must be US citizens. Because not all states tax S corps in the same way, it’s best to know the profit margin in your state before com­mit­ting to this legal structure.
• B cor­po­ra­tion: The B cor­po­ra­tion stands for “benefit” cor­po­ra­tion. They differ from other cor­po­ra­tions in mission and ac­count­abil­i­ty. These cor­po­ra­tions that meet the highest standards of social and en­vi­ron­men­tal per­for­mance, public trans­paren­cy, and legal ac­count­abil­i­ty. Their goal is to be of public benefit, while achieving a profit. To prove this, some states require B cor­po­ra­tions to file annual reports on how they have con­tributed to the public good.
• Closed cor­po­ra­tion: This is a cor­po­ra­tion with only a small number of share­hold­ers and without a board of directors. These small companies have a less tra­di­tion­al business structure, because they are not publicly traded on any stock exchanges and are not open to public in­vest­ment.
• Public cor­po­ra­tion: A publicly held cor­po­ra­tion is a publicly traded cor­po­ra­tion. Almost all C cor­po­ra­tions are publicly traded companies, where shares are traded on a public stock exchange.
• Pro­fes­sion­al cor­po­ra­tion: Also known as pro­fes­sion­al service cor­po­ra­tions, these cor­po­ra­tions were created to allow pro­fes­sion­als like doctors, lawyers, ac­coun­tants, and the like to operate as a pro­fes­sion­al business. This means they can benefit from limited liability and cen­tral­ized man­age­ment. However, shares can only be trans­ferred to those prac­tic­ing the same pro­fes­sion.
• Nonprofit cor­po­ra­tion: These cor­po­ra­tions exist for char­i­ta­ble, religious, sci­en­tif­ic, or ed­u­ca­tion­al purposes. Since their aim is to benefit the common good, they are exempt from paying taxes – but they must first file with the IRS to receive this status.

When it comes to cor­po­ra­tions, the first thing you probably think of are en­tre­pre­neur­ial business as­so­ci­a­tions. But this kind of as­so­ci­a­tion can also be chartered without any financial goals.

In the United States, so called “public purpose cor­po­ra­tions” are formed to help society, like the United States Postal Service, or the Cor­po­ra­tion for Public Broad­cast­ing. Gov­ern­ments can also form public purpose cor­po­ra­tions, which are called “public authority public purpose cor­po­ra­tions.” Although the governing body will have increased control, its purpose is to assist the public, for example to help build af­ford­able housing or medical centers.

Lastly, a “quasi-public purpose cor­po­ra­tion” isn’t in­cen­tivized to create profit. The main dif­fer­ence to public purpose cor­po­ra­tions and public authority public purpose cor­po­ra­tions is that this one is privately operated, and its goal is to carry out its un­der­ly­ing purpose.

Even though the various cor­po­ra­tion types have different char­ac­ter­is­tics, there are some qualities that they all have in common.

A cor­po­ra­tion is a “legal entity.” This means, it operates sep­a­rate­ly from its owners. As such, it can acquire assets, sue and be sued (although the same applies to part­ner­ships). In addition, it’s possible that a cor­po­ra­tion can be rep­re­sent­ed by a third party rather than by its owners. The identity of a cor­po­ra­tion does not change if owners join or leave: Public cor­po­ra­tions enjoy the same rights and re­spon­si­bil­i­ties as in­di­vid­u­als, and are therefore also referred to as “legal persons.”

A cor­po­ra­tion has its own assets that are invested by its owners. Since the cor­po­ra­tion is regarded as a legal person, all its business trans­ac­tions only affect the cor­po­ra­tion’s assets. While the founders did have to invest their own assets (to start it or at another time), cor­po­ra­tions offer the strongest pro­tec­tion to its owners from personal liability. This means that the total assets of the owners are not at risk, should the business declare in­sol­ven­cy. Not least, this risk mit­i­ga­tion helps strength­en the will­ing­ness to invest.

There are also dis­ad­van­tages to this low risk corporate model. Generally speaking, corporate owners get dividends, because they are regarded as share­hold­ers. However, many growing companies don’t give dividends but inject profits back into the cor­po­ra­tion to promote further growth.

In the US tax code, S cor­po­ra­tions do not pay corporate income taxes on profits. Instead, the profits are allocated to share­hold­ers according to their stake in the company, and the share­hold­ers report those profits as taxable income on their personal returns.

In a cor­po­ra­tion, it’s necessary that the owners can manage the business. As mentioned above, it’s also possible for a cor­po­ra­tion to be rep­re­sent­ed by a third party. Beyond this, it’s also possible for the owners to elect a CEO from their ranks like those on the board of directors or those on the su­per­vi­so­ry board. It can also make sense to separate investors from man­age­ment. That’s because an investor isn’t by nature capable of or in­ter­est­ed in running a business.

The in­de­pen­dent legal status and the liability clause that is limited to personal assets poses strict re­quire­ments when it comes to es­tab­lish­ing a cor­po­ra­tion. Some states require owners to hold a business license, which needs to be in place before the cor­po­ra­tion can be formed. You also might have to choose an entity name that meets state re­quire­ments, common corporate suffixes include “cor­po­ra­tion” or “in­cor­po­rat­ed” for a business cor­po­ra­tion, or “PC” for a pro­fes­sion­al cor­po­ra­tion. Next, you should draft your corporate by-laws, where you define the rights and rules of share­hold­ers, directors, and officers. Lastly, you need to register your cor­po­ra­tion in your state. This will include a filing fee and a reg­is­tra­tion form.

Generally speaking, the owners add different amounts of financial value to the business. Depending on the amount that you con­tribute towards a business, share­hold­ers are entitled to the amounts that are pro­por­tion­ate to their per­cent­age share­hold­ing.

For example, if a share­hold­er has con­tributed 20% of the assets, then they are possibly also entitled to 20% of the earnings. In other words, share­hold­ers are entitled to the amounts that are pro­por­tion­ate to their per­cent­age share­hold­ing. The same goes in the case of liq­ui­da­tion: a liq­ui­da­tion dis­tri­b­u­tion is con­sid­ered to be full payment in exchange for the share­hold­er’s stock, rather than a dividend dis­tri­b­u­tion, to the extent of the cor­po­ra­tion’s earnings and profits.

Each type of cor­po­ra­tion has its own unique set of book­keep­ing and tax re­quire­ments. While smaller cor­po­ra­tions (S cor­po­ra­tions) pass their earnings on to share­hold­ers and reported on each owner’s tax returns, C cor­po­ra­tions are a little more complex. The biggest dis­ad­van­tage of C cor­po­ra­tions is that they are taxed twice: first as a corporate entity and then on dividends paid to share­hold­ers. A C cor­po­ra­tion must file a Form 1120S each year to report its income and to claim its de­duc­tions and credits.

Income earned by a cor­po­ra­tion is normally taxed at the corporate level using the corporate income tax rates shown in the table below:

Although re­quire­ments vary across ju­ris­dic­tions, C cor­po­ra­tions are required to submit state, income, payroll, un­em­ploy­ment, and dis­abil­i­ty taxes. In addition to reg­is­tra­tion and tax re­quire­ments, cor­po­ra­tions must establish a board of directors to oversee man­age­ment and the operation of the entire cor­po­ra­tion.

The choice of which business structure to choose for your business is not an easy one. After all, your choice will have sig­nif­i­cant con­se­quences on the nature and the success of the business, and once you’ve made your decision, it’s not so easy to change it. That’s why it makes sense to be informed about the ad­van­tages and dis­ad­van­tages of the various legal struc­tures, before you make your choice.

The fact that cor­po­ra­tions offer the strongest pro­tec­tion to their owners from personal liability is probably the biggest advantage of choosing the C corp as your legal entity of choice. Your en­tre­pre­neur­ial risk is clearly laid out and straight­for­ward. In addition, there’s the fact that C corps act as a legal entity that’s separate from its owners: Assets can be easily moved around and trans­ferred – including buying and selling shares. When it comes to running a C corp, an optional division between share­hold­ers and directors is a further advantage. An investor might want to invest in a company, but doesn’t have the skills or the desire to run it. For this, a cor­po­ra­tion is the perfect solution.

But forming a cor­po­ra­tion can also cause problems for new en­tre­pre­neurs. The complex process that involves reg­is­ter­ing your business with your state, getting a tax ID number, and filing ap­pro­pri­ate licenses and permits can be daunting. In addition, cor­po­ra­tions also require a higher start-up cost compared to other struc­tures.

A further dis­ad­van­tage of cor­po­ra­tions is the taxation. Unlike sole pro­pri­etors, part­ner­ships, and LLCs, cor­po­ra­tions pay income tax on their profits. In some cases, they’re taxed twice: first, when the company makes a profit, and again when dividends are paid to share­hold­ers on their personal tax returns.

Many small business owners find them­selves having to choose between forming a part­ner­ship and a cor­po­ra­tion. The biggest dif­fer­ence between the two is that a part­ner­ship is not a separate legal entity and not a legal person, it is a “pass through entity.” This has several con­se­quences: While a part­ner­ship does come with rights and re­spon­si­bil­i­ties, the general partners owning the business are held liable for all company debts and legal re­spon­si­bil­i­ties. In other words, the assets of the general partners will be taken to pay company debts in the case of an in­sol­ven­cy.

Taxation differs too: Since any profit or loss passes through to the general partners in a part­ner­ship, part­ner­ships do not have to pay business taxes. Part­ner­ships have to file a tax return with the IRS to report a profit or loss, which is also where the general partners must include their results. Further ad­van­tages compared to cor­po­ra­tions are that part­ner­ships are cheaper and simpler to form.

Part­ner­ships are also often ac­com­pa­nied by part­ner­ship agree­ments which clearly state the per­cent­age that each general partner has con­tributed and is re­spon­si­ble for.

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