CORPORATIONS

RELATED MATERIALS REGARDING CORPORATIONS

Incorporating in Massachusetts. An overview of the processes and considerations involved in starting and operating a business corporation in the Commonwealth of Massachusetts.

Choice of Entity Considerations. Unsure whether to form a corporation or limited liability company? Read about corporation and limited liability choice of entity considerations.

Choice of Entity Taxation Considerations. Read about choice of entity considerations related to Federal income taxation.

What is a corporation?

A corporation is legal entity created pursuant to state law by filing incorporating documents with the Secretary of State. One or more classes of stock are authorized under the incorporating documents and shares of that stock are issued to one or more shareholders. Corporations can be formed by one or more persons and all owners can participate in management without jeopardizing their liability protections. The shareholders adopt corporate by-laws and elect a board of directors.

The board of directors then elects a president, a treasurer and a secretary; they may also elect one or more vice presidents and any other officers they deem necessary and in the best interests of the corporation. The officers of the corporation under the direction of the board of directors manage the daily affairs of the corporation and its operation.

The statutes governing corporate existence require that regular shareholder and board of director meetings be held and that minutes of these meetings be documented and maintained with the books and records of the corporation. All major corporate action must be approved in formal written resolutions. Shareholders of a corporation are shielded from personal liability for the debts and obligations of the corporation; however, non-compliance with the statutorily mandated requirements of corporate operation can relieve shareholders of their limited liability protections and leave shareholders vulnerable to personal liability for corporate debts and obligations.

The Internal Revenue Service (IRS) treats a corporation as a separate taxpaying entity and corporations must pay an entity level tax on income. In addition, shareholders of a corporation pay income tax on distributions (made from after-tax dollars) they receive from corporations. This is often referred to as “double taxation.” This two-tiered tax regime can be avoided by filing a “Subchapter S” election with the IRS.

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What is a subchapter S Corporation or “S Corporation?”

A “S” corporation is a corporation that elects to be taxed under Subchapter S of the Internal Revenue Code by filing Form 2553 with the IRS. Once this filing is properly completed and maintained, the corporation is taxed as a “pass-through” entity. This means that the “S” corporation almost never pays taxes itself. Instead, it files Form 1120S with the IRS and issues the shareholders K-1 Forms. The K-1 forms show the shareholders’ portion of the net income of the corporation. So, if the shareholder owns ten percent (10%) of the outstanding capital stock of the company and the corporation’s net income in $400,000, the K-1 for that shareholder will show $40,000 of income. This illustrates how the income of the corporation passes through to the shareholders. A downside to the “S” corporation is that the shareholder has to include his K-1 income on his income tax return even if he received no dividend (cash distribution) from the corporation. This means that the shareholder may have to pay income tax on income he has not actually received. A “S corporation” may have no more than 100 shareholders (these shareholders may not be corporations, nonresident aliens, general or limited partnerships, pension plans, charitable organizations or certain trusts). In addition, a “S corporation” may not have subsidiaries nor may it authorize or issue more than one class of stock.

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Is a corporation the right type of entity for a new business venture?

Protect Personal Assets from Business Liabilities. When a person or group of persons start a new business they need to understand that proper business planning at the outset can avoid many problems down the road. People are increasingly “sue happy,” and too many owners of small businesses (operating as a sole proprietorship or general partnership) find themselves defending law suits and facing judgments that threaten a business owner’s personal assets. Unless shareholders of a corporation agree to be personally liable for the debts of the corporation, their personal assets are shielded from judgments against the corporation. Protection of personal assets is one of the primary reasons persons starting their own businesses form a corporation. The organization of a limited liability company will also accomplish this goal.

Federal Income Taxation. In general, the IRS requires that corporations pay income taxation as a separate and distinct entity from its shareholders. In addition, the IRS taxes shareholders on distributions received from corporations. A small business owner operating a corporation may be subject to two levels of taxation or “double taxation” if they do not plan properly. The IRS permits shareholders of small business corporations to avoid “double taxation” by electing to be taxed under Sub-Chapter S of the Code thereby making the corporation a “flow-through” entity for Federal income tax purposes. This election provides taxpaying business owners some relief, but the IRS requires “S corporations” to continually comply with a set of complex rules in order to maintain the Sub-Chapter S election. These rules include limiting the number and type of shareholders a corporation may have, prohibitions on owning subsidiaries and issuances of greater than one class of stock.

See also, Choice of Entity Considerations and Choice of Entity Taxation Considerations

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Why not wait to create a corporation until the business is up and running?

If a business is not properly organized at “start-up,” a host of problems are likely to arise. Once business activities commence, there will be little time to dedicate to organizational issues, as the operators of the business will be consumed with ensuring the venture’s success. In addition, when two or more persons start a business each has different expectations (whether they believe so or not). If these expectations are not documented and agreed to in advance, confusion and disagreements will inevitably ensue regardless of any previously existing personal relationships.

Here are a few examples. Who may withdraw funds from company bank accounts? How will the owners be compensated for their labors? What happens in the event of the death, incapacity or divorce of an owner? These are just a few of the issues that can arise in the operation of a business without advance planning and agreement. However, with proper planning; disagreements, lengthy legal battles and hard feelings can be easily avoided – everything is documented. By forming a corporation and entering into a shareholders’ agreement prior to opening up for business many potential disputes can be avoided – who will have the final say on major business decisions, who will have the power to contractually bind the company, who will be charged with maintaining company funds, what will happen to the business in the event one of the owners wants to sell, and so on – all of these questions can be answered in advance in a written agreement among the shareholders. A shareholders’ agreement can be drafted as a simple document taking into account just the basics or it can be a complex and comprehensive document which takes into account all facets of business operation and contingencies. In addition, by forming a corporation prior to beginning business operation, the owners will be shielded from personal liability from day one. Once a liability has been created, the window has closed on forming a corporation to protect personal assets from that particular liability.

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How much does it cost to organize and maintain a corporation?

The cost of filing the proper documentation with the Secretary of State differs from jurisdiction to jurisdiction and depends on the number of shares authorized for issuance to shareholders. There is an additional fee on an annual basis to maintain the existence of the corporation under state corporate law. There is also the attorney’s fee for preparation and filing of the formation document. Much of the cost involved in creating a corporation is incurred in the preparation of by-laws, shareholder and board of director resolutions, and agreements among the shareholders. Standard documents can be prepared in just a few hours, while highly complex shareholder agreements can witness over forty hours of attorneys’ time prior to execution.

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Which is the better choice: Subchapter S Corporation or a Limited Liability Company (LLC)?

As is almost always the case with the law, the answer to this question lies in the particular situation at hand. A corporation comes with liability protection identical to that of an LLC. “S corporations” avoid the corporate level tax by electing to be taxed under Subchapter S of the Code, however, there are many rules that these corporations must follow to maintain the election. An LLC does not have to live up to these requirements. Corporations must maintain certain records and jump through statutorily mandated hoops to conduct business. An LLC need not operate under such a stringent regime.

Despite the LLC benefits noted above, there are circumstances in which an “S corporation” is an appropriate entity choice for an aspiring entrepreneur. Some states do not permit certain types of businesses to be operated as an LLC (for example, California presently does not permit professionals to conduct business as an LLC). In addition, some investors (both angels and venture capitalists) have their own business and financial reasons for wishing an entrepreneur to elect a corporation and sometimes an “S corporation” as the entity through which to operate the business venture. The facts and circumstances of each situation will dictate whether an LLC or an “S corporation” is the best entity choice upon starting one’s own business.

See also, Choice of Entity Considerations and Choice of Entity Taxation Considerations

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Is a corporation better than a general partnership or limited partnership?

A general partnership is created when two or more people agree (even verbally) to go into business together. The downside to operating as a general partnership is that each partner is fully liable for the acts and misdeeds of his or her partners, not only his own. The general partnership provides no limited liability protections to its partners. For this reason it is often not advisable to operate a business as a general partnership.

A limited partnership is created by completing a filing with the Secretary of State. The limited partners in a limited partnership receive limited liability protection and only their investment in the entity is at risk. However, the general partner who is charged with operating the business has unlimited liability for the debts and obligations of the limited partnership. In addition, if the limited partners become involved in management and operating of the business of the limited partnership they lose limited liability protection. The corporation provides much greater limited liability protection to its owners.

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Can the shareholders of a corporation participate in management without losing their limited liability protections?

One of the major benefits of the corporation is the fact that all shareholders can participate in the management and operation of the business of the corporation while maintaining limited liability protections.

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Why not operate as a sole proprietor or a general partnership?

While a sole proprietor or partners of a general partnership may avoid state filings and fees, corporate maintenance obligations, and business attorneys’ fees, there is no limited liability protection between individual and business assets. Organizing a separate legal entity, whether it be a corporation or limited liability company, will save entrepreneurs money on an ongoing basis and protect the assets they are working so hard to accumulate.

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