Company owners seeking the greatest level of protection may choose to incorporate their businesses. The courts have clearly determined that corporations are separate legal entities, and their owners are protected from claims filed against the corporation's activities. An owner (shareholder) in a corporation can't get sued or face collections because of actions the corporation takes.
The veil of protection makes a powerful case in favor of incorporating. However, the obligations that come with incorporating are tremendous, and a corporation needs significant resources to pay for the required legal and accounting services. Many businesses don't incorporate and choose instead to stay unincorporated or to organize as an LLC to avoid these additional costs.
Before incorporating, a business must first form a board of directors, even if that means including spouses and children on the board. (Imagine what those family board meetings are like!)
Boards can be made up of both corporation owners and nonowners. Any board member who isn't an owner can be paid for his service on the board.
Before incorporating, a company must also divvy up ownership in the form of stock. Most small businesses don't trade their stock on an open exchange. Instead, they sell it privately among friends and investors.
Corporations are separate tax entities, so they must file tax returns and pay taxes or find ways to avoid them by using deductions. Two types of corporate structures exist:
S corporations: These corporations have fewer than 100 shareholders and function like partnerships but give owners additional legal protection.
C corporations: These corporations are separate legal entities formed for the purpose of operating a business. They're actually treated in the courts as individual entities, like people. Incorporation allows owners to limit their liability from the corporation's actions. Owners must split their ownership by using shares of stock, a requirement specified as part of corporate law. As an investor, you're most likely a shareholder in a C corporation.
Paying taxes the corporate way
If a company organizes as an S corporation, it can avoid corporate taxation but still keep its legal protection. S corporations are essentially treated as partnerships for tax purposes, with profits and losses passed through to the shareholders, who then report the income or loss on their personal tax returns.
The biggest disadvantage of the S corporation is the way profits and losses are distributed. Although a partnership has a lot of flexibility in divvying up profits and losses among the partners, S corporations must divide them based on the amount of stock each shareholder owns.
This structure can be a big problem if one of the owners has primarily given cash and bought stock while another owner is primarily responsible for day-to-day business operations. Because the owner responsible for operations didn't purchase stock, he isn't eligible for the profits unless he receives stock ownership as part of his contract with the company.
Only relatively small businesses can avoid taxation as a corporation. After a corporation has more than 100 shareholders, it loses its status as an S corporation. Also, only U.S. residents can hold S corporation stock. Nonresident aliens and nonhuman entities (such as other corporations or partnerships) don't qualify as owners. However, some tax-exempt organizations — including pension plans, profit-sharing plans, and stock bonus plans — can be shareholders in an S corporation.
One big disadvantage of the C corporation is that its profits are taxed twice — once through the corporate entity and once as dividends paid to its owners. C corporation owners can get profits only through dividends, but they can pay themselves a salary.
Unlike S corporations, partnerships, and sole proprietorships, which pass any profits and losses to their owners, who then report them on their personal income tax forms, C corporations must file their own tax forms and pay taxes on any profits.
Reporting requirements
A company must meet several requirements to keep its corporate veil of protection in place. For example, corporations must hold board meetings, and the minutes from those meetings detail the actions the company must take to prove it's operating as a corporation. The actions that must be shown in the minutes include:
Establishment of banking associations and any changes to those arrangements
Loans from either shareholders or third parties
The sale or redemption of stock shares
The payment of dividends
Authorization of salaries or bonuses for officers and key executives (Yep, those multimillion-dollar bonuses you've been hearing about as major corporate scandals must be voted on in board meetings. The actual list of salaries doesn't have to be in the minutes but can be included as an attachment.)
Any purchases, sales, or leases of corporate assets
The purchase of another company
Any merger with another company
Changes to the Articles of Incorporation or bylaws
Election of corporate officers and directors
These corporate minutes are official records of the company, and the IRS, state taxing authorities, and courts can review them. If a company and its owners are sued and the company wants to invoke the veil of corporate protection, it must have these board minutes in place to prove that it operated as a corporation.
If a C corporation's ownership is kept among family and friends, it can be flexible about its reporting requirements. However, many C corporations have outside investors and creditors who require formal financial reporting that meets GAAP standards. Also, most C corporations must have their financial reports audited.