Corporations FAQ

What sets a corporation apart from other types of businesses is that a corporation is an independent legal entity, separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners. Other important characteristics also result from the corporation's separate existence: A corporation doesn't dissolve when its owners (shareholders) change or die, and the owners of a corporation have limited liability—that is, they're not personally responsible for the corporation's debts.

Corporations are made up of shareholders, directors, and officers. Shareholders own stock (made up of individual shares) in the corporation. The directors, or board of directors, oversee the corporation and make the major decisions for the business. Finally, the officers manage the corporation's day-to-day activities and generally report to the board.

To learn more about how a corporation is run, read our article on understanding corporate structure.

Unlike corporations, partnerships and sole proprietorships don't provide limited personal liability for business debts. Limited liability means that creditors of those businesses can go after the owner's personal assets to collect what's due. However, organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, because no formal paperwork is required.

A limited liability company (LLC), on the other hand, does offer limited personal liability, like a corporation. And while formal paperwork is required to form an LLC, running an LLC is less complicated than running a corporation. LLC owners do not have to hold regular ownership and management meetings or follow other corporate formalities, for example.

Corporations also differ from other business structures in the way they're taxed. The corporation itself must pay corporate income taxes on its "profits"—whatever's left over after paying salaries, bonuses, and other deductible expenses. In contrast, partnerships, sole proprietorships, and LLCs aren't taxed on business profits; instead, the profits "pass through" the business to the owners, who report business income or losses on their personal tax returns.

For guidance on deciding which ownership structure is most suitable for your business, read our article choosing the best ownership structure for your business.

If a business owner has "limited liability," it means that they aren't personally responsible for the corporation's debts and obligations. In other words, if the corporation is sued, only the assets of the business are at risk, not the owners' (shareholders') personal assets, such as their houses or cars. The corporation's owners must comply with certain corporate formalities, keep up with paperwork requirements, and adequately fund ("capitalize") their business to maintain this limited liability privilege.

Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating. However, other business structures, such as LLCs, now offer this limited personal liability to business owners. Sole proprietorships and general partnerships don't.

Because of the expense and formalities involved in setting up a corporation and issuing stock (shares in the corporation), you should form a corporation only if you have good reason to do so. If you merely want to limit your personal liability for business debts, forming an LLC is probably smarter, because LLCs cost less to form and are easier to run. But here are some situations in which incorporating your business instead of forming an LLC might make sense:

• Your business needs the ability to issue stock or stock options to attract key employees or outside investment capital.
• Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year. This strategy—called "income splitting"—takes advantage of the lower tax rates on corporate income.
• You own a family business and you want to begin making gifts of ownership to your family as part of your financial or estate plan or to plan for the next generation of owners. You can easily make gifts of shares in your corporation without necessarily giving up management control and, if it's done correctly, without paying gift tax.
• Others insist that you incorporate your business. For example, if you're an independent contractor, companies you want to work for might ask you to incorporate before they'll sign contracts for your services. These companies don't want the IRS or another government agency to reclassify you as an employee, which is very unlikely if you're incorporated.

There are several steps required to legally create a corporation. The first is filing a short document called "articles of incorporation" with the corporations division of your state government. (Some states refer to this organizational document as a "certificate of incorporation," a "certificate of formation," or a "charter.") You'll have to pay a filing fee that ranges from about $100 to $800, depending on the rules of the state where you file. This document contains basic information such as:

• the name of your corporation
• the corporation's address
• the name and address of your "registered agent" (the person to be contacted by any member of the public who needs to speak to someone about the corporation), and
• in some states, the names of the corporation's directors.

When forming your corporation, you must also create "corporate bylaws," a longer document that sets out the rules that govern your corporation, including decision-making procedures and voting rights.

Finally, before you start doing business, you must hold an initial meeting of your board of directors to take care of some formalities, and you need to issue shares of stock to the initial owners (shareholders).

If you're interested in reading more, check out our book, Incorporate Your Business, A Step-by-Step Guide to Forming a Corporation in Any State, by Anthony Mancuso. This book gives detailed guidance on how to incorporate and provides all the forms you need to establish your corporation.

Yes. Corporations require paperwork to start and run the business. As with an LLC but unlike with unassociated businesses, you must register your corporation with the state. After you register your business, many states require you to file annual reports to keep your corporation in good standing.

Additionally, corporations must comply with statutory rules that other businesses, such as LLCs, partnerships, and sole proprietorships don't. For instance, corporations must observe corporate formalities such as holding and taking minutes of annual shareholder and director meetings and documenting important decisions. Also, corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping system to record business transactions, complete with daily journals and a general ledger.

To learn more about corporate paperwork, read our article on how and when to document corporate decisions.

Unlike sole proprietors and owners of partnerships and LLCs, a corporation's owners don't pay individual taxes on all business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends. (Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings").

Note that this taxation scheme doesn't apply to S corporations, which are corporations that have elected partnership-style taxation. (Regular corporations, discussed above, are called "C corporations.")

S corporations, like sole proprietorships, partnerships, and LLCs are pass-through tax entities. If your corporation elects to be taxed as an S corporation, all of the corporation's profits and losses will "pass through" to the owners, who'll report them on their individual income tax returns.

For more information on regular corporate taxation, see Nolo's article how corporations are taxed.

Many people have heard that corporate income is taxed twice: once to the corporation itself and then a second time when earnings are paid out to the corporation's owners (shareholders). This double taxation is true only for earnings paid out to shareholders in the form of dividends—that is, profits paid by the corporation to its shareholders in return for their investment in the company.

In practice, this sort of double taxation seldom occurs in a small corporation. The reason is simple: Shareholders rarely pay themselves dividends. Instead, they work for the corporation and pay themselves salaries and bonuses. Because the corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay corporate tax on them.

Dividends, on the other hand, aren't tax-deductible corporate expense, so both the corporation and the shareholder must pay tax. As long as you work for your corporation, even in a part-time or consulting capacity, you can avoid double taxation by taking home profits in the form of a salary and bonuses rather than dividends.

Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to jump through some hoops before accepting investments in exchange for shares of stock (the "securities"). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Registration takes time and typically involves extra legal and accounting fees.

Fortunately, many small corporations can skip the registration process because of exemptions provided by both federal and state laws. For example, SEC rules don't require a corporation to register a "private offering," which is a non-advertised sale of stock to either:

• a limited number of people (generally 35 or fewer), or
• those who, because of their net worth or income earning capacity, can reasonably be expected to take care of themselves in the investment process.

Most states have enacted their own versions of this popular federal exemption.

If you and a few associates are setting up a corporation that you'll actively manage, you'll no doubt qualify for an exemption, and you won't have to file any paperwork. For more information about federal exemptions, visit the SEC website. For more information on your state's exemption rules, go to your secretary of state's website.

The word "foreign" can be used to describe a corporation that's outside of the United States. Individual states, however, usually use the word "foreign" to refer to a company that was formed in another state.

For example, suppose you incorporate your business in Delaware but your corporation operates in Delaware and New York. To New York, your business would be considered a "foreign corporation" because you didn't incorporate in New York. On the other hand, in Delaware, your corporation would be considered a "domestic corporation" because you did form your company in Delaware.

If you incorporate your corporation in one state but want to do business in another state, then you'll need to qualify to do business in that other state. Each state has its own procedure for when and how foreign corporations need to register to do business.

A professional corporation is a special kind of corporation that only members of certain professions, such as lawyers, doctors, and healthcare workers, can create. By forming a professional corporation, professionals can limit their personal liability for the malpractice of their associates.