A stock corporation may elect Subchapter S status for tax purposes. Once such an election is made, the corporation is referred to as a Subchapter S corporation. This election is discussed in the section on taxes.
Most states also recognize non-stock corporations, which are commonly used for nonprofit organizations, community associations, etc. There are no owners in a non-stock corporation, although there may be members. Because this form of corporation is rarely used by small businesses, it will not be
further discussed in this booklet.
The Corporate Formalities
If you decide to do business as a corporate entity, you will have to comply with the formal requirements of state law to create the corporation. Note that members of certain professions, such as doctors or lawyers, may be required to do business as a professional corporation.
The individual(s) who will own the business (i.e., the shareholders or stockholders) must agree on the following to create a corporation:
- The name of the business.
- The total number of shares of stock the corporation can sell or issue (known as "authorized shares").
- The number of shares of stock each of the owners will buy.
- The amount of money or other property each owner will contribute to buy his or her shares of stock.
- The business in which the corporation will engage.
- Who will manage the corporation (i.e., who will be the directors and officers of the corporation).
Once the shareholders agree on these issues, they must prepare and file articles of incorporation or a certificate of incorporation with the corporate office of the state in which they want to incorporate. (A corporation may be formed in its home state or in any other state.)
Fees Paid to the State
You cannot form a corporation without filing with the appropriate state office. Most states charge an initial fee for filing the corporate documents and an annual fee for allowing the corporation to continue. These fees are sometimes based upon the number of shares of stock authorized and the par value of the
stock. Because each state has its own rules and schedule of fees, call your state's corporate commission or secretary of state to determine what fees will apply to your business.
The corporation will also need bylaws, i.e., a set of rules of procedure by which the corporation is run. These include rules regarding stockholder meetings, director meetings, the number of officers in the corporation and the responsibilities of each officer.
The corporation is a legal entity separate from its owners; therefore, it will need a separate bank account and separate records. The money and property that the shareholders pay to buy their stock, and the assets and money that are earned by the corporation, are owned by the corporation and not by the
A Word About the Corporation's Name
When you send your corporate documents to the state, you must include the name of the corporation. If the name you have selected is already used by another company, your documents will be rejected. In many states, you can telephone the corporation commission and they will tell you whether the name you have selected is available as a corporate name. You also should take care to avoid using a name that is similar to that of an existing company or product.
The Owners Have Ultimate Control
The shareholders of the corporation elect, at least once a year, a group of individuals to act as the board of directors. Usually, the directors must be elected by enough of the owners to represent a simple majority of the outstanding shares, although a higher vote requirement can be required. Thus, those who hold a majority of the shares have ultimate control over the corporation. Terms of directors often are for more than one year and are staggered to provide continuity. Shareholders can elect
themselves to be on the board of directors.
Certain major decisions must be approved by the shareholders, such as amendments to the articles of incorporation, merger with another company and dissolving the corporation. In some states, certain of these decisions require more than a majority of the shareholders to agree; be sure to consult an attorney about your state's voting requirements.
In some states, small businesses are permitted to incorporate without a board of directors or with other differences. Seek professional advice regarding what types of options may be permitted in your state.
The Board of Directors Makes Major Decisions
The board of directors is responsible for the major decisions of the corporation. It must meet at least once a year. Each director on the board is given one vote; usually the vote of a majority of the directors is sufficient to approve a decision of the board. Directors may be paid for their services, although payment is not required. The board of directors elects the officers of the corporation. The officers usually consist of a president, vice president, secretary and treasurer. In many states, one person may hold any or all of these offices.
Day-to-Day Decisions Are Made by the Officers
Officers of the corporation are responsible for running the day-to-day business of the corporation. Although they often are employees of the corporation and receive a salary, they can be nonemployees and/or serve without pay. The shareholders can be elected as officers.
How Do the Owners Get Paid?
If you own stock in a small business corporation and also work as an employee in that corporation, there are two ways you may be paid: (1) as an employee, you should receive wages or a salary for the work you perform and (2) if the corporation's business makes enough money, you may be paid a dividend or distribution on the stock you own. (A dividend must be paid equally to all shares of common stock and is usually expressed as an amount per share, such as "$5 per share.") The board of directors decides whether
dividends shall be paid. If dividends are not allowed in any given period, a shareholder has no right to any of the money the corporation's business has made (except as an employee receiving a salary or wages). This is because the corporation is a separate legal entity, and the money it makes belongs to the corporation.
The most important reason for you to consider incorporating your business is because a corporation is its own legal "person," separate from its owners. This means, among other things, that creditors of the corporation may look only to the corporation and the business assets for payment. The individual shareholders are not personally liable for the losses of the business if the corporation is properly established and properly operated. The shareholders' only risk is their investment in the corporation.
There are certain cases in which shareholders do incur some liability for the corporation. For example, if the shareholders do not observe the statutory requirements for running the corporation or do not keep the corporation's money, accounts and assets separate from their personal accounts, then they may also be found to be personally liable for the business's losses. Also, if the shareholders "guarantee" the obligations of the corporation in order to borrow money or to rent space, for example, then they are legally responsible for the obligations guaranteed. Finally, if shareholders make loans to the corporation and the business fails, their loans may be paid off only after the other loans of the corporation are paid.
Continuity and Transferability
The corporation, as a separate legal person, does not cease to exist if one or more of its owners dies. Its corporate existence lasts as long as its shareholders decide it should; a corporation's "life' is usually perpetual.
Ownership of a corporation can be transferred by sale of all or a portion of the stock. Additional owners can be added either by selling stock directly from the corporation or by having the current owners sell some of their stock. (Before selling shares of stock to outsiders, check to see whether federal or state
securities laws permit the sale.)
Small businesses that are corporations are often owned by a small group of shareholders who all work in the business. Often these shareholders formally agree to certain restrictions on the sale of their shares, so they can control who owns the corporation.
The corporation must file its own income tax returns and pay taxes on its profits. The corporation must report all income it has received from its business and may deduct certain expenses it has paid in conducting its business.
Dividends paid to shareholders by the corporation are taxed to each shareholder individually. This is why there is said to be a "double tax" on corporations. The corporation must pay taxes on its profits, and the shareholders must pay taxes on the dividends paid to them from the profits.
Subchapter S Corporations
You may elect Subchapter S status for your small business corporation if it meets the following requirements: (1) the corporation has no more than 35 shareholders; (2) the corporation has only one class of stock; (3) all of the shareholders are U.S. residents, either citizens or resident aliens; (4) all of the
shareholders are individuals (i.e., no corporations or other entities own the stock) and (5) the corporation operates on a calendar year financial basis.
To elect Subchapter S status for your business, you will need to complete Federal Form 2553 and, in some states, file a separate state election form.
Generally, a Subchapter S corporation does not pay taxes on the income generated by the business. Instead, the income or losses are passed through to the individual shareholders and reported on
their tax returns. The income or losses are divided among the shareholders based upon the percentage of stock of the corporation that they own.
You may be required to pay tax on the income of a Subchapter S corporation even if you have not been paid any money (i.e., dividends or distributions) from the corporation.
Pros and Cons
- Provides limited liability to owners.
- Is easy to transfer ownership.
- Is easy to add additional owners/investors.
- Is more costly to set up and maintain.
- Requires separate tax returns.
- Is subject to double taxation.