Corporation Basics

Corporations limit personal liability for business debts, but running them takes work.

Most people have heard that forming a corporation provides "limited liability" -- that is, it limits your personal liability for business debts. What you may not know is that there's more to creating and running a corporation than filing a few papers. You'll need to keep good records to handle the more complicated corporate tax return and, in order to retain your limited liability, you must follow corporate formalities involving decision making and record keeping. In short, you've got to be organized.

Limited Personal Liability

One of the main advantages of incorporating is that the owners' personal assets are protected from creditors of the corporation. For instance, if a court judgment is entered against your corporation saying that it owes a creditor $100,000, you can't be forced to use personal assets, such as your house, to pay the debt. Because only corporate assets need be used to pay business debts, you stand to lose only the money that you've invested in the corporation.

Exceptions to Limited Liability

There are some circumstances in which limited liability will not protect an owner's personal assets. An owner of a corporation can be held personally liable if he or she:
· personally and directly injures someone
· personally guarantees a bank loan or a business debt on which the corporation defaults
· fails to deposit taxes withheld from employees' wages
· does something intentionally fraudulent or illegal that causes harm to the company or to someone else, or treats the corporation as an extension of his or her personal affairs, rather than as a separate legal entity.

This last exception is the most important. In some circumstances, courts can rule that a corporation doesn't really exist and that its owners should not be shielded from personal liability for their acts. This might happen if you fail to follow routine corporate formalities such as:
· adequately investing money in ("capitalizing") the corporation
· formally issuing stock to the initial shareholders
· regularly holding meetings of directors and shareholders, or keeping business records and transactions separate from those of the owners.

Liability Insurance

Incorporating should never take the place of good business insurance. Even though forming a corporation protects your personal assets, you should use insurance to guard your corporate assets from lawsuits and claims.

A solid liability insurance policy can protect you against many of the risks of doing business. For instance, if you operate a clothing store, good business insurance should adequately cover the bill if someone slips and falls in your store.

Also, insurance can protect you where the limited liability feature will not. For example, if you personally injure someone while doing business for the corporation, say by causing a car accident, liability insurance will usually cover the accident so that you won't have to use either corporate or personal assets to pay the bill. However, insurance won't help if your corporation doesn't pay the bills: commercial insurance usually does not protect personal or corporate assets from unpaid business debts, whether or not they're personally guaranteed.

Paying Corporate Income Tax

If an owner of a corporation works for the corporation, that owner is paid a salary, and possibly bonuses, like any other employee. The owner pays taxes on this income just like regular employees, reporting and paying the tax on his or her personal tax return.

The corporation pays taxes on whatever profits are left in the businesses after paying out all salaries, bonuses, overhead, and other expenses. To do this, the corporation files its own tax return, Form 1120, with the IRS and pays taxes at a special corporate tax rate.

Alternatively, corporate shareholders can elect what's called "S corporation" status by filing Form 2553 with the IRS. This means that the corporation will be treated like a partnership (or LLC) for tax purposes, with business profits and losses "passing through" the corporation to be reported on the owners' individual tax returns.

Forming a Corporation

To form a corporation, you must file "articles of incorporation" with the corporations division (usually part of the secretary of state's office) of your state government. Filing fees are typically $100 or so.

For most small corporations, articles of incorporation are relatively short and easy to prepare. Most states provide a simple form for you to fill out, which usually asks for little more than the name of your corporation, its address, and the contact information for one person involved with the corporation (often called a "registered agent"). Some states also require you to list the names of the directors of your corporation.

In addition to filing articles of incorporation, you must create "corporate bylaws." While bylaws do not have to be filed with the state, they are important because they set out the basic rules that govern the ongoing formalities and decisions of corporate life, such as how and when to hold regular and special meetings of directors and shareholders and the number of votes that are necessary to approve corporate decisions.

Finally, you must issue stock certificates to the initial owners (shareholders) of the corporation and record who owns the ownership interests (shares or stock) in the business.

Retaining Corporate Status

Corporations and their owners must observe certain formalities to retain the corporation's status as a separate entity. Specifically, corporations must:
· hold annual shareholders' and directors' meetings
· keep minutes of shareholders' and directors' major decisions
· make sure that corporate officers and directors sign documents in the name of the corporation
· maintain separate bank accounts from their owners
· keep detailed financial records, and
· file a separate corporate income tax return.

© 2009 Nolo

S Corporation Facts

S corporations limit owners’ liability and offer the tax structure of a partnership.

Many entrepreneurs have two goals when choosing a structure for their business: protecting their personal assets from business claims (limited liability) and having business profits taxed on their individual tax returns. Not long ago, an S corporation was the only choice for these business owners. In recent years, however, S corporations have been largely replaced by limited liability companies (LLCs). Still, some businesses can benefit by organizing as S corporations.

What Is an S Corporation?

An S corporation is a regular corporation that has elected "S corporation" tax status. Forming an S corporation lets you enjoy the limited liability of a corporate shareholder but pay income taxes as if you were a sole proprietor or a partner.

In a regular corporation (also known as a C corporation), the company itself is taxed on business profits. The owners pay individual income tax only on money they receive from the corporation as salary, bonuses, or dividends.

By contrast, in an S corporation, all business profits "pass through" to the owners, who report them on their personal tax returns (as in sole proprietorships, partnerships, and LLCs). The S corporation itself does not pay any income tax, although an S corporation with more than one owner must file an informational tax return, like a partnership or LLC, to report each shareholder's portion of the corporate income.

Most states follow the federal pattern when taxing S corporations: They don't impose a corporate tax, choosing instead to tax the business's profits on the shareholders' personal tax returns. About half a dozen states, however, tax an S corporation like a regular corporation. The tax division of your state treasury department can tell you how S corporations are taxed in your state.

Should You Elect S Corporation Status?

Operating as an S corporation may be wise for several reasons:
· Forming an S corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you (and your spouse, if you're married) have from other sources.
· When you sell your S corporation, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.
· S corporation shareholders are not subject to self-employment taxes (active LLC owners are). These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.

Aside from the benefits, S corporations impose strict requirements. Here are the main rules:
· Each S corporation shareholder must be a U.S. citizen or resident.
· S corporations may not have more than 100 shareholders.
· S corporation profits and losses may be allocated only in proportion to each shareholder's interest in the business.
· An S corporation shareholder may not deduct corporate losses that exceed his or her "basis" in corporate stock -- which equals the amount of the shareholder's investment in the company plus or minus a few adjustments.
· S corporations may not deduct the cost of fringe benefits provided to employee-shareholders who own more than 2% of the corporation.

Fortunately, a decision to elect to be an S corporation isn't permanent. If your business later becomes more profitable and you find there are tax advantages to being a regular corporation, you can drop your S corporation status after a certain amount of time.

How to Elect S Corporation Status

To create an S corporation, you must first create a regular corporation by filing articles of incorporation with your secretary of state's office or your state's corporations division. Then, to be treated as an S corporation, all shareholders must sign and file IRS Form 2553.

Want Some Help?

If you're ready to incorporate, Nolo offers the following helpful guides, which come with forms on CD-ROM:

· Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State , by attorney Anthony Mancuso, or

· How to Form Your Own California Corporation , by attorney Anthony Mancuso.

S Corporation Alternatives

You can get the benefits of limited liability and pass-through taxation by creating a limited liability company (LLC). Because an LLC offers its owners the significant advantage of greater flexibility in allocating profits and losses, and because LLCs aren't subject to the many restrictions of S corporations, forming an LLC is often the better choice.

A limited liability company (LLC) offers protection from personal liability for business debts, just like a corporation. However, unlike a corporation, which must pay its own taxes, an LLC is a pass-through tax entity: The profits and losses of the business pass through to its owners, who report them on their personal tax returns just as they would if they owned a partnership or sole proprietorship. Moreover, while setting up an LLC is more difficult than creating a partnership or sole proprietorship, running one is significantly easier than running a corporation.

Here are the main features of an LLC:

Limited Personal Liability

Like shareholders of a corporation, all LLC owners are protected from personal liability for business debts and claims. This means that if the business itself can't pay a creditor -- such as a supplier, a lender, or a landlord -- the creditor cannot legally come after an LLC member's house, car, or other personal possessions. Because only LLC assets are used to pay off business debts, LLC owners stand to lose only the money that they've invested in the LLC. This feature is often called "limited liability."

Exceptions to Limited Liability

While LLC owners enjoy limited personal liability for many of their business transactions, this protection is not absolute. This drawback is not unique to LLCs, however -- the same exceptions apply to corporations. An LLC owner can be held personally liable if he or she:
· personally and directly injures someone
· personally guarantees a bank loan or a business debt on which the LLC defaults
· fails to deposit taxes withheld from employees' wages
· intentionally does something fraudulent, illegal, or reckless that causes harm to the company or to someone else, or
· treats the LLC as an extension of his or her personal affairs, rather than as a separate legal entity.

This last exception is the most important. If owners don't treat the LLC as a separate business, a court might decide that the LLC doesn't really exist and find that its owners are really doing business as individuals who are personally liable for their acts. To keep this from happening, make sure you and your co-owners:
· Act fairly and legally. Do not conceal or misrepresent material facts or the state of your finances to vendors, creditors, or other outsiders.
· Fund your LLC adequately. Invest enough cash in the business so that your LLC can meet foreseeable expenses and liabilities.
· Keep LLC and personal business separate. Get a federal employer identification number, open up a business-only checking account, and keep your personal finances out of your LLC accounting books.
· Create an operating agreement.Having a formal written operating agreement lends credibility to your LLC's separate existence.

Additional Protection: Business Insurance

A good liability insurance policy can shield your personal assets when limited liability protection does not. For instance, if you are a massage therapist and you accidentally injure a client's back, your liability insurance policy should cover you. Insurance can also protect your personal assets in the event that your limited liability status is ignored by a court.

In addition to protecting your personal assets in such situations, insurance can protect the LLC's assets from lawsuits and claims. But your LLC won't be protected if it doesn't pay its bills: Commercial insurance usually does not protect personal or corporate assets from unpaid business debts, whether or not they're personally guaranteed.

LLC Taxes

Unlike a corporation, an LLC is not considered separate from its owners for tax purposes. Instead, it is what the IRS calls a "pass-through entity," like a partnership or sole proprietorship. This means that business income passes through the business to the LLC members, who report their share of profits -- or losses -- on their individual income tax returns. Each LLC member must make quarterly estimated tax payments to the IRS.

While an LLC itself doesn't pay taxes, co-owned LLCs must file Form 1065, an informational return, with the IRS each year. This form, which partnerships also have to file, sets out each LLC member's share of the LLC's profits (or losses), which the IRS reviews to make sure LLC members are correctly reporting their income.

LLC Management

The owners of most small LLCs participate equally in the management of their business. This arrangement is called "member management."

There is an alternative management structure -- somewhat awkwardly called "manager management" -- in which you designate one or more owners (or even an outsider) to take responsibility for managing the LLC. The nonmanaging owners (sometimes family members who have invested in the company) simply sit back and share in LLC profits.

In a manager-managed LLC, only the named managers get to vote on management decisions and act as agents of the LLC. Choosing manager management sometimes makes sense, but it might require you to deal with state and federal laws regulating the sale of securities.

Forming an LLC

To create an LLC, you file "articles of organization" (in some states called a "certificate of organization" or "certificate of formation") with the LLC division of your state government. This office is often in the same department as the corporations division, which is usually part of the secretary of state's office. Filing fees range from about $100 to $800. Now, in every state, you can form an LLC with just one person.

Many states supply a blank one-page form for the articles of organization, on which you need only specify a few basic details about your LLC, such as its name and address, and contact information for a person involved with the LLC (usually called a "registered agent") who will receive legal papers on its behalf. Some states also require you to list the names and addresses of the LLC members.

In addition to filing articles of organization, you must create a written LLC operating agreement. You don't have to file your operating agreement with the state, but that doesn't mean you can get by without one. The operating agreement is a crucial document because it sets out the LLC members' rights and responsibilities, their percentage interests in the business, and their share of the profits.

Ending an LLC

Under the laws of many states, unless your operating agreement says otherwise, when one member wants to leave the LLC, the company dissolves. In that case, the LLC members must fulfill any remaining business obligations, pay off all debts, divide any assets and profits among themselves, and then decide whether they want to start a new LLC to continue the business with the remaining members.

Your LLC operating agreement can prevent this kind of abrupt ending to your business by including "buy-sell," or buyout, provisions that set up guidelines for what will happen when one member retires, dies, becomes disabled, or leaves the LLC to pursue other interests.

The Next Step

If you're ready to create an LLC for your business, Form Your Own Limited Liability Company, by Anthony Mancuso (Nolo), provides you with guidance and forms on CD.