Sometime in the life of nearly every small business, the question arises, “Should this be a corporation?” The answer is, “Yes, no, and maybe.”
There are advantages to being incorporated, but those advantages come with some cost. There’s legal expense, accounting expense, and changes to the names on accounts and other assets. You can incorporate the business yourself, but you probably shouldn’t. It isn’t as simple as filling in the blanks in some preprinted forms. You’re creating a creature that hasn’t heretofore existed.
And there are ongoing expenses. You will have to pay for the preparation and filing of regular tax returns for the entity, in addition to the personal returns that you file. These ongoing costs are minimal and infrequent, but they do exist.
Taxation of the corporation will, in part, depend on certain tax elections you make on the advice of your accountant. A “regular corporation” pays a tax on its net earnings before the profits are distributed to the shareholders. If the corporation has made an “S election,” there is no separate tax at the corporate level, and business income and losses are passed through to the shareholders and reflected on their individual tax returns.
As a corporation, you will have to be more structured than you may be accustomed to. You will no longer just grab cash out of the register; you will draw a salary, with tax withholding. Besides being an owner, you will now be an employee of this new “thing.”
You will need to document business decisions and policies. A bank will want some evidence that the corporation is, in fact, authorized to open an account, and a phone call from you will not be enough. You will need some written evidence that the corporate directors voted to do whatever the corporation proposes to do. Again, these formalities are not usually burdensome or terribly inconvenient, but they must be observed. The required documentation compels a level of organization and structure that may be sorely lacking in the sole proprietorship.
You have created a separate, legal entity that is in many ways like another person who didn’t exist before the incorporation. It can buy things, sell things, enter contracts, and do just about anything a living person can do. It even has its own separate tax ID number. Its articles of incorporation is like its birth certificate.
Incorporating also allows beneficial ownership of an asset or assets to be separated from the assets themselves. For example it would be awkward for four individuals to own different percentages of a retail store with its inventory, accounts receivable, and other assets. It is relatively simple, however, for a corporation to own all of the business assets, while the four individuals each own a different percentage of the corporation.
In a family business, shares can be gifted from parents to children over time, so that the children get an ownership interest in the operation, but the parents retain control. This has valuable estate planning possibilities.
Of course, the most important benefit of incorporating is “limited liability.” Because the corporation is an entity unto itself, separate and distinct from its owners, it is solely responsible for its own debts and liabilities. If things go wrong, and the company can’t pay its bills, creditors usually can’t look to the shareholders for payment. The creditors’ claim is against the entity, and their ability to collect is limited to what the entity can pay.
Limited liability assumes that the principles haven’t “personally guaranteed” the corporate debt. Because of their experience, some creditors require the owners of small corporations to personally guarantee all corporate debt.
Personal guarantees aren’t the only ways limited liability may be lost. Often, failure to file tax returns or to pay taxes, especially employee withholding and other taxes that are held “in trust” for the government, can render the responsible party liable for the tax. If a corporation is initially funded with so little capital that it is unreasonable to expect it to carry out its intended purpose, the shareholders may incur personal liability on the theory that there was no way the company could have been expected to pay its debts from the day it was set up.
Sometimes, personal liability is imposed on the shareholders of a corporation just because they didn’t keep the company business separate from their own. If the affairs of the corporation are mixed up with those of the shareholders, a court may well not separate corporate affairs from those of its owners. It must be clear to all parties that they are dealing with a corporation, or a court may determine that they were not.
There is no question that the formalities can seem intimidating. Between the federal and state tax filings, the required filings with the state, and the necessary internal minutes of meetings and resolutions, setting up and operating a corporation may look as complicated as conducting a High Mass at Easter, only less inspirational. It is, however, usually delegated mostly to lawyers and accountants and becomes second nature to the corporate officers quickly.
Brent R. Slater is an attorney with Gross, Minsky & Mogul in Bangor. He has practiced law for 38 years and focuses on business and estate planning.
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