The word ‘corporation’ can conjure up some big images. Big business. Big expense. Big complexity. Big headaches.
While it’s true that forming your business as a corporation takes some extra pains, it comes with distinct advantages over sole proprietorships and general partnerships. And it can actually prevent some of the worst headaches inherent in those business organizations.
A corporation is a separate legal entity that is owned by one or more shareholders, and formed according to state laws. Corporations themselves are responsible for the debt and obligations of the business. In most cases, the shareholders are insulated from personal liability for company debts and expenses.
That’s a stark contrast to sole proprietorships, which are owned by one person; are legally indistinguishable from their owners; and in which the owners are personally liable for business debts and expenses.
There are two main types of corporations: “C” Corporations and “S” Corporations. The structures differ in how income and expenses are reported, and how profits are distributed and taxed.
Here are the major factors to consider when deciding whether a corporate structure is right for your business.
Complexity and Expense
Corporations tend to rank high on the scale of complexity and expense. Procedures for forming and governing a corporation are set out in state law, and penalties for not following them can be harsh. “S” corporations add an even greater level of complexity when it comes to taxes and transferability of shares.
Because it is a separate legal entity, in most cases the corporation is liable for business debts. Shareholders are generally exempt from personal liability and risk losing only the money they’ve invested in the business.
Distribution of Profits and Losses
In a “C” corporation, profits and losses belong to the corporation. Profits may be distribute to shareholders in the form of dividend, or they may reinvested or retained (within limits) by the corporation. Losses are not claimed by individual investors. Shareholders include dividends and the gain or loss on the sale or liquidation of stock as income.
In an “S” corporation, profits and losses flow through to shareholders in proportion to their shareholdings. Shareholders include the gain or loss on the sale of stock or liquidation of stock as income but exclude dividends.
Management Control and Decision-Making
The rules for corporate decision-making are set by state law but many rules may be modified by the articles of incorporation or bylaws. Shareholders elect the board of directors, which manages the operation of the business. Except in the case of very small corporations, shareholders generally will not directly participate in management decisions.
Financing Startup and Operation
Generally, a corporation is the easiest form of organization for raising capital from outside investors through the sale of stocks or bonds. Such sales are complex, highly regulated, and may be too costly for startups. Long-term bank financing is easier for a corporation to structure because corporate assets may be used to secure financing.
Transferability of Ownership Interest
Ownership is transferred by sale of stock, and a change of ownership does not affect the existence of the corporation. Technically, stock is freely transferable, but some restrictions on stock sale may be governed by articles of incorporation or bylaws.
Rules government corporations are driven by state law and the company’s articles of incorporation. They are far more formal and complex than those governing other business structures. Tax laws are also more complex. Some corporations may be required to file periodic reports with state and federal regulators.
The tax-related issues surrounding corporations are too numerous to touch on here. Two touchstones: Corporations are separate legal and taxable entities. They must file federal and Minnesota tax returns. Taxable income and tax are determined before distribution of profits to shareholders.
Consultants at our Small Business Assistance Office can help you understand more about corporations. And our network of Small Business Development Centers has experts located in nine main regional offices and several satellite centers statewide.
Our Guide to Starting a Business in Minnesota provides a detailed look at this and other important issues.