Operating a small business isn’t easy and these businesses fail at a staggering rate. Every year, over a million people in the United States form small businesses and by the end of the first year of operation, at least 40 percent will go bankrupt. Within five years, more than 80 percent will have failed.
The small business’s structure affects how much an owner pays in taxes, the paperwork he files, how he raises capital to grow the business, and most importantly, his personal liability. So, the owner must choose carefully and wisely. There could be restrictions on converting the business structure and attempting to do so could lead to numerous tax consequences and even unintended dissolution.
The simplest small business an entrepreneur can form is a sole proprietorship. It is the least expensive to establish, the owner makes all decisions, and keeps all profits. Since the proprietorship isn’t a formal business entity, however, the biggest disadvantage is that legally, the business owner and the business are one. If the sole proprietorship files for bankruptcy or is sued, his personal assets can be seized to satisfy these liabilities.
Knowing this, a small business owner is often better off with a structure that separates his business from his personal assets. He can incorporate his business with a “closely held corporation.” The two categories of closely held corporations are the C corporation and the S corporation.
Compared to forming a partnership or operating the business as sole proprietorship, incorporating is expensive and includes the cost of federal and state law compliance. There are also legal barriers that must be satisfied prior to incorporating, including raising of capital, defining who can be a shareholder, and filing the necessary paperwork.
In this module, we’ll cover these issues and learn about how small business owners incorporate and the two different types of corporations ideal for small business owners, C corporations and S corporations.
Incorporation
A small business owner who incorporates gains access to several advantages that wouldn’t be available if he organized his business as a sole proprietorship or general partnership. The first is that the business exists perpetually. Unlike a general partnership, which could dissolve if any partner leaves the partnership, the corporation will continue to exist regardless of what happens to the original owners who formed it. The corporation’s perpetual existence attracts investors because it can be a more stable investment vehicle for them to invest in; turnover of owners and shareholders won’t lead to dissolution.
Second, a corporation has numerous tax advantages, and the business owner can deduct employee fringe benefits, like daily business expenses, medical insurance, and retirement plans. Additionally, some corporations may permit pass-through taxation, so income or losses are taxed only once after they are passed on to owners and investors according to their ownership stake.
Corporate bylaws structure the corporation. They describe how the company is operated along with the rights and obligations of the shareholders, any information concerning regulations about the management of the company, the shareholders’ relationship, the ownership of shares, what happens to a shareholder’s interest if he leaves the business and shareholder privileges. The bylaws are not filed with a state agency and only serve internal uses.
The importance of well-written bylaws and their impact on global commerce emerged in the news recently. International cosmetics giant L’Oreal has 655 million global shares, but 352 million of these shares are held by the company’s founding family, the Bettencourts. Nestle is also a major shareholder and owns the second-most number of shares in L’Oreal.
In late 2017, L’Oreal’s matriarch, Liliane Bettencourt, passed away. After her death, questions arose as to future ownership. Could the Bettencourt family or Nestle increase their shares in L’Oreal? Financial experts predicted hostility between these two parties, but conflict was avoided. L’Oreal’s bylaws addressed ownership changes definitively and they stipulated that either party could increase their stakes in L’Oreal six months after her death.
Finally, the shareholder agreement may include a provision that restricts a shareholder’s ability to transfer his shares to a third party. However, to be enforceable, all restraints must be reasonable. In determining reasonableness, a court will consider the size of corporation, the extent of restraint, the length of time the restraint is in place, and whether the restraint serves valid corporate goals.
In the Texas case, Sandor Petroleum Corp. v. Williams, the court examined the issue of reasonable restraints. There, the plaintiff received two stock certificates for 1,250 shares each in the corporation after helping it obtain certain oil and gas leases. Later, a disagreement between the plaintiff and the controlling shareholder arose regarding the corporation’s management. The plaintiff wanted to sell his shares, but Sandor Petroleum’s other three shareholders adopted a new bylaw restricting the transfer of stock and giving the corporation the option to purchase any stock offered for sale at a price fixed by an appraiser.
The court found that the newly-adopted restriction was an unreasonable restraint on share transfer and couldn’t be enforced. It reasoned, “Such a restriction on previously unrestricted stock would unreasonably restrain and prohibit its sale and transfer and could result in depriving the owner of the full value of his stock.” Here, the restraint didn’t serve any corporate goal other than to punish the plaintiff for his disagreement with the controlling shareholder and denied him the right to sell his share at a price that could be secured on the open market.
The first formal step to incorporating is to write the articles, or certificate, of incorporation. Each state has its own requirements for what must be included in the articles of incorporation, but they typically must provide the corporation’s name, the authorized shares, the corporation’s purposes, the corporation’s secretary, the designation of an agent for service of process and the location where the Secretary of State sends service of process.
Next, a party known as the incorporator files the articles of incorporation with the Secretary of State in the state of incorporation. The incorporator can be anyone over the age of 18. The state of incorporation can be the state where the corporation is doing business or anywhere else. In making the decision of where to incorporate, the corporation will weigh its budget against its business goals. If the corporation is a smaller business that primarily conducts business within a single state, it’s best to incorporate within that state because the costs of local incorporation will usually be less than incorporating in another state. Qualifying to do business as a foreign company in that state may be expensive. Foreign doesn’t mean international: it simply means “out of state.” So, an Arizona corporation and a Mexican corporation would both be considered foreign corporations if registered in Texas.
Third, the corporation’s secretary will prepare the organizing minutes and hold the first meeting of shareholders and directors. At this meeting, all parties will prepare the corporation’s bylaws. The secretary will prepare and issue the share certificates to the shareholders and will keep a record of all the shares issued.
Closely Held Corporation
A “closely held” corporation is a private business entity owned by a small number of shareholders whose shares of stock are not publicly traded. The Internal Revenue Service defines a closely held corporation as one where more than half of the stock is owned by five or fewer shareholders at any time in the second half of the year and is not a personal service corporation, meaning a corporation owned by professionals like attorneys, physicians, or accountants.
Over 90% of all businesses in the United States are closely held. Ownership and control of the closely held corporation is often integrated where a small group of people actively manage the small business. By contrast, in a large, publicly-traded corporation listed on a stock exchange, shareholders typically play no role in the management of the corporation.
Though a closely held corporation tends to be a small business with few assets, don’t think of it as a “mom and pop shop.” For example, members of the Cargill family own and manage Cargill, a corporation that specializes in manufacturing agricultural products. Though it has very few shareholders, Cargill is the United States’ largest closely held corporation that employs 140,000 people across the world and reported $136.7 billion in revenue in 2013.
The primary benefit of forming a closely held corporation is that there is limited liability for its owners and shareholders. While a sole proprietorship isn’t legally distinct from its owner, in a closely held corporation, the corporation, and not the corporate shareholders, is responsible for paying off debts.
However, courts can hold shareholders personally liable for corporate debts with a process called “piercing the corporate veil.” A court will pierce the corporate veil if a creditor proves that the shareholder and the corporation are one and the same “person” and that it would be inequitable not to hold the shareholder personally liable. This is a fact-dependent analysis, but over decades, hundreds of cases have identified several factors that guide this analysis.
Let’s assume, for example, that Adam forms a closely held corporation to manufacture and sell bowling balls. The company’s name is “Adam’s Bowling Equipment” and in all purchase agreements for equipment and materials used to make the bowling balls, Adam names himself as the purchaser. His name, and not the company’s, is listed as the tenant in the equipment manufacturing factory lease. Though his corporation is small, Adam routinely bypasses the board of directors and doesn’t seek its approval prior to making business decisions and completing expensive purchases. Finally, Adam doesn’t have separate bank accounts for the business and instead, he pays debts from his own personal account.
Should Adam fail to pay a creditor and a creditor sues him, the court will most likely pierce the corporate veil and hold Adam personally liable for his debts. Here, there’s been comingling of assets, Adam has failed to adhere to corporate formalities and he hasn’t held himself out to be separate from his business. It would be unfair to the creditor to not hold Adam personally liable for business debts.
The two most commonly-formed closely held corporations are the C corporation and the S corporation.
C Corporation
The C corporation is the classic corporation. A corporation will be classified as a C corp. unless the owner elects to be treated as an S corporation. The federal tax rules that apply to C corp.’s are those that appear in Subchapter “C” of the Internal Revenue Code. A C corp. can enter into contracts, sue in court, invest money, pay its own income taxes and own property.
A C corp. provides more flexibility in planning and strategizing federal income taxes than either a partnership or a sole proprietorship. Other advantages of a C corp. are that it can:
- limit liability for directors, officers, shareholders, and employees;
- have an unlimited number of shareholders;
- raise money from investors through the sale of shares of stock; and
- issue more than one type of stock
There are some pitfalls to operating as a C corp. The most well-documented is that a “double taxation” is often imposed on C corporations because the profits are taxed to the corporation when earned and again taxed when distributed to the shareholders as dividends. All dividends are taxable and must be reported, but dividends are taxed at different rates depending on the type. Ordinary dividends are taxed as ordinary income to the recipient.
A dividend is qualified if it was issued by a U.S. corporation and if the shareholder held the share for more than 60 days during the 120-day period beginning 60 days before the dividend date. Qualified dividends are taxed at the preferred long-term capital gains tax rates. While ordinary income tax rates go as high as 37%, long term capital gains and qualified dividends are taxed at a maximum of 20%. For shareholders in a lower tax bracket, qualified dividends are taxed at very low rates.
A C corp. can avoid double taxation via various strategies. The first is for it to distribute its income to employees in the form of salaries, wages, or fringe benefits, such as health, disability or group term life insurance, rather than as dividends. C corporations don’t have to pay corporate taxes on money paid out as business expenses because it can deduct the income distributed for these purposes as business expenses.
The second way to avoid double taxation is for the C corp. to retain corporate earnings and have shareholders reinvest the cash in the corporation rather than receive a dividend. This way of avoiding double taxation sometimes doesn’t appeal to shareholders in closely held C corporations though, because they may depend on receiving dividends to earn an income.
S Corporation
The S corporation is the second common corporate structure for small businesses and closely held corporations. The difference between an S corp. and a C corp. lies in IRS treatment. An S corp. is a corporation that files taxes under Subchapter S of Chapter 1 of the Internal Revenue Code. According to IRS statistics, there are over four million corporations and over 99% of them had 10 or fewer shareholders. In 2012, the US Census Bureau estimated that about 2.9 million S corporations employed more than 29 million people.
The IRS designates a business as an S corp. if the corporation qualified to be treated as an S corp. and it files an IRS Form 2553 “Election by a Small Business Corporation,” which must be signed by the shareholders. To be eligible, the corporation must:
- be a domestic corporation;
- have only allowable shareholders, such as US citizens and permanent residents, certain trusts, and estates and NOT partnerships, corporations or non-resident alien shareholders;
- have no more than 100 shareholders; and
- have only one class of stock.
The most important benefit of forming an S. corp. is that, like a partnership and unlike a C. corp., there’s no double taxation. S corporations don’t pay income tax themselves. An S corp. takes its profits, losses, deductions and credit and passes them through to the shareholders, who then report those incomes as their own incomes. Moreover, there is only a once annual tax filing requirement, while in a C corp., taxes must be filed quarterly.
In addition to these tax benefits, an S corp. provides a high degree of personal liability protection. If the S corp. harms another person or business, a subsequent lawsuit will be filed against the S corp. and not against the small business owner himself. As a result, the owner’s personal assets are protected from any lawsuit.
An S corp. has several drawbacks relative to other business forms. First, there are additional expenditures for accounting and many states also impose annual report and franchise tax fees. A small business owner will also have to pay increased legal fees to comply with tax laws and regulations. These fees may not be expensive, but they add up and are costs that a sole proprietor or general partnership will not incur. Second, an S corp. must be vigilant to maintain its status. The IRS scrutinizes S corporations to ensure conformity with tax laws. Filing mistakes or failure to adhere to the eligibility requirements can lead to IRS revocation of the status.
The other drawbacks relate to shareholders: there can only be up to 100, and if an owner seeks funding from others, they must be either U.S. citizens or permanent residents. Both requirements constrict the pool of potential investors.