What are the Common Business Entities and How Do They Work? (Part 2 – Corporations)
Last month we introduced some common types of business entities that you can use for your business. We talked about different types of partnerships and limited liability companies.
This week’s blog post will focus on corporations, discussing the different kinds of corporations and their characteristics.
Different Types of Corporations:
- S Corporations
- C Corporations
- Professional Corporations
- Social Benefit or B Corporations
- California Close Corporations
Characteristics Common to All Corporations
- OWNERS OF CORPORATIONS HAVE LIMITED LIABILITY – generally, shareholders are not personally liable for corporate debts and obligations.
- OWNERS RAISE CAPITAL BY ISSUING “SHARES” – Shareholders contribute assets (either cash or property) to the corporation, in exchange for shares of stock. If the assets contributed are noncash, the fair market value of the assets establishes the price of the stock, as determined by the board of directors.
- SECURITIES LAWS – shares are generally considered “securities” and must comply with applicable Securities & Exchange Commission laws & regulations (a topic for another blog post)
- FRANCHISE TAX PAYMENTS – California corporations must pay a minimum annual tax of $800 (called a franchise tax) to the State of California’s Franchise Tax Board for the privilege of doing business.
- HOW IS A CORPORATION MANAGED? The corporate structure generally includes the management (officers), board of directors and shareholders.
- WHAT FILINGS AND DOCUMENTS ARE REQUIRED TO FORM A CORPORATION? Corporations are created by filing “Articles of Incorporation” with the Secretary of State and payment of a filing fee, currently $100. In a corporation, the incorporators appoint the initial directors, unless the directors are named in the articles of incorporation. If an S corporation is desired, an S election must be made by filing IRS form 2553 within 75 days. Other initial documents include drafting bylaws, initial resolutions and actions of incorporator, shareholders, and directors.
- CORPORATE FORMALITIES ARE IMPORTANT – Unlike partnerships, you are required to observe “corporate formalities.” That includes having regular meetings, maintaining a corporate book with minutes, resolutions, and bylaws. If you don’t maintain these formalities you could lose your liability protection!
FORMATION AND MANAGEMENT OF C AND S CORPORATIONS
Differences Between C Corporations and S Corporations:
- PASS THROUGH TAXATION – Additional opportunity for tax savings by allocating some income as salary and some as a distribution (subject to IRS scrutiny).
- Limited number of shareholders (100).
- Shareholders limited to individuals, estates and certain trusts.
- Not more than one class of stock, though you can have both voting and non-voting common stock.
- Less attractive for raising capital.
- Better if corporations does not retain earnings.
- Subject to double taxation; once at the corporate level then again at the shareholder level for distributions other than a return of capital.
- No limit on owner number or type.
- Flexible capital structure with both common and preferred stock allowed.
- Attractive for raising capital.
- Better if corporation retains earnings.
Professional Corporations = Corporate entities allowing the use of a corporate form by licensed professionals including attorneys, architects, engineers, accountants and doctors.
They can be taxed as a C Corporation or as a S Corporation. These entities do not insulate a professional for personal liability for their own negligence or malpractice. The principal reason why professional corporations are used is that, unlike with a general partnership, an owner is not personally liable for the negligence or malpractice of other owners.
Close Corporations = Many people are confused by this one! It is important to distinguish a “closely held” corporation (an corporation that only has a few shareholders, typically colleagues, friends, or family members) versus a “statutory close corporation” discussed here. A close corporation is a corporation set up under specific California statutes and can have no more than 35 shareholders who agree in writing to relax various corporate control and operating requirements otherwise required under the General Corporation Law, which specifies which provisions of the Code cannot be relaxed or varied. Close corporations typically work in limited circumstances where the shareholders cannot structure their business as a limited liability company for a regulatory or other reason but still desire the management flexibility of an LLC. Use this structure with caution – it does not mean what you may think it means.
Benefit Corporation = New type of corporation in California (2012) that:
- will have a material positive impact on society, workers, the community and the environment in addition to profit
- has an expanded fiduciary duty that requires consideration of non-financial interests
- reports on its overall performance assessed against a third-party standard.
A benefit corporation must pursue the “general public benefit,” and may additionally name a specific public benefit to pursue. It is formed the same way a general corporation is formed, with the exception that the articles of incorporation of a benefit corporation must state that: “This corporation is a benefit corporation.” We predict that benefit corporation will continue to become more popular as time goes on and shareholders are increasingly concerned with issues beyond the bottom line. Patagonia, a maker of outdoor gear and supplies known for its environmental and social impact, was one of the first companies to adopt benefit corporation status: https://www.patagonia.com/blog/2018/08/three-guides-for-going-b-and-why-it-matters/.
CONCLUSION: As with partnerships and LLCs, this discussion could go on forever! You will note that we haven’t discussed several other types of available business entities or touched the topic of taxes in depth – another important factor in choosing the right business entity for you. The takeaway is that choosing your business entity is an important decision with far reaching consequences. Make sure that you are informed before you get started!