Business Entities 101: Corporations
This will be the first post in a series of posts outlining the different business entities one can choose when setting up a business. Each post in this series will describe the entity, how it is formed, the liability protection it provides, how it will be taxed, and if it is suitable for your business. This post will be focusing on Corporations.
What is a corporation and how is it created?
A Corporation is a business entity that is designed to provide the shareholders of the business with limited liability so long as the strict structure of, and rules for, the corporation are followed. It is formed by filing a Certificate of Incorporation with the State.
A Corporation is owned by the shareholders and is managed by a board of directors. The board of directors are given the power to hire the officers who will run the day-to-day operations of the company.
Corporations can either be a C Corporation or an S Corporation. Each structure is taxed differently (which we will discuss later), and there are some restrictions on ownership.
C corporation and s corporation.
A C corporation is the business entity you are more likely familiar with, for example, Apple, Google, etc. It has no limits on the number of shareholders, and shareholders can be anyone or any legal business entity.
An S corporation has a limit on the number and type of shareholders. S corporations are limited to no more than 100 shareholders and those shareholders must be U.S. citizens or U.S. residents. Business entities are precluded from being shareholders in an S corporation. In order to be treated as an S corporation, you have to file Form 2553 with the Internal Revenue Service. One of the main reasons one would want to elect S corporation status is to take advantage of how it is taxed.
What Is The Liability Protection Of A corporation?
When it comes to liability protection, both C and S corporations are the same. Shareholders under both enjoy the benefit of limited liability. This means the shareholders are only liable for the amount of money they put into the business; i.e. how much they paid for their shares or ownership interest. It might be best to see this in action with the below scenario:
- ABC Corporation creates a product that injures Customer. Customer then sues ABC Corporation for the injuries sustained. Customer cannot go after the shareholders and their personal assets (house, car, etc.) to satisfy the judgement on their claim. They are only able to collect from ABC Corporation.
However it is important to note that there is one caveat to this liability protection. Under very specific circumstances, the “corporate veil” can be pierced and the shareholders can be held personally liable. The “corporate veil” is a court defined term used to signify the liability protection shareholders have. The veil (liability protection) can be pierced (disregarded) in very specific scenarios. These are usually instances where someone has established a corporation, but they conducting business in their name and do not follow the statutorily mandated corporate rules or structure.
How Are Corporations Taxed?
As mentioned earlier, C corporations and S corporations are taxed differently. A C corporation is subject to double taxation. This means the corporation is taxed on earnings (at the corporate tax rate) and dividends are taxed at the shareholder level (at the shareholders’ personal tax rate). This scheme can be a burden if you are a small corporation wanting to pay out dividends to you and your co-founders.
An S corporation is considered a “pass-through” entity for tax purposes. What this means is shareholders are taxed at their personal tax rate on their share of the corporate earnings. Basically, S corporation shareholders are taxed like partners in a partnership where each individual shareholder is taxed based upon how the earnings and losses have been allocated to them. The corporation is not taxed at the corporate level.
A Texas corporation is also subject to the State’s franchise tax. For more information, please see our post about the State’s franchise tax here.
Is This The Business Entity For You?
As we attorneys love to say, “it depends”. A corporation has a lot of advantages (limited liability) but also some drawbacks (double taxation). You also have to decide if you want it to be a C corporation or an S corporation. At the end of the day, it really depends on what you want to achieve with your business. There are instances where another form of business entity will suit your business needs better. The best advice is to talk to a startup attorney as they are experts and can help you figure out all of your options.