By Hanna Hasl-Kelchner, The No Nonsense Lawyer™
Corporations are independent legal entities that have a life of their own, separate and apart from their owners. In terms of the five factors to evaluate when determining the right business structure for your new venture (ease of formation and formality, tax reporting, legal liability, management and ownership flexibility, and future needs — corporations are the most complex to create, but offer the highest degree of flexibility and liability protection for shareholders compared to other forms of business.
As a separate legal entity, corporations are individually capable of incurring debt, entering into contracts, and being tax independently. It also means that corporations, if managed properly, can have an indefinite life span. They do not cease to exist when shareholders sell their shares or die. These characteristics make it easier to transfer shares and are highly desirable for investors.
S and C Corporations
There are two types of corporations: S corporations and C corporations. While there are many similarities between the two, there are also some very important distinctions. An S corporation, for example, may only have one class of stock and a limited number of shareholders while a C corporation can have an unlimited number of shareholders and classes of stock. Some states even permit single shareholder S corporations. The biggest difference, however, is in the tax treatment of profits and losses. S corporations allow for a pass through of profits and losses directly to the shareholders. The C corporation allows for earnings to be retained by the business for use at a later date.
Limited Liability Companies
Limited liability companies (LLCs) are a hybrid business organization that marries the best of both worlds – the limited liability and pass through tax treatment of an S corporation with the unlimited classes of shares and shareholders of a C corporation. LLCs are owned by members instead of shareholders, but much of the formation process mirrors that of corporations. Another advantage of LLCs is that they have fewer ongoing administrative requirements and are less burdensome to maintain than S corporations or C corporations.
Even though the degree of formality can vary between these three forms of business organization, the formalities that do exist must be strictly guarded — otherwise the corporate benefit of limited liability can be lost. In other words, business owners must respect the separate legal identity of the business organization and not treat the business as an extension of themselves. Blurring the lines lets third parties pierce the corporate veil and reach into your personal pocket to satisfy corporate obligations. Personal liability and asset protection is lost. The theory being that if you don’t respect the legal entity, why should anyone else.
As a practical matter the corporate veil doesn’t get pierced too often because most corporations follow the rules. But the potential for piercing the corporate veil does exist and represents a real danger for the unwary.
Here are a few common traps you’ll want to avoid if you want to protect the corporate veil. First, don’t comingle business and personal funds. Keep them separate. Second, use your business title when signing business documents; otherwise someone might think you’re signing in your personal capacity instead of your business capacity. Third, don’t forget to register the company’s “doing business as” (DBA) name. Failure to connect the dots between a DBA and the underlying corporation could lead someone to conclude that the DBA is really a proprietorship.
Incorporation requirements are a function of state law. As a result, they differ somewhat from state to state, and state law should always be consulted before moving forward with the incorporation process. Check with the staff at your Secretary of State office. They can provide you with detailed information on how to create these business entities. Other options include using a service to incorporate your business, such as LegalZoom.com, Incorporate.com, or Bizfilings.com, or hiring an experienced business lawyer to do it for you.
While deciding what type of corporation to create is major step for your business, it is not an irreversible step. You can always change your form of business organization if the circumstances merit it. If you do find yourself wanting to make such a change at a later date, it is highly recommended that you consult with an accountant and an attorney who is experienced in such matters so that you can avoid unnecessary tax consequences and complications. You’ll want to be sure that all of the appropriate legal steps are taken for a smooth and seamless transition.