When to Form a Corporation for a Small Business
Most small business owners should form a separate legal entity to protect their personal assets. This protection is called limited liability protection and without it, a business owner can be held personally liable in the event of a lawsuit or bankruptcy.
You can get limited liability protection by forming a limited liability company (LLC) or corporation.
Corporations are an excellent choice for small businesses and startups that will rely on investors. Investors prefer corporations because of the way corporate profits are taxed compared to LLC profits.
Why Corporations Attract Investors
Corporations attract investors because investors are only taxed on the distributions (dividends) they receive from the corporation.
In an LLC, the investor would be taxed on their portion (based on ownership interest) of the profits even if they didn't receive a distribution.
LLCs can also be challenging for investors when they need to transfer investment interest in the LLC. Corporate shares make this process easy.
Need Help Forming a Corporation? Check out our How to Start a Corporation guide to learn how to get started.
When to Use an LLC for a Small Business
LLCs are great for small businesses that need a simple, low-cost way to get limited liability protection. Corporations can be complex to run and maintain and unless a small business needs to attract investors, small businesses should form an LLC.
Forming an LLC is Easy. Check out our How to Form an LLC guide to get started.
There are elements to a corporation that set it apart from other legal entities.
A corporation has:
- shares and shareholders (in most instances)
- a board of directors (board members)
- 21% corporate tax rate or S corporation
- tax options
- complex operational rules and regulations
Shares and Shareholders
A share of stock is the unit of ownership of a corporation. Each share of stock represents a percentage of ownership of the company. For example, if a corporation issues one share of stock the shareholder (stock owner) would then own 100% of the corporation.
Shares can be structured into classes. Each class, termed a share class, holds different rights and privileges. A corporation can have multiple classes and each class can hold any number of shares.
Authorized Shares: the number of shares the corporation is allowed to issue.
Issued Shares: the total number of shares actually issued to shareholders.
Share Class: a group of shares that has a unique set of rights and privileges.
Board of Directors
When a corporation is formed, the state's required number of directors must be appointed until the first shareholders’ meeting.
A corporate director is in charge of the adoption, amendment, and repeal of operational bylaws as well as the election, supervision, and removal of officers.
After forming the corporation, the incorporator(s) — or initial director(s), if named on the formation documents — should call an organizational meeting.
During this initial meeting, either the incorporator(s) will officially elect the board of directors or the initial director(s) will appoint the officers.
Bylaws are the rules that determine how a corporation will be governed and run. You can think of bylaws as a constitution for a corporation. It makes the rules and priorities clear for everyone involved.
TIP: There are bylaws templates available to help business owners form corporations.
A corporation’s bylaws will supplement any rules set forth by the federal government or the state.
Corporate bylaws should include:
- How the corporation will be governed, including the role of directors and officers
- How meetings are held, voting procedures, electing officers or directors
- How records will be kept and managed
- How legal documents will be executed
- How disputes will be handled
- How bylaws will be added/amended in the future
- The date of the annual shareholders' meeting
- How to negotiate contracts
- Who will file annual reports
- How the corporation will issue stock
- Fiduciary duties to the corporation (i.e. acting in the best interests of the corporation)
- What constitutes a quorum for voting purposes
- How the day to day operations of the corporation will be conducted
What is a Quorum? A quorum is the minimum number of members of an assembly that must be present at a meeting to make the meeting valid, or any of the votes held therein.
A corporation pays taxes based on the current federal corporate tax rate of 21%. The owner of a corporation must pay tax on any dividends they receive.
Corporations distribute their profits to shareholders in the form of dividends. Shareholders then have to pay personal income tax on these dividends. Because the profits of the company have already been taxed at the corporate level, corporations are said to be “double taxed".
The tax rate on ordinary dividends is the same as the individual federal income tax rate, which means it will vary depending on your income.
A corporation can choose to be taxed as a standard C corporation (C corp) or as an S corporation (S corp).
Types of Corporations - Tax Options
There are three main types of corporations. Each type is taxed differently.
A nonprofit corporation is a not for profit entity that is registered at the state level as a nonprofit corporation. The nonprofit corporation can register for tax-exempt status with the IRS as a 503(c).
A C corp is a corporation that is taxed as a default corporation with the IRS. This type of corporation is currently taxed at 21% on profit. Dividends paid to shareholders are also taxed.
A corporation can elect to be taxed as an S corp. An S corp tax model allows the business owner to avoid double-taxation but also negates the investor benefits offered by corporations. It's best to elect S corp status as an LLC.
A corporation is a legal entity that protects a business owner's personal assets from the corporation's debts, creditors of a corporation, and from lawsuits brought against the corporation.
Corporate law dictates the formation, funding, dissolution, and governance and operations of a corporation. Corporations are governed by both federal laws and state laws.
The U.S. Securities and Exchange Commission (SEC) also governs corporations and acts to protect investors, maintain fair markets, and support capital formation.
How to Start a Corporation
Forming and running a corporation is more complicated than forming an LLC, partnership, or sole proprietorship. We recommend hiring a formation service to help with the process.
Northwest offers affordable corporation formation services.
You can form a corporation yourself by creating an initial board of directors, filing the articles of incorporation, and choosing a registered agent. Choose your state to get started:
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Carolina
- North Dakota
- Rhode Island
- South Carolina
- South Dakota
- Washington D.C.
- West Virginia
Running a Corporation
In order to protect your personal assets, and not allow creditors or municipalities to pierce your corporate veil, you must:
- Maintain up-to-date bylaws
- Set up a corporate records book
- Hold required annual meetings
- Give notice of meetings when applicable
- Keep accurate meeting minutes