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Starting a Business – Forming a Corporation

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Starting a Business – Forming a Corporation


A corporation is an entity created under statute that is separate and distinct from its owners. In other words, a corporation can be created only by following the requirements of the relevant statute (in Indiana, it is the Indiana Business Corporation Law) and will not automatically be created (as can be the case with some partnerships). Once formed, the corporation is recognized as being independent from you, the owner/shareholder. The corporation is managed by directors and officers; sometimes, the directors and officers are also the shareholders. From a liability standpoint, the corporation affords you complete protection; creditors must rely on the assets of the corporation and you are notpersonally liable for anything beyond your investment and financial commitment to the corporation.

That said, lenders frequently require shareholders of smaller corporations to personally guarantee the debt of the corporation. Corporations are the most complex entities, both in terms of creation and operation. In addition to filing articles of incorporation, corporations need to adopt by-laws, elect directors and officers, and in many states, have regular meetings. There may also be annual reporting requirements with the Secretary of State in addition to annual fees.

The shares of a corporation are freely transferable and unlike a partnership or limited liability company, the transferee of yourshares will succeed to all of your rights in those shares. In other words, the person to whom you transfer your shares will be just as much an owner of the corporation as you were. This ease of transferability can have significant impact later on as you begin to implement exit strategies (that is, you are ready to retire from
the enterprise).

From a tax perspective, corporations can also be more complex than their partnership and limited liability company counterparts. Usually, a corporation is a separate taxable entity. It pays tax on its income and later, when it distributes accumulated income to the shareholders, the shareholders will pay a second layer of income tax on those dividends. This “double taxation” is a significant drawback for most corporations. There is a special type of corporation (commonly referred to as an “S” corporation) that generally is not subject to double taxation. An “S” corporation allocates income and losses on a pro-rata basis to its shareholders, although the use of losses by a shareholder is limited to that shareholder’s basis in the corporation. You must strictly adhere to rigid equirements imposed on “S” corporations, and shareholders sometimes are surprised by how easy it is to terminate an existing “S” election inadvertently.

Occasionally, a business owner might intentionally choose the double taxation of a regular corporation to take advantage of certain corporate tax benefits. For instance, while partners in a partnership cannot be employees of that partnership, shareholders in a corporation can be employees; as a result, these shareholders can participate in certain fringe benefits extended to “employees” under the federal tax law, such as flexible spending accounts. Other examples include (i) the ability of a corporation to participate in tax-advantaged reorganizations unavailable to partnerships and limited liability companies and (ii) the potential for up to $50,000 ($100,000 on a Married Filing Joint Return) of losses from the sale, exchange, or worthlessness of certain small business corporation stock to qualify for ordinary loss treatment (as opposed to capital loss treatment).

As you can see from this post and my prior business entity selection and formation posts, a good deal of thought and care must go into your decision of what type of legal form your new business should take. Quite often, the advantages of one form will be offset by disadvantages not present in another. As mentioned, within similar types of legal forms, nuances exist that make the decision all the more difficult. By identifying the right combination of advantages and disadvantages and with the assistance of competent advisors, the right choice of entity selection can help ensure your business success.

Check back soon for a post regarding limited liability companies.

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