Although only 19% of U.S. businesses are incorporated, corporations play a significant part in this country's economy, accounting for about 90% of all sales.
Corporations—in general—will be discussed first, followed by special corporate arrangements, including S corporations and professional or personal services corporations, and finally, closely held or "close" corporations, usually the best corporate prospects for business insurance.
The general federal and state laws and regulations regarding corporations apply to corporations that are sometimes called regular, ordinary or C corporations, primarily to distinguish them from the other types. The "C” refers to Subchapter C of the Internal Revenue Code, which governs how such corporations are taxed, and notice will be taken of some special rules that exist for the other types—S corporations and professional corporations. .
From a legal viewpoint, a corporation is considered an "artificial person," created under the laws of a state, as contrasted with a "natural person," which is a human being. The law distinguishes between those who form the corporation and the corporation itself, as opposed to proprietors where their businesses are considered one and the same. Furthermore, the life of the corporation is essentially unlimited; that is, it legally survives the departure, by death or otherwise, of its owners, unlike the other business forms, which normally terminate with the death or departure of an owner. However, the corporate artificial person may enter into legal transactions, own property, buy and sell products or services, sue and be sued, and otherwise operate as if it were a natural person.
Tax regulations required that corporations have certain characteristics:
Generally, any number of individuals may join together to form a regular corporation. Some states require a minimum number of owners-often three, but no maximum applies to C corporations.
Owners of a corporation formed for profit (rather than nonprofit corporations) are called stockholders or shareholders because they own a share of the business, backed up by stock that entitles them to a portion of the business profits. Corporate stock may be bought and sold in the open market, which means percentages of ownership may change.
Because state laws govern how a corporation may be formed, the requirements may differ slightly from state to state. In fact, business owners often investigate various state laws carefully to determine whether incorporation is advantageous in a particular state and how state and local corporate taxation will affect the business. The general rules for incorporation are fairly uniform however, as highlighted in the next paragraphs.
Each state requires the owners to apply for a charter, which authorizes the formation of a corporation. This includes the preparation-usually by an attorney, and filing of articles of incorporation, a document that typically includes:
In some cases, the articles of incorporation list the board of directors: in other cases, the board is elected after the charter has been approved. The board of directors is a group of people selected by the shareholders to perform oversight functions: to elect the officers of the corporation: and to decide who will manage the day-to-day business affairs. Many states require the owners to develop corporate bylaws. In addition, the corporation must maintain and report certain information to the state and provide annual reports to shareholders. A corporation operating in more than one state typically must post bond and acquire a certificate of authority from states other than the one where it was chartered. Many of these requirements call for professional assistance from attorneys and/or accountants
Unlike the other forms of business ownership, a C corporation does not act as a conduit for income, funneling earnings directly to owners and bypassing the business entity. Instead, corporations are subject to double taxation because income taxes are assessed against both the C corporation and the shareholders.
Shareholder earnings, called dividends, are reported as dividend income on the individual shareholders' income tax returns. In addition since individual shareholders may be employees of the corporation, they must pay individual taxes on any wages as well. Under corporate ownership, however, wages paid to owner-employees are not considered self-employment income, but are instead treated as employee salaries.
Corporate income paid out of profits as dividends to shareholders is not tax deductible for the corporation, resulting in the double taxation of dividend amounts as income for both the corporation and the shareholder. A corporation attempts to reduce its taxable income as much as possible by taking all deductions allowed, such as salaries and bonuses paid, business expenses and anything else the law allows. This is important for businesses earning less than $10 million since corporate income tax rates for these businesses are graduated according to income levels, as is the case for tax rates that apply to individual taxpayers.
Furthermore, Uncle Sam so likes the idea of double taxation on dividends that corporations attempting to retain too much income, rather than paying it out in dividends, are subject to a penalty called the accumulated earnings tax. This tax can be quite important and is discussed in more detail at the end of this chapter as it affects different corporate forms differently.
Corporate earnings distributed to shareholders are dividends, upon which shareholders are taxed. A dividend is taxed as a return on the shareholder's investment, representing money the corporation pays the shareholder for allowing the business to use the shareholder's funds. It is important to distinguish dividend distributions from distributions that represent a return of capital to the shareholder because a dividend is taxed, while return of capital is not taxed up to the extent of the individual shareholder's capital investment or basis. And, if a return of capital exceeds the basis, the excess is taxed differently from dividends.
From the shareholder's perspective, a return of capital means shareholder receives, from the corporation, all or part of the investment dollars (capital) the shareholder invested in the corporation. For example, suppose Carolyn Jones invested $15,000 in a small business known as Allenby Corporation, which is operated by two of Carolyn's friends. Several years later Carolyn wants to sell her shares. Allenby agrees to buy the shares rather than have Carolyn sell them to an outsider. Because Allenby’s stock is now worth more than when Carolyn purchased her shares, Allenby buys her stock for $18,000. of which $5,000 represents a return of capital to Carolyn. Assuming Carolyn's basis remains at $15,000. she pays no tax on the first $15,000 paid for her shares: instead only the additional $3,000 is taxable income for Carolyn. The corporation itself is also subject to additional tax rules when a distribution is a return of capital to investors rather than a dividend. The specific details of how various types of distributions are taxed are beyond the scope of this text.
Recognizing that some smaller businesses might want to take advantage of incorporation, but could suffer from the double taxation, Congress provided legislation that permits special treatment of certain small corporations. These are called S corporations after Subchapter S of the Internal Revenue Code, which regulates such businesses.
As a result of this special part of the tax code, federal taxation of qualifying corporations is more similar to partnership taxation than to C Corporation taxation since the S Corporation also funnels income through the corporation to the shareholders.
For an S corporation, there is no double taxation, such as that assessed against regular corporations. Likewise, because all income passes through to the shareholders, S corporations avoid the potential for paying the accumulated earnings penalty tax described previously.
Aside from federal taxation, S corporations are generally subject to the same regulations as other corporations, plus additional limitations as discussed in the next several paragraphs.
Eligibility to elect S Corporation status is limited to small businesscorporations, identified as those meeting the following requirements:
1. The corporation is domestic, which means it was incorporated in the United States.
2. Shareholders must be either individual citizens or resident aliens of the U.S. or estates or specified types of trusts; no shareholder may be a nonresident alien, another corporation or a partnership. Certain types of trusts are prohibited from ownership. The corporation may not be part of an affiliated group, defined as one where at least 80% of the stock of each affiliated company is owned by other members of the same affiliated group. For example, when a parent corporation owns a subsidiary corporation, both are considered part of an affiliated group. Neither, therefore, could elect to be taxed as an S corporation. Other prohibited corporations are financial institutions, insurance companies and a few others specified in the code.
3. The corporation may have a maximum of 100 shareholders. A wife and husband are considered to be one shareholder whether they file taxes separately or jointly. Other non-spousal couples owning stock together are considered individual shareholders. More complex rules apply in counting a trust's shareholders.
Only one class of stock is permitted. This rule is met if all shareholders that own outstanding stock have the same distribution and liquidation rights. Differences in amounts of profit distributions or in how shareholders would share in liquidation proceeds constitute a different class of stock. However, differences in voting rights are permitted without constituting another class of stock. In other words, shareholders that control and/or operate the actual business may have different voting rights from other shareholders and still remain within the limits of one class of stock.
Notice that "small" business eligibility has nothing to do with the corporation's volume of business; instead, "small" refers only to the number of shareholders. A three-person corporation that generates $100 million dollars of business technically could qualify for S Corporation status-although such an arrangements highly unlikely.
The benefits versus the limitations of electing S corporation taxation can be difficult to sort out, especially when the business begins to generate significant income. In the past, S corporations were often formed by business owners who expected the business to produce losses, rather than gains, in early years. When a business begins to generate significant income and resulting profits, the tax consequences become more complicated in terms of how profits and losses are distributed. the resulting taxation of individual shareholders, the amount of earnings that may be retained by the corporation, and numerous other tax considerations.
Thus, each owner must consider his or her own individual tax rates since S corporation profits that are paid as dividends will be reported along with any other ordinary income for the tax year. And, the corporation's rate has also been increased for taxable income above certain limits. All of these considerations must be factored in when deciding whether S corporation treatment is advisable.
Finally, in conferring special tax treatment to S corporations, Congress attached a number of complex regulations even more complex than regular corporation rules. For example, suppose the S corporation fails, even temporarily, to meet one of the requirements discussed earlier, such as having no more than 35 stockholders. This could happen inadvertently if husband and wife stockholders, who are considered to be a single stockholder for counting purposes, are divorced. The divorce causes each person to be considered a separate stockholder. If the corporation had exactly 35 stockholders before the divorce, it now has 36 stockholders, exceeding the maximum, which results in immediate termination of the S corporation status and reversion of the business to a regular corporation. This, in turn, causes the end of the S corporation's tax year and possible taxation that would not otherwise occur. A new tax year for the regular corporation starts immediately, with additional tax consequences, not the least of which is the owners are forced to deal with two short tax years. While operating as an S corporation has some advantages, eligible corporate owners must consult with their legal and tax experts in order to consider all issues that might affect their particular business and their personal tax situations before electing S status.
Shareholders of S-corporation stock must file the K-1 form with the IRS and given to the shareholders by the corporation so that shareholders can see their share of the company's income, deductions and pass-through tax credits. S-corporations file the IRS 1120S income tax return, although many S-corporations do not pay any income taxes.
The S-corporation is a pass-through tax entity as its income passes through to its shareholders in proportion to their stock holdings. While taxable income is reported to a shareholder, and listed as income on the shareholder's personal tax return, the shareholder may not actually receive any income as the corporation may elect to retain its earnings—in which case, the income is called "phantom income."
Other tax changes allow the capitalization and amortizing of organizational and start up costs. Starting 2004, companies with under $50,000 in start-up costs can elected to deduct up to $5,000 in business start-up costs the year the business begins operation.
Also, the maximum number of shareholders was increased in 2004 from 75 to 100.
Originally, the S-corporation 2was designed to allow small business owners who operated as sole proprietors to gain the limited liability protection of corporation status with a pass-through system, however, the limited-liability company (LLC) is also serving that role.
A characterization you're likely to hear in relation to both C and S corporations is "closely held" or "close" corporations. This term does not refer to a separate type of corporation, but simply means that the stock is "held closely," typically by a small group of stockholders, and is not publicly traded on the stock market. Closely held corporations are often family-owned businesses or other small businesses where just a few people are the major stockholders. Often as few as one or two people own most of the stock and control the business and these same shareholders usually take an active role in both the management and the day-to-day operations.
While many smaller closely held corporations are S corporations, they need not be. Whether a closely held corporation elects S status or chooses to operate as a regular corporation generally depends on how favorable the tax situation is at any given time and whether or not the corporation can meet the eligibility requirements.
Smaller close corporations are of special interest to insurance agents because the owners are often more accessible than the owners or managers of large public corporations. In addition, many smaller corporations are not yet adequately protected for the many potential business insurance needs we'll be discussing in this text - needs that can adversely affect small businesses that fail to provide for them.
Some closely held corporations are professional or personal service corporations, which essentially are sub-types of either S or C corporations for taxing purposes. The law defines such corporations as those in which:
Because a corporation is considered to be a separate "person" from its owners, shareholders enjoy limited liability for debts and other business liabilities. The shareholders' personal assets are not generally at risk as they are under sole proprietorships and general partnerships. If the business is forced to liquidate, perhaps because of bankruptcy, each shareholder's loss is limited to the amount invested.
This is the theory. In reality, however, small business owners, especially, might find they must make personal guarantees simply to begin or stay in business, even if they are incorporated. For example, if a small corporation needs to borrow money, the lending institution might require personal guarantees of repayment from the owners. In this case, liability for debt repayment extends beyond the corporation to the individuals. Notice this unlimited liability exists only for debts the owners personally guarantee, not all business debts.
While a corporation's status as a separate legal entity has both positive and negative aspects, an important positive aspect of regular corporations is that certain fringe benefits paid for owners who are also employees are tax deductible to the corporation. Included are fringe benefits such as life, disability and medical insurance. Remember that for other forms of business ownership, owners may deduct costs of such fringe benefits paid for non-owner employees only. Unfortunately, there is a severe restriction on this deduction for S corporations. Fringe benefits are deductible only when paid for S corporation shareholders who own two percent or less of the business.
In addition, as a separate entity, a corporation may pay owner/ employees salaries, just as any other employee is paid. Salaries then become a business expense for the corporation and owners are not subject to self-employment income tax reporting since the corporation has already withheld the appropriate taxes.
Incorporation does not guarantee greater financial stability, but theoretically, access to more capital is available to corporations. First of all, there are no limits on the number of owners who may invest in a C corporation, which means capital can be raised from numerous sources if necessary. Even with S corporation election, which is limited to 35 shareholders, significantly more capital may be available than for other types of ownership.
Furthermore, corporations may issues more shares of stock anytime after the initial offering in order to raise additional capital through more investment in the business. This option is not available to proprietors and partners, who may, of course, seek additional investment income from others, but who have no stock to offer in return.
Another benefit of corporate stock is that shareholders are free to sell the stock they hold at whatever price they and the buyers agree upon, potentially attracting more shareholders and more investment in the business.
The original federal tax breaks for qualified retirement plans were designed with corporations in mind. Today proprietors and partners have access to many of the same benefits, subject to limits described in Chapter One. For corporations, tax-deductible contributions on behalf of employees are readily available and employees, of course, enjoy tax deferral on earnings. And, unlike proprietorships and partnerships, regular or C corporations may pay and deduct contributions for owner/employees as well. Remember, however, that S corporations may do so only for two percent or less owners. The reduced maximum income that may be considered for retirement plan contributions, imposed by OBRA '93 and discussed in Chapter One, applies to corporate contributions as well.
You've learned that proprietorships and partnerships dissolve when one of the principals is removed from the business. A corporation, on the other hand, has an unlimited life in most cases, subject to some differences in state laws. Therefore, any one shareholder may completely liquidate (sell) his or her stock without causing an interruption in or termination of the corporation. However, the indefinite life of a corporation also means it can be difficult for the shareholders to go out of business if they desire, as discussed under negative aspects on the following pages.
A corporate benefit that applies only to S corporations, not C corporations, is that business losses are currently deductible from the owners' individual income taxes, subject to certain limitations. This occurs because the S election causes income, gains, losses, etc., to pass through the corporation directly to the shareholders, subject to taxation like a partnership. The ability to deduct losses currently is a significant tax benefit for businesses that expect to lose money in the early years of operation.
Organizing and launching a corporation can be complex and costly, typically requiring legal assistance to ensure compliance with state laws governing incorporation. Because state laws vary, business owners generally want to gather information about the incorporation process in order to decide whether or not to incorporate at all and, if so, which state offers the best business environment. This research can be costly in terms of both time spent and actual expenses incurred. Preparation of the articles of incorporation, meeting any special state requirements, and other expenses associated with filing for a state charter contribute to the cost and complexity.
In many states, corporations are subject to state income tax rules that do not apply to other forms of business ownership. Some states require corporations to pay other taxes not assessed against unincorporated businesses, as well as fees to gain a charter and/or to continue operating in the state.
As stated earlier, C corporations are subject to doublefederaltaxation. Shareholders who receive dividends from the corporation must pay federal income taxes and the corporate entity also pays taxes on its profits. S corporations avoid the double taxation, but not every corporation is eligible for S status.
Since most insurance solutions are targeted primarily toward closely held corporations, you should know that, even under C status, close corporations rarely pay dividends. Instead, any profits not required to operate the business are generally paid out as salaries or bonuses. Thus, double taxation on dividends is avoided and the corporation may deduct these amounts as business expenses.
While S corporation losses may be deducted from the owner’s current income taxes, C corporation losses must offset corporate income, so they are not currently deductible. This means that a C corporation experiencing a loss in the first year of operation, for example, must carry the loss forward to a future year to offset income. Suppose the business has a $2,000 loss the first year. In the second year, this $2,000 may be used to offset the corporation's taxable income-let's say it's $10,000-thereby reducing taxable income to $8,000 for that year.
Incorporated businesses are especially subject to both federal and state government controls. Corporations often must meet reporting requirements not imposed on other types of business. These requirements mean the corporation must maintain records in a form dictated by the governing agency, provide annual reports, and conform to any other legal requirements related to corporations.
While centralized control by professional managers who operate the corporation can be a benefit, it also has a down side. Many shareholders will not be active in the business itself and, therefore, have almost no voice in business decisions. These shareholders can express opinions only through voting for the board of directors. Some may see this as a disadvantage, especially if they are not happy with the way the business is being operated.
If the owners of a corporation decide or are forced to completely terminate the business and liquidate all assets, they will find that dissolution can be difficult and costly. Corporate liquidation regulations are among the most complex rules of the tax code, affected by such variables as the type of corporation, whether assets are sold or are distributed to shareholders, when the liquidation occurs, whether assets have appreciated, amounts of gain or loss, amount of each shareholder's basis and numerous other factors. Couple all of these variables, and more, with frequent changes in tax laws, the lack of clarity in the tax code, and the unpredictability of the IRS in interpreting and issuing rulings on individual cases, and the liquidation to the corporation and its shareholders. While we cannot discuss the details here, in general both the shareholders and the corporate entity are subject to taxation when a corporation dissolves. Later you'll learn how insurance products can help avoid the sometime financially devastating results of forced liquidation.
When comparing the limited liability company (LLC) and the corporation, you'll need to be aware of special tax implications that specifically affect corporations, but not LLCs.
A corporation can accumulate its earnings: Once it pays tax on them at the corporate level, it need not pay them out as dividends and can thus avoid the second part of the double taxation scheme. This is true with some caveats.
From 2003 through 2008, the IRS imposes an additional "accumulated earnings" tax of 15 percent (previously set at the highest individual tax rate before enactment of the Jobs and Growth Tax Relief Act of 2003) on earnings a corporation accumulates above $250,000. The limit is $150,000 for certain "personal service corporations" (i.e., corporations in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts or consulting, where the owners provide the services – see below for more detail). This tax does not apply to LLCs.
This tax is designed to dissuade corporations from accumulating earnings just to avoid paying taxable dividends. However, this tax is usually easy to avoid, for three reasons:
A personal holding company is a regular "C" corporation that derives 60 percent or more of its earnings through passive income (interest, dividends, rents, royalties, etc.), where more than 50 percent of the value of the stock is owned by five or fewer individuals. In 2003 through 2008, the personal holding company tax rate is 15 percent of the corporation's undistributed earnings (per the Jobs and Growth Tax Relief Reconciliation Act of 2003), and is in addition to the regular corporate income tax. The tax does not apply to LLCs.
The tax is extremely complicated due to its many exceptions. In practice, the tax will not usually apply to small business owners. While the typical small business may be owned by five or fewer individuals, in most cases its income will not be passive, or will fall within some of the exceptions.
However, in an arrangement where a holding company and an operating company are used, the tax may very well apply to the holding company unless a consolidated tax return is filed. That consolidated return opens its own set of complications and complexities.
This tax can be avoided by making a subchapter S election, since S corporations are not subject to the tax. Once again, however, with an LLC you don't have to worry about dealing with this tax, or avoiding it.
A professional service corporation is a designation created by law. Professionals in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (where the owners provide the services) may elect this business form.
The professional service corporation has to pay a flat tax of 35 percent on its earnings, rather than using the progressive rate structure that normally applies to corporations. The result will be higher taxes.
This tax scheme can be avoided by making the subchapter S election.
Both individual and corporate tax rates start at 10 or 15 percent and approach a top rate of nearly 40 percent, although the levels of income that are subject to each rate vary in each tax schedule. Whether your taxes on a given level of income would be lower in the LLC at the individual rates or in the corporation at the corporate rates will depend on a number of factors, including your filing status, personal and dependency exemptions, and your other sources of income.
Of course, when earnings are being distributed by the corporation as a deductible salary to the business owner, the corporate earnings will be reduced to zero and, instead, taxed at the individual level anyway. This is a likely scenario in the small business corporation, as the owner seeks to avoid double taxation of dividends. If the earnings are distributed in a non-tax-deductible way (i.e., through the payment of dividends), the owner will experience the problem of double taxation of dividends.
Chapter 2 Review Questions
1. Corporations are organized under the laws of and must be chartered by the
A. federal government.
B. state.
C. state & federal government.
D. New York Stock Exchange.
2. Corporate dividends are
A. tax deductible by the corporate.
B. taxed to the shareholder.
C. taxed to the corporate directors.
D. received tax free.
3. Corporations that retain what the government considers excessive income, rather than paying the income out as shareholder dividends, are in danger of being assessed
A. offset income tax.
B. S corporate tax.
C. undistributed dividend tax.
D. accumulated earning tax.
4. Individual corporate owners are subject to what type of liability insofar as the corporation's debts and liabilities are concerned?
A. limited.
B. unlimited.
C. no liability.
D. vicarious liability.
5. What type of corporation is not subject to double taxation?
A. C Corporations.
B. closely held corporations.
C. professional corporations.
D. S Corporations.
6. For S Corporation eligibility all of the following are required EXCEPT
A. a maximum of 35 shareholders.
B. the corporation is incorporated in the United States.
C. only one type of stock.
D. a shareholder may be another corporation.
7. In a Personal Service Corporation
A. the stock is usually traded on the NYS Exchange.
B. services are performed by employee owners.
C. all employees must be shareholders.
D. the stockholders are personally responsible for the debts of the corporation.
8. Shares of a closely held corporation
A. may be bought and sold.
B. are usually traded publicly on a national exchange.
C. cannot be transferred by will.
D. cannot exceed $50.00 in value.
9. When a shareholder of a corporation dies the
A. corporation is dissolved.
B. spouse automatically becomes the new shareholder.
C. corporation continues in business.
D. remaining shareholders decide what happens to the deceased shareholders interest.
10. With a Corporation, corporate earnings are ________, and the shareholders that receive
dividends from the corporation are _______.
A. taxed, taxed.
B. deductible, taxed.
C. deductible, not taxed.
D. taxed, not taxed.
ANSWERS
1B 2B 3D 4A 5D 6D 7B 8A 9C 10A