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6 Things to Consider Before Incorporating Your Business

By: Mike Gallagher, District Director
North Dakota District Office

After talking about sole proprietorships and partnerships as options for a new business, we’ll be moving on to discuss the corporation - a long-recognized structure in this country.

The corporation is an entity created by state statute and the law provides a specific method for creating a corporate “person”.  In North Dakota this is covered under Chapter 10-19.1 of the North Dakota Century Code (NDCC) and known as the North Dakota Business Corporation Act. Articles of Incorporation are filed with the Secretary of State and require information such as: the name of the corporation; principal place of business or address of the registered agent; the purpose of its existence; types of stock to be issued; shares of stock to be issued and many other details. The Secretary of State reviews the information to determine if there are any other corporations in the state with the same name and purpose. If it is unique, they will issue a Certificate of Incorporation and the corporation is born.

As in past articles, we will evaluate the corporation using the same six factors: complexity, liability, number of owners, capital, taxation and survivorship.

Complexity
To create a corporate entity, the articles of corporation must follow the state statutory requirements as well as annual filing requirements. Visit the Secretary of State’s website for forms for the Articles of Incorporation and annual reports. A corporation is structured according to the organization and operation of the business and there are some significant differences for Farm Corporations, Public Traded Corporations and Professional Corporations.  If you don’t develop the articles of corporation and the bylaws correctly, or fail to file annual reports, you may lose your corporate standing.

Liability
This factor is the primary reason most people consider a corporation. Generally, an owner (shareholder) is only liable for the operation of the corporation to the extent of the equity invested. Of course there are exceptions to the rule. We mentioned some of these in the first article.

First, you are always responsible for your own actions. If you are the one driving the car for work and are involved in an accident, you are responsible. On the other hand, if the business is set up as a corporation and it is an employee involved in the accident, the corporation and the employee are responsible. You are not personally liable.

Second, if you withhold employment taxes from an employee’s paycheck and don’t send it in to the IRS, the IRS will hold the responsible individuals liable for those taxes. Usually those individuals are the owners and officers.

Third, you must continue to maintain the structural integrity of the business form. For instance, you cannot use the business checking account as a personal account, and all required annual reports must be filed. Otherwise it appears as if the corporation is a sham and you are the business.

Finally, if you personally guarantee the obligations of the corporation, you are personally responsible for those obligations if the corporation does not pay.

Number of Owners
The corporation can have one owner or an infinite number based on the shares it has the ability to issue.

A Sub-chapter S corporation is limited to no more than 100 owners.

Capital
By selling small pieces of ownership you can raise capital.  You are raising money by adding owners, but the capital raised is not based on the owner’s personal assets, but on the value of the business itself. For instance, if the business has a net worth of $100,000 and there are 10,000 shares of stock issued and outstanding, then each share of stock is worth $10. So, if you want to raise additional funds, you could sell more shares of stock at $10 per share.

Most small businesses raise capital by selling to family and friends. However, if you need to raise a large amount of capital and want to sell to individuals other than family and friends, you must register the stock under the state and federal securities laws. If your goal is to eventually take the corporation “public”, then you should be planning with the assistance of an attorney that is familiar with securities laws.

Taxation
Early in the formation process, the corporation requests a federal identification number from the IRS (also known as an Employer Identification Number or EIN). The corporation files its own separate income tax return and pays its own taxes each year.  A regular corporation does this using Form 1120, U.S. Corporation Income Tax Return.  Check out the IRS website for more information on corporate taxation.

Frequently the term “double taxation” is brought up with C corporations. There are generally two ways for the owners to take money out of their business: they either pay themselves a salary and/or declare a dividend.  Although the salary or wages a corporation pays to all of its employees, including the owners, is a business expense or deduction for tax purposes, payment of a dividend is not an allowable expense. When the dividend is paid, the corporation must issue a 1099-DIV form and the owner has to include the dividend as income on their personal tax return. So, the income is taxed twice: once as income to the corporation and again as dividend income for the owners.

Any wages or salary paid to an owner is also subject to employment taxes such as Social Security, Medicare, unemployment tax (federal and state) and workers compensation. If a corporation is not making a large profit and the owner(s) has to take wages from the business for personal living expenses, they could be seeing significant employment taxes without any benefit of a lower corporate tax rate.

Corporate tax rates are generally less than personal tax rates, so a corporation makes sense if you can leave the money in the corporation for expansion and growth rather than distributing profits in the form of a dividend. Visit with your accountant or attorney and plan other ways for the owners to receive income. One such idea is to personally own the building, vehicle or equipment and rent it to the corporation. You receive the income and have to pay taxes on it, but the money used to pay the rent is deductible as an expense from the corporate income, and this may avoid the double taxation.

Sub-chapter S Corporation
Another way to avoid double taxation is to file as a  Sub-chapter S corporation. S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.

To qualify for Sub-chapter S corporation status, the corporation must meet the following requirements:

  • be a domestic corporation;

  • have only allowable shareholders;

    • may be individuals, certain trusts, and estates;

    • may not be partnerships, corporations or non-resident alien shareholders;

  • have no more than 100 shareholders;

  • have only one class of stock;

  • not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

In order to become a Sub-chapter S corporation, the corporation must submit a Form 2553, Election by a Small Business Corporation, no more than 2 months and 15 days after the beginning of the tax year in which the election is to take effect or any time in the preceding tax year.

Survivorship
As the corporation is a separate person with its own identification number, it is set up to continue as an entity no matter who owns the stock. Upon the death of an owner, the ownership of the business simply passes according to the owner’s wishes.


Mike Gallagher, District DirectorMike Gallagher joined the U.S. Small Business Administration in 1984 as a Business Development Specialist.  He was chosen as the Deputy District Director in 2005 and the District Director in November 2013.  A graduate of the University of North Dakota, Mike is a Certified Public Accountant and a former business owner.  He can be reached at michael.gallagher@sba.gov.

 

Other Articles in this Series

How Do I Choose a Business Structure?

Pros and Cons of Sole Proprietorships

The Ins and Outs of Business Partnerships