- What is Incorporating?
Incorporating is the forming of a new Corporation — a legal “person” which, while being composed of natural persons, exists completely separate from them. The internal affairs that govern a Corporation are determined by the law of the state of incorporation. When forming a Corporation, one has the opportunity to “forum shop” for the state with the most favorable business-friendly laws. These laws are rarely from the state where the owners happen to reside.
Over half of the Fortune 500 companies choose to incorporate in the state of Delaware. Some of the reasons these companies choose Delaware are:
- Delaware offers unique protection and predictability for stockholders and Directors.
- The U.S. Chamber of Commerce has rated Delaware the number one state for its litigation system in each of the past five years.
- Delaware courts were rated the most fair and competent at resolving business disputes.
C-Corporations vs. S-Corporations
- The Pre-Incorporation Decision
The C-Corporation vs. S-Corporation discussion should not impact your pre-incorporation decision.
There is no distinction between the Certificate of Incorporation for a C-Corporation versus that for an S-Corporation. Every Corporation filed with any of the 50 US States starts out simply as a Corporation.
Although many small business owners fear “Double Taxation”, there are some very compelling financial benefits of the C-Corporation structure.
C-Corporation Financial Benefits:
- Low 15% corporate income tax on the first $50,000 of income (allowing more “working capital” to either remain in the company or pay off corporate debts)
- Dividend tax rate of 15% on distributions of after tax income to owners
- Ability to borrow money from the Corporation by using promissory notes
- Optional election of a fiscal year
- Ability to shift profits and losses between years to “income average” and reduce taxes
- Ability to build up operating losses during first few years to offset future gains
- More tax deductions are possible (e.g. Medical Expense Reimbursement Plan)
- Net tax paid by owners may be much lower than that paid under a “Subchapter S” election
Consultants and the C-Corporation:
Although the C-Corporation status is technically not available for Personal Service Corporations, consultants who would like the benefits of the low tax from a C-Corporation can take advantage of a loophole in the C-Corporation tax code.
A consulting business can, in fact, be classified as a C-Corporation if at least 6% of the stock is issued to a “non-employee”. This can easily be accomplished by issuing 6% of the stock to a spouse or another trusted individual who does not work for the company.
The S-Corporation is a vehicle that many business owners use to reduce the amount they contribute to Social Security and Medicaid. (Note: The S-Corporation structure is not available to Partnerships, which are taxed under “subchapter K”).
While part of the owner’s salary and bonuses are subject to self-employment tax, the remaining taxable income is deemed to be an “S-Distribution”. The S-Distribution is not subject to Medicaid and Social Security tax, only individual tax. This creates a huge loophole in the federal tax system, allowing business owners to reduce their employment tax burden by 3% or more.
- Choosing C Corporation or S Corporation
The Internal Revenue Code provides that a Corporation filed with any U.S. state shall be taxed under “Subchapter C.” This essentially means that all Corporations start out as C-Corporations for tax purposes.
Should a Corporation’s owners later wish to be taxed as an S-Corporation, they would file a “Subchapter S” federal tax election (Form 2553) within 75 days of incorporating or within 75 days of the beginning of the calendar year. To do this, the Corporation would need to have less than 100 owners, all of whom must be either U.S. Citizens or permanent resident aliens (“Green Card” holders). Once the “S” tax election is made, the return to be filed is the 1120 “S”, rather than the 1120. Whether or not you decide to be taxed as an S-Corporation, your company is still a “General Corporation” in the eyes of the state of incorporation.
An LLC can also choose to be taxed as an S-Corporation or as a C-Corporation, rather than as a Partnership. To be taxed as an S-Corporation, the LLC owners would need to file the IRS Form 2553. To be taxed as a C-Corporation, they would need to file the IRS Form 8832.
A Note about Asset Protection:
We usually suggest that liabilities between separate businesses be “segregated.” For owners of small businesses, such as restaurants, it is usually best to own land through an LLC and lease that property to your active business, which is run as an S-Corporation. This will prevent a judgment creditor of your business from being able to collect against your equity in the real estate.