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Choosing the Best Kind of Corporation for Your Future Business
Excerpted from Form Your Own Corporation, 5E by W. Kelsea Eckert, Arthur Sartorious, III, and Mark Warda © 2006
Before forming a corporation, you must make a few choices. Will it be n S or a C corporation? Will it be a closely-held corporation, a professional service corporation, or a not-for-profit corporation? The choices you must make are discussed in this chapter, along with the features of the corporation types you have to choose from.
Domestic Corporation or Foreign Corporation
A person wishing to form a corporation must decide whether the corporation will be a domestic corporation or a foreign corporation. A domestic corporation is one formed in the state in which it is doing business. A foreign corporation is one incorporated in another state or country.
In the past, there was some advantage to incorporating in Delaware, since that state had very liberal laws regarding corporations. Many national corporations are incorporated there. However, in recent years, most states have liberalized their corporation laws—so today, there is no advantage to incorporating in Delaware for most people.
Delaware Corporations
If your state has high corporate fees (such as California), you might save some money by incorporating in Delaware if you are not actively conducting business in your state. If your state has high income taxes (i.e., New York), you might lower your taxes by having your local corporation pay out all of its profits to a Delaware corporation (which does not pay Delaware income tax if it is not doing business in Delaware).
Nevada Corporations
Nevada has liberalized its corporation laws recently to attract businesses. It allows bearer stock and has other rules that allow more privacy to corporate participants. It also does not share information with the Internal Revenue Service and does not have a
state income tax.
Double Incorporation
One way that a Nevada, Delaware, or other corporation can be useful is if your state has high income taxes. By using two corporations, you could transfer your profits to a state that has no income tax.
Example: Suppose you were a painting contractor who owned a building and equipment. You could incorporate in your home state as a painting contractor, but put the building and equipment into a Nevada corporation. The Nevada corporation would then lease these to the local corporation. After paying the workers, buying supplies, paying you a salary, and making lease payments to the Nevada corporation, your local company could break even with no taxable profit. The profit would all be in the Nevada corporation, which may not be required to pay taxes in your state.
From a federal tax standpoint there would seldom be an issue, because taxes would have to be paid on the profits no matter which corporation they were in.
From a state tax standpoint there would be a couple of issues. For example, one is whether the Nevada corporation was doing business in your state. If the acts of the Nevada corporation are passive enough, it might not even need to register as doing business in your state. For example, if it just loaned money to your corporation, it would not have to register (especially if you happened to go to Las Vegas to sign the loan papers). In most states, merely owning rental real estate does not require a corporation to register.
A second issue would be whether your state has any catch-all tax laws that would prevent this kind of setup. If you are going to set up two corporations for this purpose, you should meet with a local tax specialist to be sure that it is done correctly under your state requirements.
Additional Considerations
If you form a corporation in a state other than the one in which your business is located, you will be required to have an agent or an office in that state, and you will have to register as a foreign corporation doing business in your state. This is more expensive and more complicated than incorporating in your own state. Also, if you are sued by someone who is not in your state, he or she can sue you in the state in which you are incorporated, which would probably be more expensive for you than a suit filed in your local court. In some states, your corporation may be required to pay state income tax.
S Corporation or C Corporation
A corporation has a choice of how it wants to be taxed. It can make the election at the beginning of its existence or at the beginning of a new tax year. The choices follow.
S Corporation
Formerly called a “Subchapter S corporation,” an S corporation pays no income tax and may only be used for small businesses. All of the income or losses of the corporation for the year are passed through to the shareholders, who report them on their individual returns. At the end of each year, the corporation files an information return, listing all of its income, expenses, depreciation, etc., and sends each shareholder a notice of his or her share as determined by percentage of stock ownership.
Advantages. Using this method avoids double taxation and allows the pass-through of losses and depreciation. For tax purposes, the business is treated as a partnership. Since tax losses are common during the initial years due to start-up costs, many businesses elect
S status and switch over to C corporation status in later years. Be aware that once a corporation terminates its S status, there is a waiting period before it can switch back. Typically, S corporations do not have to pay state corporate income tax.
Disadvantages. If stockholders are in high income brackets, their share of the profits will be taxed at those rates. Shareholders who do not materially participate in the business cannot deduct losses. Some fringe benefits, such as health and life insurance, may not be
tax deductible.
Requirements. To qualify for S corporation status, the corporation must:
? have no more than one hundred shareholders, none of whom are nonresident aliens or corporations, and all of whom consent to the election (shares owned by a husband and wife jointly are considered owned by one shareholder);
? have only one class of stock;
? not be a member of an affiliated group (only individuals, estates, and certain exempt organizations and trusts qualify);
? generate at least 20% of its income in this country and have no more than 20% of its income from passive sources (interest, rents, dividends, royalties, securities transactions); and,
? file Election by a Small Business Corporation (IRS Form 2553) with the IRS before the end of the fifteenth day of the third month of the tax year for which it is to be effective, and be approved by the IRS. Approval is usually routine.
C Corporation
A C corporation pays taxes on its net earnings at corporate rates. Salaries of officers, directors, and employees are taxable to them and deductible to the corporation. However, money paid out in dividends is taxed twice. It is taxed at the corporation’s rate as part of its profit, and then at the individual stockholders’ rates as income, when distributed by the corporation to them.
Advantages. If taxpayers are in a higher tax bracket than the corporation and the money will be left in the company for expansion, taxes are saved. Fringe benefits, such as health, accident, and life insurance, are deductible expenses.
Disadvantages. Double taxation of
