Executive Summary
This document synthesizes key principles for forming, maintaining, and protecting a small business corporation, The central argument is that a corporation, while offering significant liability protection and tax advantages, requires diligent adherence to corporate formalities to be effective.
Merely filing incorporation documents is insufficient; ongoing maintenance is critical to creating a “bulletproof” entity that can withstand legal and IRS scrutiny.
Key takeaways include:
• The Corporate Shield is Earned, Not Given: A corporation is a distinct legal entity separate from its owners. This separation, which provides liability protection, is only upheld if the corporation is treated as such through meticulous record-keeping, separate finances, and adherence to all procedural formalities.
• Formalities are Non-Negotiable: The most common failure of small corporations is neglecting post-incorporation steps and yearly maintenance. This includes holding organizational and annual meetings, documenting all major decisions through corporate resolutions, issuing stock certificates, and keeping an updated minute book. Failure to do so can lead to “piercing the corporate veil,” exposing shareholders to personal liability.
• Strategic Tax Structuring is Crucial: Corporations offer significant tax planning opportunities, primarily through the choice between a C corporation and an S corporation.
◦ C Corporations are taxed separately at a flat 21% rate (as of 2018) but face potential “double taxation” on distributed profits. Their primary advantage lies in the full deductibility of employee fringe benefits, such as health and medical reimbursement plans.
◦ S Corporations are pass-through entities, avoiding corporate-level tax but taxing all profits to shareholders personally. This structure can save significantly on self-employment taxes compared to a sole proprietorship.
• Capitalization and Fund Extraction Require Precision: How money is put into and taken out of the corporation has major tax implications. Shareholder loans are preferable to capital contributions for tax purposes but are heavily scrutinized by the IRS and must be formally documented with promissory notes and reasonable interest rates. Extracting funds should be done strategically through salaries, fringe benefits, and documented expense reimbursements before considering dividends.
• Advanced Strategies Enhance Protection: For businesses with significant assets or operations, using multiple corporations can segregate liability and offer advanced tax-planning benefits. A common strategy involves establishing a Nevada corporation to own assets or lend money to an operating corporation in a higher-tax state, thereby reducing state income tax and protecting assets from creditors.
Understanding Corporate Structure and Rationale
A corporation is defined as a fictional legal entity, created by state law, that is separate and distinct from its owners (shareholders), directors, and officers. It can conduct business, hold bank accounts, and engage in legal proceedings in its own name. This legal separation is the foundation of its primary benefits.
Core Components of a Corporation
• Shareholders (Stockholders): The owners of the corporation, whose ownership is evidenced by stock certificates.
• Board of Directors: The “brain” of the corporation, responsible for making major policy decisions. A corporation can have one or more directors.
• Officers: The “arms and legs” of the corporation (President, Secretary, Treasurer), appointed by the board to handle daily operations. In many states, one person can hold all roles.
The foundational principle is to always maintain a clear legal and practical distinction between the corporation and its owners.
“A corporation, like a dog, will protect you if you feed him and treat him right.However, if your dog is not taken care of, it will eventually sneak up and bite you!”William Bronchick JD, Expert
Comparison of Business Structures
The decision to incorporate should be made after considering four key factors: ease of creation/dissolution, tax implications, paperwork burden, and liability protection.
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Business Structure
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Formation & Formalities
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Tax Implications
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Liability Protection
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Sole Proprietorship
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No formal action required, aside from a possible DBA filing. No legal separation between owner and business.
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Profits/losses reported on owner’s personal Schedule C. Subject to self-employment tax (15.3%).
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None. Owner’s personal assets are fully at risk for business debts and lawsuits.
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General Partnership
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Can be formed with a simple verbal agreement. No state filing required.
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Pass-through taxation. Profits/losses flow to partners’ personal returns (Schedule E) and are subject to self-employment tax.
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None. Partners are “jointly and severally” liable for business debts and the actions of other partners.
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Limited Liability Company (LLC)
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Requires filing Articles of Organization with the state. Owned by “members.”
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By default, taxed as a partnership (multi-member) or sole proprietorship (single-member). No tax advantages for a single-member active business.
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Members are not personally liable for company debts beyond their investment.
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Corporation
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Requires filing Articles of Incorporation with the state. Involves the most significant formalities and paperwork.
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Two types: C Corp (taxed at corporate level, potential double taxation) and S Corp (pass-through taxation, avoids self-employment tax on profits). Offers significant tax planning benefits and audit protection.
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Highest level of protection. Shareholders are shielded from corporate debts and lawsuits if formalities are maintained.
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The Incorporation Process: From Filing to Functioning
Step 1: Filing the Articles of Incorporation
The corporation is legally “born” when the Articles of Incorporation are filed with the appropriate state agency (usually the Secretary of State).
Key Information for Articles:
• Corporate Name: Must be unique and include a corporate designator (e.g., “Inc.,” “Corp.,” “Ltd.”). Using a personal surname is discouraged for privacy and reputational reasons.
• Principal Business Address: Can be a home address, but a private mailbox service is recommended for privacy.
• Registered Agent: A person or entity designated to accept legal papers on behalf of the corporation. Must have a physical address in the state of incorporation.
• Stock Information:
◦ Authorized Shares: The maximum number of shares the corporation can issue. Starting with 100 shares of common stock is recommended for small businesses.
◦ Par Value: An accounting term for the minimum price of a share. “No par value” is suggested for flexibility, unless a state’s franchise tax is based on it.
• Incorporator: The person who files the documents. Using an incorporation service can keep the owner’s name off this public record.
Certain states (e.g., GA, AZ, NE, PA) require the publication of a legal notice in a newspaper as part of the process.
Step 2: Critical Post-Incorporation Formalities
Filing the articles is only the first step. The majority of small business owners fail at this stage by not completing the necessary organizational tasks.
1. Organizational Meeting of Incorporators:
◦ Adopt the filed Articles of Incorporation.
◦ Adopt the corporate Bylaws (the “house rules” for running the corporation).
◦ Appoint the initial Board of Directors.
2. First Meeting of Directors and Shareholders:
◦ Elect Officers (President, Secretary, Treasurer). Note that some states prohibit one person from being both President and Secretary.
◦ Issue Stock Certificates: Physical stock certificates must be issued to the shareholders in exchange for capital (cash, property, etc.). This step is often overlooked but is critical.
◦ Adopt Resolutions: Formally document key decisions, including:
▪ Opening a corporate bank account.
▪ Choosing a tax year (usually calendar year).
▪ Electing S Corporation status (by filing IRS Form 2553).
▪ Adopting an IRC §1244 Stock plan to allow for ordinary loss treatment if the business fails.
▪ Authorizing medical reimbursement plans or other fringe benefits.
▪ Electing to amortize organizational expenses (IRC §248).
3. Obtain Federal and State IDs:
◦ Employer Identification Number (EIN): File IRS Form SS-4 online to get the corporation’s tax ID number, which is required for opening a bank account.
◦ State Tax IDs: Apply for any necessary state sales tax or other business-specific licenses.
4. Open a Corporate Bank Account:
◦ This must be done after obtaining an EIN.
◦ The account must be kept strictly separate from personal accounts to avoid commingling of funds.
Ongoing Maintenance and Corporate Hygiene
To maintain the corporate shield, a corporation must be run like one. This requires annual diligence.
• Annual Meetings: The board of directors and shareholders must hold and document at least one meeting per year. At this meeting, directors and officers are re-elected, and major business of the past year is ratified.
• Corporate Resolutions: All significant corporate actions must be authorized by a formal, written resolution approved by the board of directors (and sometimes shareholders). This includes:
◦ Purchasing or selling major assets.
◦ Entering into leases or loans.
◦ Declaring dividends.
◦ Changing the corporate name, address, or registered agent.
• The Minute Book: This is the corporation’s official legal record. It is the first thing an attorney or the IRS will demand in a dispute and must contain the articles, bylaws, all meeting minutes, stock ledger, resolutions, and tax returns.
• Annual Reports: Most states require the filing of an annual report and fee to keep the corporation in good standing. Failure to file can result in administrative dissolution.
Capitalizing and Funding the Corporation
Money and assets can be put into the corporation in two primary ways, each with distinct tax consequences.
1. Purchase of Stock (Equity Capitalization): The owner contributes cash or property in exchange for stock. This is typically a non-taxable event under IRC §351. This is the required method for initial capitalization.
2. Loans to the Corporation (Debt Capitalization): The owner lends money to the corporation. This is often preferred because the corporation’s repayment of the loan principal is not taxable income to the owner (only the interest is). However, shareholder loans are heavily scrutinized by the IRS and require:
◦ Formal Documentation: A signed promissory note with a reasonable, market-rate interest and a defined repayment schedule.
◦ Board Resolution: The loan must be formally approved by the board of directors.
◦ Arm’s-Length Terms: The transaction must appear commercially reasonable.
◦ Reasonable Debt-to-Equity Ratio: Most CPAs recommend a ratio no higher than 4:1 to avoid the IRS recharacterizing the debt as an equity contribution.
Extracting Money from the Corporation
Strategically removing money from the corporation is key to maximizing tax benefits.
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Method
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C Corporation Treatment
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S Corporation Treatment
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Key Considerations
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Salary
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Deductible expense to the corporation. Taxable income to the employee, subject to payroll taxes.
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Deductible expense. Taxable income to the employee, subject to payroll taxes.
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Must be “reasonable” for services rendered to avoid IRS reclassification as a dividend.
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Dividends / Distributions
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Double Taxed. Taxed first at the 21% corporate rate, then again as income to the shareholder.
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Single Taxed. All profits pass through and are taxed at the shareholder’s personal rate, but are NOT subject to self-employment tax.
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This is the least desirable way to get money from a C Corp but the most desirable (after a reasonable salary) from an S Corp.
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Fringe Benefits (Health/Medical Plans, Life Insurance)
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Fully Deductible to the corp and non-taxable to the employee. A major C Corp advantage.
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Not Deductible for shareholders owning >2% of stock. Premiums can be a personal deduction.
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Medical reimbursement plans can cover 100% of family medical expenses with pre-tax dollars in a C Corp.
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Expense Reimbursements (Auto, Travel, Education)
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Fully deductible to the corp and non-taxable to the employee if properly documented.
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Fully deductible to the corp and non-taxable to the employee if properly documented.
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Requires meticulous record-keeping (logs, receipts). Auto expenses can use a standard mileage rate or actual costs.
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Loans to Shareholders
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Permitted for small amounts (<$10,000) without interest, but larger loans must be documented with a promissory note and interest.
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Same as C Corp.
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Can be reclassified as a dividend by the IRS if not structured and treated as a legitimate loan.
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Section 179 Expense: Allows for the immediate deduction of up to $1,000,000 (in 2018) for qualifying business equipment, including large SUVs over 6,000 pounds, rather than depreciating it over time.
Liability, Risk, and “Piercing the Corporate Veil”
The primary benefit of a corporation is limited liability. However, this protection can be lost if a court decides to “pierce the corporate veil,” holding shareholders personally liable. This typically occurs under legal theories like Alter-Ego (the owner and corporation are indistinct) or Instrumentality (the owner exerts excessive control).
Key Factors for Maintaining the Corporate Shield
• Follow All Corporate Formalities: Maintain the minute book, hold annual meetings, and pass resolutions.
• Avoid Commingling Funds: Never use corporate funds for personal expenses or vice-versa. Maintain separate bank accounts and credit cards.
• Maintain Public Perception: All business cards, contracts, websites, and letterheads must use the corporate name with its legal designator (“Inc.,” “Corp.”).
• Sign in a Representative Capacity: Officers must sign all documents as an agent of the corporation (e.g., “ABC Corporation, by John Smith, its President”), never just with their personal signature.
• Adequate Capitalization: The corporation must be funded with enough capital to be a viable business entity. A shell company with no assets is more likely to be pierced.
• Obtain Proper Insurance: General liability, E&O, and other relevant insurance policies demonstrate responsible management and provide a primary layer of defense.
• Avoid Personal Guarantees: When possible, refuse to personally guarantee corporate debts like leases or vendor credit lines. Offer a larger security deposit instead.
Advanced Strategies: Multi-State and Multiple Corporations
Incorporating in Other States
• Foreign Corporation: A corporation doing business in a state other than where it was incorporated. It must register as a “foreign corporation” in that state.
• Delaware: Favorable laws for large corporations, especially regarding limitations on director liability in shareholder lawsuits.
• Nevada: Highly favorable for small corporations due to no state corporate income or franchise tax, strong director liability protection, and enhanced privacy (Nevada does not share information with the IRS).
• General Rule: For most small businesses operating in one location, incorporating in their home state is most practical. Incorporating elsewhere adds fees and complexity.
Using Multiple Corporations
This strategy is used to segregate liability and optimize taxes.
1. Liability Limitation: By placing different business functions (e.g., manufacturing, real estate holdings, operations) into separate corporations, a lawsuit against one entity does not endanger the assets of the others.
2. Tax Reduction: A Nevada corporation can be used to own valuable assets (equipment, real estate) and lease them to an operating corporation in a high-tax state. The lease payments become a deductible expense for the operating company, shifting profit to the tax-free Nevada entity.
3. Asset Protection: A Nevada corporation can act as a secured lender to the operating company. By filing a UCC-1 lien against the operating company’s assets, the Nevada entity becomes the primary creditor. If the operating company is sued, it can default on the loan, allowing the Nevada “bank” to repossess the assets, leaving nothing for other creditors. This strategy requires meticulous, arm’s-length documentation.
