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BUSINESS LAW: CorporationsThe Law Offices of David D. Murray provides all of the services necessary to support our corporate clients, including the formation of the appropriate business entity (i.e., partnership, corporation, limited liability partnership, limited liability corporation, or personal corporation), contract preparation and negotiation, updating of corporate books and minutes, business planning, corporate governance, business purchases and sales, and, if necessary, litigation or international arbitration. Besides limiting the owners, officers and directors of the company from certain personal liabilities, incorporating a business can have other advantages, among them overall tax treatment. We suggest you obtain individual tax advice from a tax professional who can advise you on all aspects of your personal tax matters. Taxation is complex. Our firm does not provide tax advice and we provide the below tax-related information just to show some of the options that are available for you to discuss with your tax accountant. Besides taxation, there are a few other things of which a business owner should be aware, when they chose a business entity. We have provided some of those considerations below. ____________________________________________________________________________________ WHAT IS A CORPORATION? A general corporation is a separate and distinct legal entity recognized separately from its shareholders, officers, and directors. It is purely a creature of statue. If properly formed and operating, a corporation shields its shareholders from corporate liabilities. Rights and obligations of the corporation, its directors, and shareholders are clearly spelled out in the General Corporation Law of each state. These statutory rights and obligations may be altered, within limits, by agreement. A corporation is also a separate entity for purposes of taxation. LIMITATION OF PERSONAL LIABILITY . . . Corporations afford the principals and shareholders freedom from the liabilities of the business if the corporation is validly formed, complies with the formalities necessary, and is adequately capitalized. This is especially important when a principal has significant income or assets outside the business. A corporation's director who acts in good faith, and in a manner that the director believes to be in the best interest of the corporation and its shareholders, exercising such care as an ordinarily prudent person would use in similar circumstances, is generally not liable for any alleged failure to discharge the duties of a director. Officers of the corporation, as its agents, are not personally liable for acts done within the scope of their authority. The corporation may, to a limited extent, indemnify its directors and agents against monetary damages. The limited liability afforded by incorporation is of less practical value than might be expected, especially for closely held businesses. First, insurance is ordinarily available to cover anticipated liabilities. Second, shareholders in newer, smaller corporations are often required by creditors to execute personal guarantees for major commitments undertaken by the corporation. Third, an individual may not avoid liability for his or her tortuous conduct by transacting business through a corporation. Tortuous conduct, either negligent or intentional, subjects an individual to liability. Corporations have a potentially unlimited duration. Unless specific actions are taken to dissolve the corporation, either voluntarily or involuntarily, a corporation will continue to exist. LIQUIDITY OF CORPORATE STOCK AND ASSETS . . . A sale of a corporate business may take place through a sale of either the assets of the corporation by that corporation or the shares of the corporation itself by the shareholders. Shares of stock in a closely held corporation, however, are often no more readily transferable than interests in other business entities. This is primarily because of the restricted market for shares of stock in closely held corporations and the significant restrictions that can be placed on the ability to dispose of shares in a closely held corporation. ADVANTAGES OF INCORPORATION . . . An advantage of incorporating is in the centralized management that a corporation provides. The management and control of a corporation is delegated by the shareholders by shareholder election to a board of directors that, in turn, appoints the officers, whose position it is to implement the policies of the board of directors. Therefore, unless special voting or other rights are given to minority shareholders by the corporate articles of incorporation or bylaws, a shareholder with majority control is able to control the management of a corporation, even if there is dissent from minority shareholders. When incorporating, various corporate formalities that do not apply to other entities must be followed. These corporate formalities usually involve filings with the State, which entails the payment of fees. All significant corporate actions undertaken by the board of directors must be documented in the minutes of the board of directors meeting or by action by unanimous written consent of the directors. Also, shareholders' meetings must be regularly noticed and held and the actions taken should be recorded and maintained in the corporate records. Failure to adhere to the corporate formalities may result in the shareholders, officers and directors being held personally responsible for debts and other liabilities of the corporation. Corporate Formalities . . . A corporation can be created only by compliance with General Corporation Law of the state of incorporation. This usually requires filing of Articles of Incorporation with the appropriate state entity (usually the Secretary of State) and payment of the requisite state fees and taxes. A corporation is required to have a board of directors, corporate officers, annual shareholders meetings, and to maintain separate books and records. Failure to observe such formalities may result in the personal liability of shareholders for corporate debts. However, where the corporation has only one shareholder, many states, including California, allow that one shareholder to act as director and all officers (President, Secretary, and Treasurer). Corporations are required to have annual shareholders meetings and director's meetings, and to properly record notices and minutes thereof in the corporate minute book, signed by the appropriate corporate authorities. Failure to keep up the corporate formalities can result in the piercing of the "corporate veil" of liability protection, resulting in the shareholders, officers and directors being personally liable for corporate debts and responsibilities. Therefore, it is very important that legal counsel be consulted in this regard. Beware of corporations that are set up by accountants, that often overlook the corporate formalities, in favor of tax treatment. It takes both a competent tax accountant and a competent lawyer to protect your corporate entity and to advise you under both tax laws and the general laws that apply to your corporation. Separate Legal Entity Status . . . A Corporation or a Limited Liability Company is a separate legal entity existing under authority granted by state law. It has its own identity separate and apart from its shareholders/owners. Sole Proprietorships or Partnerships may not offer this type of separateness. Broad Range of Corporate Powers . . . As a separate legal entity, a corporation has the power to act in any way permitted by law and by its own corporate charter. For example, a corporation can enter into contracts, buy and sell both real and personal property, sue and be sued, and can even be responsible for breaking the law (i.e. committing a crime). Access to Small Claims Court . . . In most jurisdictions, any officer or director or employee can appear in small claims court on behalf of the corporation. In some states, including California, there may be restrictions on how many small claims actions a corporation can bring in one year. Separate Liability for Corporate Debts . . . As a separate legal entity, a corporation is responsible for its own debts. Normally, shareholders, directors, and officers are not responsible for corporate liabilities. If the corporation suffers losses, the corporation itself must bear those losses to the extent of its own resources, and not the personal assets of the individual shareholders. In effect, however, shareholders indirectly bear these losses by a decline in the value of the stock they hold in the corporation. Note however, that shareholders, directors, and/or officers may be held liable for the debts of the corporation where the court imposes "alter-ego liability" or where the individual has personally guaranteed the corporate debt. Perpetual Duration . . . A corporation is capable of continuing indefinitely. Its existence is not affected by the death or incapacity of shareholders, directors, or officers of the corporation. Duration of Corporation Compared to LLC . . . A Limited Liability Company (LLC) has a limited existence. Absent a contrary agreement, an LLC is dissolved upon the death, withdrawal, or bankruptcy of a Member, unless the business is continued by unanimous vote of the remaining members. Although the operating agreement can be drafted to avoid such a result, the life of the LLC is still limited to the termination date established in the Articles of Organization. California New Hire Reporting . . . Federal law requires all employers to report basic information about employees who are newly hired, rehired, or who return to work after a separation of employment. Employers must submit a report for each newly hired employee. Failure to report new hires within 20 days of their hire date may result in civil penalties. There may be a $24 fine per each newly hired employee or, if the State of California determines there is a conspiracy between employer and employee not to report, the penalty can be up to $500 per newly hired employee. Form I-9 Reporting Requirements . . . The immigration and nationality laws of the United States require employers to properly complete and keep on file a Form I-9 for every employee hired, regardless of place of birth or citizenship. If the U.S. Citizenship & Naturalization Services audits an employer, and if the employer is found not to be in compliance with this record keeping requirement, there can be substantial monetary penalties. Of course, if an employer is found to have knowingly hired or retained an undocumented worker, additional penalties, and criminal penalties can attach. Please see our full explanation of the Form I-9 record keeping requirements under the Immigration section of our web site. Also, learn the penalties for failure to properly conform to I-9 requirements in the event of a U.S. Customs & Immigration Enforcement Audit. California Limited Offering Exemption Registration . . . . All stock issued by California corporations must comply with the Corporate Securities Laws of the State of California. The regulations governing Corporate Securities are very strict. Whenever a corporation is formed and the owners take shares of stock, in order to take advantage under one of the state’s issuance and fee exemptions, the exemption must be registered with the state within 15 days of the issuance of the shares - otherwise the state can fine the corporation up to $2,500. ____________________________________________________________________________________ TAXATION CONSIDERATIONS . . . WHAT'S ALL THIS ABOUT "C" CORPORATIONS
. . . The myths dispelled and explained . . . There
is no such thing as TAX RELATED INCORPORATION CONSIDERATIONS . . . In reality, there is only one "type" of corporation (with some technical exceptions of "closely held", public, etc.). All corporations in the United States are formed under the laws of their state of incorporation and must abide by and are controlled by the laws regarding status, existence and maintenance, etc. written down in the Corporations Code of each state. Of course, the federal government controls issues relating to stock offerings and public companies through the Securities and Exchange Commission (SEC). Nobody "forms" a "C corporation", or an "S corporation". They merely form a corporation. These are merely designations as to under which Internal Revenue Code (IRC) section the owners have, after formation, to be taxed under. The tax election (or failure to elect resulting the default Subchapter "C" taxation) is often referred to by accountants as a "C" corporation or an "S" corporation, but in reality it is not a "type" of corporation. If no tax election is affirmatively made to be taxed under Internal Revenue Code Subchapter "S", a corporation is taxed under Internal Revenue Code Subchapter "C" by default. Thus, the confusion when somebody says, I have a "C" corporation . . . well, true, you have a corporation that is taxed under IRC Subchapter "C" . . . big deal, and you may be foolish. Perhaps a corporation taxed under Subchapter "S", or a Limited Liability Company, or a Sole Proprietorship would better suit your needs. While a company with a Subchapter S election cannot go public, it can easily switch to taxation under Subchapter C by notifying the Internal Revenue Service, and then going public. Accountants love Subchapter C corporations, because they can charge
more for the burdensome tax preparation. Lawyers really don't care
which election is made, so long as the election does not violate
the law regarding nationality of the owners and the number of owners
allowed. CORPORATIONS WHO HAVE CHOSEN TO BE TAXED UNDER
Election to be taxed under Internal Revenue Code Subchapter "S" (Tax Savings) . . . If the owners of a corporation are citizens or permanent residents of the United States, this is the most tax advantageous type of corporation because it is taxed like a partnership, allowing pass-throughs to the shareholders and avoiding corporate tax, whereas a corporation taxed under Internal Revenue Code Subchapter "C" is subject to Federal Corporate Income Taxes and profits are taxed first on the corporate level, and then again at the individual level of the shareholders to whom the profits are distributed. This double taxation could result in a combined tax rate of 70% or higher. Whoa, that's not good! A corporation that qualifies and elects to be taxed under Internal Revenue Code Subchapter "S" is a pass-through entity defined by statute. An "Subchapter S corporation" provides limited liability to shareholders in the same manner as a general Subchapter C corporation, but is not subject to federal taxation at the corporate level. Instead, income, deductions, losses, and credits are passed through to the individual shareholders. The Subchapter S corporation, which is solely a creature of tax law, is a possible way to avoid much of the tax cost of the Subchapter C corporation, while retaining the advantages of the corporate entity. However, because of the limitation on the number of shareholders and the prohibition against so-called exotic shareholders (such as corporations, certain trusts, and nonresident aliens), the Subchapter S corporation may be unavailable as a practical matter. The restriction that Subchapter S corporations may have only a single class of stock may hinder flexibility in using some of the more sophisticated arrangements for business financing that are becoming prevalent, particularly financing obtained through hybrid types of debt instruments having strong equity characteristics. Despite its conduit nature, a Subchapter S corporation must file annual tax returns detailing taxable income allocations to owners and, under certain circumstances, reporting corporate taxes due. Subchapter S corporations may also be subject to estimated tax payment requirements. Subchapter S corporations, like general Subchapter C corporations, offer their shareholders the benefit of limited liability. Subchapter S corporations are subject to the same practical considerations as general corporation shareholders with respect to limited liability. Thus, insurance, creditor insistence on personal guarantees for major financial commitments made by the corporation, and continued personal liability for tortuous conduct may limit the actual importance of the statutory limitation of liability. Subchapter S corporation status also insulates the corporation's assets from the personal liabilities of its shareholders. As with a general corporation, a Subchapter S corporation may have a perpetual existence. The death of a Subchapter S corporation shareholder does not terminate the existence of the S corporation as an entity. Like a general corporation, a Subchapter S corporation may be voluntarily dissolved under state law. In addition, Subchapter S corporation status (not the corporation itself) may be terminated by any of the following:
A Subchapter S corporation may not have more than 75 shareholders, and shareholders must generally be individuals (other than nonresident aliens), qualifying trusts, or, after 1997, certain exempt organizations. This relatively free transferability of S corporation shares, however, is often illusory because of the limited market for shares, and because of restrictions imposed on their transfer by securities laws. For sound planning reasons, shareholders may require buy-sell agreements, cross-purchase agreements, or other arrangements that restrict free transferability of shares. The same management and control advantages with respect to Subchapter C corporations also apply for Subchapter S corporations. Compliance and housekeeping costs for Subchapter S corporations are more numerous and somewhat more costly than for other entities and partnerships. When incorporating, various corporate formalities that do not apply to other entities must be followed, and filing fees are usually involved. In addition, all significant corporate actions undertaken by the board of directors should be documented in the minutes of the board of directors meeting or by action by unanimous written consent of the directors. Also, shareholders' meetings must be regularly noticed and held and the actions taken should be recorded and maintained in the corporate records. Subchapter S corporations must also assure that statutory requirements pertaining to S corporations are not violated. Thus, they must take care to issue only one class of stock. They must also maintain records to assure that the number of shareholders never exceeds 75 and that no ineligible party becomes a shareholder. _______________________________________________________________________ CORPORATIONS WHO HAVE NOT TAX TREATMENT OF SUBCHAPTER "C" CORPORATIONS . . . The corporate tax rate is 15 percent of taxable income up to $50,000; 25 percent of taxable income between $50,000 and $75,000; 34 percent of taxable income between $75,000 and $10,000,000; and 35 percent of taxable income in excess of $10,000,000. Also, if taxable income is between $100,000 and $335,000, a 39 percent tax rate applies. If taxable income is between $15,000,000 and $18,333,333, a 38 percent tax rate applies. Corporations are not eligible for a special tax rate for capital gains, unlike individuals. It currently stands at a flat 35 percent of the net capital gain. If an individual or pass-through entity is anticipating sizable net capital gains, a decision to incorporate should be postponed until the gain has been recognized. Incorporation carries with it the problem of double taxation. First, a corporation is taxed on its net taxable income. Then, when corporate earnings are distributed to the shareholders as dividends, the dividend is taxed to the individual shareholder as ordinary income. Therefore, despite the advantageous corporate tax rates, unless all but a small portion of the profit of a corporation will be paid out to the principals as reasonable compensation, it is unlikely that Subchapter C corporations will offer significant tax advantages to closely held businesses. The repeal of the General Utilities Doctrine has made the Subchapter C corporation less appealing than before. Previously, a corporation recognized no gain or loss on certain liquidating distributions of its assets to shareholders, on certain nonliquidating distributions relating to qualified stock, or on certain liquidating sales of its assets. Tax was not imposed until the shareholder level, meaning no double taxation. The repeal of the General Utilities Doctrine eliminated this potential for relief from double taxation and significantly increases the tax cost of liquidating a Subchapter C corporation. A number of penalty taxes may be imposed on a closely held corporation. The potential application of these taxes must be taken into account when determining whether or not to choose the corporate form of entity:
TAX TREATMENT OF PASS-THROUGH ENTITIES . . . A pass through entity is an entity that is not taxable on its own, but which provides a pass through of tax attributes, such as profits, losses, and credits, to its owners. Proprietorships, general partnerships, limited partnerships, limited liability partnerships, limited liability corporations, and S corporations all have elements of and are generally characterized as pass through entities. Section 1 of the Internal Revenue Code provides the amount of income tax imposed on individuals. The rates differ depending upon whether an individual is filing as the head of a household, married and filing jointly, married but filing separately, or unmarried. Listing the actual rates would not be feasible as adjustments are made to the tax tables each year so that inflation will not result in tax increases. Always certain, however, is that the maximum individual tax rates are 36 and 39.6 percent. Recent amendments to the code have made the maximum individual rate applicable to capital gains generally around 20 percent. For tax years beginning in 2001 and later years, the 20 percent maximum rate will be reduced to 18 percent. The difference in capital gains treatment between corporations and individuals is one of many recent changes by Congress that has made the corporate choice of entity less appealing than in the past. ____________________________________________________________________________________ FEDERAL ENTITY CLASSIFICATION RULES . . . Effective beginning January 1, 1997, federal entity classification regulations now allow “eligible entities” to elect their tax classification for federal tax purposes as either an association (taxable as a corporation) or a partnership (pass-through taxation). Entities with only one owner may elect to be classified as a corporation, or may elect to be disregarded as an entity separate from the owner. Any business that is not required by federal law to be treated as a corporation for federal tax purposes is an “eligible entity”. The promulgation of these new federal regulations has given California businesses the ability to structure an entity in the most suitable manner without triggering a classification as a corporation, thereby incurring double taxation. Previously, regardless of the choice of entity for state filing purposes, a business enterprise was classified as a corporation for federal tax purposes if it possessed the four characteristics of a corporation: Continuity of life, centralization of management, limited liability for debts of the enterprise, and free transferability of interests. Now an eligible entity can possess these desired characteristics while still receiving pass-through taxation status by making an affirmative election of classification on Form 8832. ____________________________________________________________________________________ OTHER CORPORATE TAX CONSIDERATIONS Internal Revenue Code Section 1244 Stock (Tax Savings) . . . Election to have stock classified as IRC Section 1244 stock allows for a substantially larger application of the deduction from business losses to ordinary income than regular stock. With regular stock, you can only offset $3,000 against ordinary income. With the issuance of Section 1244 Stock, the corporation can claim an ordinary loss deduction of as much $100,000. A company that issues Section 1224 stock, and elects to be taxed under the provisions of the IRC provides its shareholders the best of both possible worlds from a tax standpoint. A qualified tax professional should be consulted for a determination as to tax matters. Federal Tax ID Number . . . A Federal Tax ID Number is the equivalent of a Social Security Number for a corporation. It will be needed to pen a bank account for the corporation. California Unemployment Tax Account Number . . . For California employers, this number is used to withhold California Unemployment Taxes from a corporation's payroll. Employers having employees on the payroll, including the owner of the corporation, need this account number. California Sales Tax Number . . . If the corporation sells goods or taxable services, it needs a
Seller’s Permit
and Registration as a retailer with the State of California. This
account number also allows the corporation to buy goods for resale
or export and not pay any state sales tax.
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