CHOOSING A BUSINESS ENTITY: THE CORPORATION
November 22, 2016
By Jeff Wolfe
Earlier this year, we started a new blog series on one of our key practice areas at the Forrest Firm, our assistance to entrepreneurs and executives as they weigh matters of business entity formation or transition. Business leaders have multiple options at their disposal when choosing a corporate entity type, including partnerships (both general and limited, limited liability companies, and corporations.
In our initial post of the series, we discussed the limited liability company (LLC), an entity type known for its flexibility to protect both individual business people and partners. Recently, we took a look at what many people think is an entity, the S corporation, which is actually a federal tax election made with the Internal Revenue Service and not an actual entity type recognized within a state jurisdiction.
Today, let’s take a look at the LLC’s standard alternative, the corporation. As a default, corporations are taxed as C corporations, meaning there is a “double tax” since the corporation pays tax at the entity level and then the people that own or manage the entity are taxed when the profits are distributed to them. This is the number one reason clients focus on LLCs and the S corporation election, which allow for pass-through taxation.
To form a corporation, the chief requirement is filing articles of incorporation (or a certificate of incorporation in some states) with the Secretary of State. When we work with executives to form corporations, we are typically are deciding between forming the entity here in North Carolina or in Delaware due to that state’s prominence in the corporate world (to learn more about reasons for choosing Delaware, visit this article by my colleague, Jesse Jones).
The articles or certificate of incorporation, which you’ll also see referenced as the corporate charter, lays out a basic framework for the corporation. Although this is the only document filed with the state, the formation documents for a corporation include various other documents, including corporate bylaws. The purpose of bylaws is to articulate how the company will operate and the basic rights and responsibilities of the shareholders, board of directors, and officers. A shareholders’ agreement may also be appropriate to set forth agreements among the shareholders.
Generally, shareholders own the company, the directors on the board serve an advisory and oversight function, and the officers run the day-to-day management of the company. It’s important to know that in a corporation, the ultimate power lies with shareholders who have the right to elect the board of directors, which has the power to appoint and remove officers.
Corporations, like limited liability companies, offer owners the protection of limited liability. This means that when you invest in a corporation, you are generally able to shield your personal assets and holdings from liabilities related to the operations of the business. However, one of the reasons a corporation needs a robust set of formation documents is to maintain this protection and defend against attempts to “pierce the corporate veil”.
Another drawback to corporations is that they require additional corporate formalities (which are very simple with LLCs, by comparison), such as holding an annual meeting of shareholders. Furthermore, tax filings get imminently more complicated and expensive, as our counterparts in accounting must file separate returns for corporations with the Internal Revenue Service.
So you may be wondering why anyone would choose to form a corporation that keeps its C corporation tax status. The answer is that investors may be opposed to a pass-through tax election where they will be responsible for paying taxes on their share of the entity’s income, even if that income is not distributed. In other words, an investor in an early-stage growth company may prefer to defer taxes on their investment until an exit event, rather than paying taxes on an annual basis with money that could otherwise be used for additional investments.
As you can see, the answer on which entity is the best choice for a business is not always an obvious answer. Contact us today to receive advice and counsel that will tailor your entity selection to optimal risk management and growth-oriented business development.