Corporate Structure

By: Jay W. Henderson

From time to time one of my clients will ask me the intricacies of how we choose to use a corporation and how we choose just which type of corporation to use for his or her business venture.

These choices are based on a calculus of interacting factors, each one of which will apply to your situation in different degree than it applies to the situation of others. Unfortunately, it really does take years of experience to understand how these factors interact and when and how theory meets reality.

Following is a very elementary discussion of some of those factors. As you consult your legal and tax advisor, this list should allow you to ask relevant questions about your own particular situation.

As you consider each factor, please remember that while corporations were once designed almost exclusively to limit liability of the shareholders, they are now tax devices first and all other considerations are secondary.

General Considerations

1. Shareholder Liability. Companies in which the liability of owners is limited date from the War between Britain and Spain, circa 1585. However, starting formally with the British Corporations Act of 1865, Corporations were designed to limit the liability of the owners of the cargo in ships. Under partnership law, if something happens to create liability for one partner, each of the other partners can be forced to pay the entire liability. This was not good if all you wanted to do was buy into a small percentage of the venture. So, corporations limited by stock were invented in which your liability would be limited to your investment, or your “stock” ownership. It’s the same today.

Except!! It’s just not always true. While this aspect of a corporation still holds true for most purposes, the government got into the act many years ago and courts have now held that if one or more of certain “practices” are carried on by the corporation owners, then liability is not limited at all. In addition, licensed professionals (physicians, attorneys, CPA’s) cannot limit liability with a corporation; it’s against the law. They can incorporate and use the entity for many purposes, but not to limit liability. In addition, you just can’t limit personal liability with a corporation in the face of a government attack. If the tax people or the FTC or most other government agencies decide they want to come after a person trying to conduct his or her activities in a side corporation, liability won’t be limited for personal acts. Remember, the guy who signs the paychecks for those government employees, also signs the paychecks of the judges that are going to make the decision about your liability.

2. Successor Liability. In addition, most states have “successor” liability for people and entities that take over operations of a corporation that somehow broke the law. However, liability that might slop over on you for the actions of other participants in the venture is limited to the amount you invested, or is “at risk” in the venture.

3. Business Action. The corporation acts through its directors and officers, since it can’t really act for itself. Usually, this means a majority of the shareholders and/or directors can cause the corporation to act and can direct the officers to do so.

4. Management. Management is conducted by the directors setting policy and telling the officers what to do. Then the officers figure out how to get the job done and make it so. Shareholders need not participate in management in order to get paid on their investment.

Structure of Ownership

1. Formal Action Required. For business purposes, almost all corporations are formed in a state, under state law. While there are many considerations in choosing a state in which to incorporate, if your business deals with the public, pays sales tax, or requires a license to operate, you will usually incorporate in the state you are doing business in.

2. Qualified Owners. There are no limits to the kind of person or entity allowed to own the stock of a corporation, unless it is an “S” corporation, where severe restrictions apply.

3. Type of Interest. Except for the “S” corporation, which is allowed to have only one class of stock, you can have as many types of stock as you like. For instance, if you want to manage the company but your friend wants to invest but have no say in management, you can create two classes of stock, yours to be voting stock and his or hers to be non-voting stock which receives some type of preferential dividend treatment.

4. Transfer of Ownership. Again, except for the “S” corporation, which lives under some severe restrictions regarding who can own stock, ownership of a corporation’s stock is easily transferred to any other person or entity. This makes the corporation form of entity ideal when you desire to easily transfer ownership of something that may not be as easily transferred itself. Patents are a good example. Transfer of ownership can also be restricted by state securities laws or by agreement, if that is desirable.

5. Flexibility. Corporations are as flexible as you make them and the law allows. There is truly a huge spectrum of combinations of ownership, management and benefit.

6. Capital Requirements. Are met by sale of stock or issuance of debt securities (bonds) or by taking on other corporate debt. There are restrictions, of course, on “S” corporations which can issue only one class of stock to a limited number of persons.

Treatment of Income And Expense

1. Character of Income and Deductions. Net income (after deductions) is taxed at the corporate level, in theory. If the organization under consideration is small, though, while a significant (though not substantial) dividend must be paid each year, the profit is moved out of the corporation in deductible ways. However, in the “S” type corporation, taxation is based on a “conduit theory” and there are severe restrictions on what can be deducted. Therefore, there is very much less control of what falls onto the personal tax return of the shareholders than with a “C” corporation. This can create some nasty surprises.

2. Capital Gain. Is taxed at the corporate level, unless it is an “S” corporation, in which case capital gain is passed through to the individual stockholder.

3. Capital Loss. Is carried back three (3) years and forward for five (5), unless it is an “S” corporation, in which case the loss is passed through to the personal tax return of the stockholder(s). An expected loss is the most beneficial time to use the “S” form of corporation. Fortunately, none of us set out to lose money in any endeavor and an unexpected profit will also be dropped directly to the stockholder’s personal tax return.

4. Section 1231 Gains and Losses. Taxable or deductible at the corporate level. If it is an “S” corporation, it automatically goes through the “conduit” to the personal tax return of the stockholder, where it is taxed as ordinary income.

5. Expensing of Depreciable Business Assets. Deductible up to one hundred thousand dollars ($100,000.00), but phases out at four hundred thousand dollars ($400,000.00).

6. Organization Costs. Amortizable over sixty (60) months.

7. Charitable Contributions. Corporations are limited to ten percent (10%) of Modified Taxable Income. Unused portions are carried forward five (5) years. If it is an “S” corporation, the limitation applies at the individual level.

8. Dividends Received. Seventy percent (70%) to one hundred percent (100%) deduction, with “taint” inflicted on dividends from closely held stock. “S” corporations conduit the deduction to the individual tax return, but the taint remains.

9. Accounting Method. A corporation can use cash or accrual method, but if a “C” corporation goes over five million dollars ($5,000,000.00) in gross receipts, it must switch to the accrual method.

Compensation and Benefits

1. “Reasonable” Compensation. Deductible to the corporation and taxable to the employee.

2. “Current” Benefits (Medical Insurance, Life Insurance, Medical Reimbursement). Cost is deductible to the corporation and generally not taxable to the employee, if the plan is “qualified.” However, “S” corporations operate under rather draconian limitations that pass the cost of these benefits to the personal tax returns of the owners.

3. Retirement Benefits. All types of “qualified” and non-qualified plans available, though benefits from defined benefit plans are limited to the lesser of ninety thousand dollars ($90,000.00) per year or one hundred percent (100%) of compensation, whichever is LESS. Subchapter “S” corporations are limited to very much less valuable partnership type retirement plans.

Other Items Not Ordinarily Deductible

1. Education Plan. Your corporation can install an employee education plan under which the corporation can pay for and deduct the cost of education for the corporation’s employees who want to participate in the plan. If those employees are your children, so much the better, but they must be real employees with W-2 income from the corporation.

2. Medical Reimbursement. Many medical costs are not covered by insurance. Sometimes, you and your family are healthy enough and insurance is so expensive that you just don’t want to spend the money. With this kind of plan, all medically related expenses such as co-pay, deductibles, drugs and so on are paid for and deducted by the corporation. This kind of expense is deductible to you only if it exceeds two percent (2%) or your adjusted gross income.

3. Auto Deductions. Automobiles are inevitably used for the business. If the corporation owns the vehicle, under current law, it can deduct part or all of the purchase price, depreciate the rest of the purchase price on very favorable terms, and deduct all of the operating and maintenance expenses. It then bills you, on some reasonable basis, for your personal use of the vehicle, if any. If you own the vehicle, you must keep track of how much you use it for business, then deduct a proportionate amount using one of two different methods for doing so.

What You Trade

1. Complexity. A corporation is more complex to operate than a proprietorship. There is no doubt about it. In addition to the normal filings with governments that you would have whether you operate a proprietorship, a partnership or a corporation, there are yearly and special minutes, filings with the state, additional income tax returns and the ever present need to keep your personal life separate from the corporation.

On the other hand, we live in a complex world. If complexity scares you, maybe you need to be a teacher or other type of employee and forget about running your own business. You must also look at the cost-benefit analysis. What do you get for the complexity? You get to make many things that were just expenses formerly tax deductions to the corporation. You get to look like you are really in business. You get to forget about the endless Fictitious Business Name filings and trying to explain to your insurance agent that you really are in business but the insurance needs to be in your personal name.

And, you get the increased protection a corporation gives your family and your business.

2. Expense. Is a corporation more expensive than some other form of business entity? Not really. It looks that way up front because that is where the fees are. But if you plot the real expenses of running the corporation over five (5) years against the expenses of running some other entity over the same period, it is about the same - especially in Nevada, which has no corporate or LLC tax. California, on the other hand, starts taxing small corporations in the third year and LLC’s in the first year. I am convinced, based on 39 years’ experience in the legal and business world, that it is still worth it.

How We Handle Corporations

In this office, we believe that corporations are, by their nature, tax devices. As such, we believe it is in the best interests of our clients to tax structure every corporation we create. Because a corporation is a creature of statute, which is printed on paper, corporate structure is accomplished on paper, through corporate documents. Therefore, in our corporation clients, you will generally find the following structure, which makes maximum use of the corporation and allows it to establish very beneficial employee benefit plans in the future.

The documents are:

First Minutes of the corporation. These minutes structure the corporation for a great deal of tax benefit.

They need to be signed and placed in the corporate minute book.

These minutes, along with the other documents, contain the tax structure of the corporation. They contain the following provisions especially tailored to the situation of our client:

By-laws specially created for a small business in the business you are engaged in and containing the special provisions necessary to have the corporation licensed, if it is the type that needs a license.

The appointment of the director(s) and the officers of the corporation.

The provision adopting the corporation seal.

The authorization for the issuance of stock in compliance with an exemption from the securities registration laws and authorization to file the correct notice for that exemption to be effective. This is one place where most “packaged” corporations violate the law with possible tragic future consequences.

The IRC 1244 Plan. This plan allows you to deduct any loss on the sale of the stock of the corporation, even if you sell the assets of your business sometime in the future and shut down the corporation. Without this provision, any loss would be deductible at only two thousand dollars ($2,000.00) per year. This is like an insurance policy against future events, but it is very good tax planning.

Authorization to establish a bank account, without which the corporation bank account might be considered a personal bank account by the IRS.

The location of the corporate office. This establishes the corporation’s home for contracts, taxes, lawsuits and other purposes.

Authorization to apply for a license, professional or otherwise, for the corporation, if you need one. In California and some other states, if a contractor, broker or professional renders services through a corporation, that corporation, as well as the individual rendering the service, must be licensed by the state. Nevada does not require this kind of licensing.

Authorization to apply for a city business license, without which your corporation can be fined by the city.

Authorization to repay yourself out of the corporation for all costs associated with setting up and getting the corporation running. This provision makes those costs tax deductible to the corporation over a period of years. They are not deductible at all to you.

A provision for indemnification of the officers and directors. This is a very important provision, usually not included in California corporations because of its limited application in California.

Authorization for the corporation to enter into an employment agreement with its officers and others. This agreement makes employment with the corporation formal and makes much of what was personal expense to you when operating as a proprietorship now deductible as employee expense. The salary is set at a reasonable guess of what would be left in the corporation after payment of business expenses by the corporation. That figure can be adjusted at a later date, either by changing the salary or by paying a bonus. Remember to pay attention to the payroll taxes regarding salary and bonuses.

Please remember that this is a “C” corporation and all net income left in the corporation near the end of the year must be taken out either as salary or as bonus to you prior to year end. That “C” status may be changed to “S” status during the first thirty (30) days of any fiscal year.

Authorization to use your automobile for corporation business. This provision makes much of the operating and maintenance expense for your automobile deductible to the corporation if you use the car for corporate purposes.

Authorization to implement a Medical Reimbursement Plan. The plan allows you to pay from the corporation all medical costs not covered in some other way. They are then deductible to the corporation. There is no two percent (2%) of gross income limitation for the corporation. This plan is in two (2) parts. Each part must be dated and signed. Then it is placed in the corporate minute book.

Authorization to return disallowed expenses to the corporation. This is a tax device that allows the corporation some protection from an attack by IRS based on unreasonable compensation. Ask me about this one.

Authorization for the corporation to pay reasonable travel and entertainment expenses for your travel and entertainment when you are on corporation business. Please remember the record keeping requirements for these kinds of deductions. Ask me about how to travel for corporate business

In addition, we always include the Minutes of the First Meeting of the Shareholders of the corporation.

The Shareholders and Directors will need to sign these Minutes in the locations indicated and place them in the minute book.

We also always issue the stock of the corporation by filling out Stock Certificates. These certificate(s) need to be signed at both lines on the bottom of the certificate and placed in the minute book.

More importantly, along with the stock certificate(s), we correctly prepare a Commissioner of Corporations, State of California, Notice of Transaction Pursuant To Corporations Code Section 25102(f) document. This document, once filed with the correct state office, protects you from attack under the securities laws by establishing an exemption from registration. Without this form on file, the exemption does not exist.

The form must be signed and dated and then sent to the correct office WITHIN FIFTEEN (15) DAYS AFTER SIGNING THE STOCK CERTIFICATE. A copy with the send date on it is then placed in the corporate minute book for future reference. Nevada does not require this registration.

We also prepare the SS-4 form for filing with the IRS to obtain a corporation identification number. This is the number, much like a social security number for an individual, under which the corporation will file tax returns and otherwise identify itself.

While the state of California also requires its own employer identification number for corporations, the state, unlike the feds, presumes that, if you file the form, you have employees and will start to get in your face about filing employment tax returns. We suggest that the corporation not file for a California ID number until it actually pays wages or files a return, whereupon the number will be issued automatically.

We also correctly prepare and file with the state the Corporate Officer’s and Director’s Information Form. This s a state requirement almost everywhere.

We also obtain the corporate minute book, specially created for our clients. We put in the book the Certified Articles of Incorporation along with the other documents mentioned above. If the corporation is licensed, you will need to keep the license in the minute book under the “Certificate of Registration” tab.

Whatever you do, please have an attorney familiar with the intricacies of corporate tax law look after your corporation for you. Treat it as a cost of doing business. If the IRS or some other government agency comes to call, it is very cheap insurance, indeed.

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