Why Should You Incorporate?
There are many reasons to consider incorporation. There are also many myths about incorporation; so, let’s examine the real business reasons to be a corporation, presuming that the person reading this article is a small business person getting ready to incorporate or change their business status in some other way.
History
Companies with limited liability actually started in the late 1500’s and early 1600’s during the war between England and Spain. During that period the Spanish Armada sunk large numbers of British ships that were bringing trade goods back from “the Orient” and America. That war started in 1585 and didn’t end until 1604 some 19 years later. During the early part of the war, when a Spanish ship would sink a British merchantman, anyone who owned a small percentage of the cargo in the hull of the ship became liable to all other holders of cargo on the ship, and even the ship’s owner, as a “partner”, for everything that was on the ship. That meant that each and every partner was liable for the entire value of the enterprise. Even today this is called joint and several liability. Limiting that kind of liability is one reason to incorporate.
About 1590, it became impossible to find investors that would send a ship to India or North America to get trade goods and the merchants of England were beginning to see a depression on the horizon. The British parliament suggested that, if there were some way to limit liability to only what you had invested, then possibly they could find investors for these enterprises which, in fact, were very risky.
And so was born the “company limited by stock”. If you invested 2000 lbs and the ship was sunk, the most you could lose was your 2000 lbs. But, you were not liable to anyone else for their losses. These companies were later designated with the suffix “LTD”. Even today, some British companies are noted with the corporate ending “LTD” instead of “INC”.
The idea of limiting liability to only the amount of money you have invested in the enterprise spread world wide and became embodied in different kinds of companies with different name designations and, incidentally, different levels of liability. In America, we generally call these corporations and either use the word corporation in the name, for instance Chrysler Corporation, or affix the suffix “INC” or the word incorporated to the name, to tell everyone that the enterprise is in fact a company limited by stock.
So, as a company “limited” by stock, one of the attributes of the corporation is that it is a separate entity or “person”.
Separate Entity
In the law of virtually every state in the United States and in many foreign countries, a corporation is considered a separate “person”. That “person” has certain attributes given to it by the law of the state where it is incorporated and has further attributes given to it by the states in which it does business. All of these attributes are embodied in documents. The fact that it is a separate person means that it can conduct business through its own bank accounts, its own invoices and contracts and its own relationships with customers and vendors. Those relationships and contracts are enforceable in court, in the name of the corporation.
If business is conducted in an appropriate manner, any losses will be sustained by the separate person that is the corporation. If those losses cut too deeply, the shareholders are liable only for the money they put in, but no more. This is true, even though the shareholders may, in fact, be the company directors and officers.
Continuity of Existence
Another very important attribute of the corporation is that, since it is a separate person, it does not die. It can be sold, traded, owned, and transferred to heirs. The people may come and go, but the corporation can continue on. Notice that General Motors, Ford Motor Company and Chrysler Corporation are all very good examples of different kinds of treatment of corporate entities. General Motors has changed personnel, combined divisions, split divisions and put divisions in and out of business for almost a century. Ford Motor Company, while it has a public presence, is essentially controlled by a single family and has been for a hundred years. Chrysler Corporation was sold first to the United States Government, then to shareholders, and then to Daimler Benz. Likewise, smaller companies can do virtually any of these things. The Continuity of Existence means that you can treat the corporation, or at least the stock of the corporation, as a commodity that can be dealt with on a different basis than the business owned by the corporation.
Flexibility of Participation
For those businesses that find the need to raise outside capital, a corporation provides literally an infinite spectrum of ownership and participation possibilities. For instance, the officers and directors might own stock of one class, while outside shareholders might own stock of another class. “Options” can be used to motivate managers or sales staff. Different classes of stock can be given different rights of participation in profit or even in liquidation. One class of stock, because it invested in the enterprise at an earlier development stage, might be paid a higher percentage of profit than the normal common stock of investors who came in after the enterprise was proven to be viable business opportunity. This flexibility of participation gives the managers an unlimited arsenal with which to locate and bring in capital participation. This kind of participation is very hard to develop and document without a corporate structure.
Estate Ownership
A corporation gives great flexibility to your estate planner. Because you’re dealing not with the business itself, but with the owning entity or shell in which the business exists, that corporate shell can be held in many different kinds of estate planning devices. That stock can even be gifted to children, gifted to charity and used in many other ways that enable your estate planner to both accomplish your goals and reduce your taxes.
Centralized Management
One of the great developments of the last few centuries in the American and European countries is the development of professional, centralized management. In a corporation, a management structure can be created whose boundaries can be defined by both the corporation and by job descriptions, where an organizational chart can be created that explains and even limits the reporting and responsibility requirements of each position, and in which consequences are generated for both good and bad performance. While this same management structure might be able to be developed inside a non-incorporated business, it is much easier to use inside the corporation.
Separate Taxation
Corporations, because they are separate people, are taxed separately. Consequently, the taxes applied to the “bottom line” (which is total cash flow minus ordinary and necessary business expenses which then leaves the “bottom line” profit). A normal corporation, which some people refer to as a “C” Corporation, is taxed on that bottom line. Federal tax rates vary from zero to as high as 38 percent, while California imposes a flat 8.84 percent rate and does not recognize capital gains. Other state tax rates vary between zero and 12 percent with most of them falling into the 5 and 6 percent range. If you operate a C Corporation, then, the game is to extract as much of that profit as you can in the form of salary, bonuses, benefits, contract rights and pension plan contributions, in order to get the “bottom line” as low as possible. If you have shareholders who expect dividends, the dividends are paid from what is left on that bottom line, after taxes.
Subchapter-S
SubChapter-S allows your corporation to be taxed as a partnership but with some very important restrictions. For more detailed explanation of the attributes of the SubChapter-S Corporation, please see the article on this website entitle “The SubChapter-S Corporation”
Section 1244
Under Section 1244 of the Internal Revenue Code, the shareholders of an electing small business corporation (subject to definition inside the Internal Revenue Code, which includes a capital base of no more than a million dollars and some special rules regarding property exchange for stock and recapitalization) can deduct losses on the stock as ordinary loss, all in one year. Should a loss be sustained on a Section 1244 stock, which means you must sell the stock or declare it worthless in the tax sharing in which you take the deduction, up to $50,000 for an individual and up to $100,000 for a married couple is deductible as an ordinary loss. The balance of the loss is carried over. There are other limitations involved in Section 1244 stock, for instance, 1244 stock cannot be owned by a trust. The benefits of Section 1244, however, may overpower the need to hold stock of a losing enterprise in your family trust. There are also some commentators who believe that SubChapter-S status automatically prohibits use of Section1244, but this is not true. Subchapter S losses may be generated or may be deducted using the capital account to fund those losses. At the point the company goes out of business and the “owners” declare the stock to be worthless, the only thing available to write off under Section 1244 would be any amounts left in the capital account of the company. Your CPA can explain more about how that account would be used; if, in fact, you feel like you might need to use Section 1244.
Nevertheless, it is available as one of the attributes of a corporation.
Other Attributes
There are other tax characteristics that should also be noted. Various kinds of insurance are deductible to a C Corporation that are not deductible under any other form of business entity. For instance, hospitalization, disability and certain amounts of group life insurance, the premiums of which are deductible to the corporation, make incorporating of great benefit if those insurance devices are part of your corporate planning. Qualified pensions, profit sharing (401K) and other kinds of tax free savings accounts are also available to the corporation, but not to other forms of business entities. Stock option plans are available using special provisions under the tax code that are not available to other forms of businesses. And, of course, deferred compensation is available. There are even provisions for expense reimbursement, college tuition plans and other forms of employee benefits that have tax implications in the corporation that is simply not available elsewhere.
Negatives
However, there are some attributes of the corporation that people consider to be negatives. The first one is that it is more complicated to operate than a partnership or a proprietorship. This is true, it is more complicated. However, if you are the kind of person who decries complication and wants to live the simple life, you probably shouldn’t be in business and you certainly shouldn’t drive on the freeway. Complications may take some of your time, and certainly some of your attention but it is not prohibitive by any means.
Another negative is that the Internal Revenue Code requires that you distribute the earnings of the corporation on a periodic basis. If you are a SubChapter-S corporation, that distribution is handled automatically, whether you actually disburse the money or not. Whatever is left on the profit line simply lands on your personal income tax return, and IRS doesn’t care whether you took the cash out of the company or left it in the company. It, in fact, has tax paid on it at the personal level. However, if you are a “C” Corporation, the Internal Revenue Code imposes an accumulated earnings tax if you don’t distribute the profit. IRS will impose a tax that is intended to be motivation for you to disburse the money to the shareholders. This is a tax that you should avoid, and is easy to avoid.
There’s also another kind of tax on what is euphemistically called a “Collapsible Corporation”, in which none of my clients have ever been involved. Those are corporations that are created for a single transaction and then go out of business after the transaction. The Collapsible Corporation penalty is applied only in limited circumstances but they are worth noting.
Conclusions
So, you have in one, rather inexpensive, simple creation of statute an entity that has a separate existence, gives you the opportunity to operate it as a stand alone individual being (albeit on paper only) gives you the opportunity to have very flexible relationship with your investors by your employees and others and give you certain tax benefits which are not available to other forms of business organizations. There are many businesses that benefit from being corporation (for instances, organizations doing business with the government). Consequently, you might want to consider a corporation for your business. Please discuss these matters with us and let us show you how the corporate attributes might apply to your specific situations.
JWH
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