The Corporation as an Entity.
A corporation is an entity. A corporation exists separate from its owner(s). A corporation can sue and be sued. A corporation has its own “social security number” in the form of its Employer Identification Number or EIN.
A corporation is owned by its shareholders. If you own stock in any corporation, you are an owner of that corporation. The shareholders elect the Board of Directors. The Board of Directors is in turn responsible for running the corporation on behalf of the shareholder-owners. The Board of Directors then elects and oversees the officers of the corporation that are responsible for the day-to-day operation of the corporation subject to the oversight of the Board of Directors.
Federal Insurance Contributions Act (FICA) Taxes
FICA is used to provide for the federal system of old age, survivors, disability and hospital insurance. The first three of these is funded by the Social Security system. Hospital insurance is funded by a Medicare tax. Both the corporation as employer and the employee(s), are required to pay FICA taxes on income earned as an employee of the corporation. The FICA tax rate is 7.65%. The breakdown of the 7.65% is 6.2% for the Social Security portion (old age, survivors and disability or OASDI) and 1.45% for the Medicare portion.
It is important to note that FICA taxes are paid by BOTH the corporation and the employee at the rate of 7.65%. Thus, the actual FICA tax rate is 15.3%. So, if you are the owner/shareholder of your own corporation, as well as the employee of your corporation, your income you’re your corporation will be subject to a 15.3% FICA tax. It should be noted that there are limits on the amount of OASDI taxes. However, that is beyond the scope of the discussion here. For now, you simply need to understand what FICA taxes are, the FICA tax rate and that they are paid by both the corporation and the employee(s) of the corporation.
Another tax that must be understood by all owners of corporations is the unemployment tax. IRS regulations require that all corporations have at least one employee. For most small business owner, they will end up being shareholder/owner, director, officer and employee of the corporation they own. Many states will require the owner of the corporation to carry unemployment insurance for the employee(s) of the corporation even if the only employee of the corporation is its owner. Even if the state of incorporation does not require unemployment insurance, the federal government will. What the small business owner needs to understand is that they will need to pay for unemployment insurance for themselves as the employee of their corporation. However, because they are the sole owner of the corporation, they cannot collect unemployment should the corporation they own ever fail and they find themselves without an income from their corporation.
C Corporations and S Corporations
A corporation can either be a “C” corporation or an “S” corporation. “C” and “S” refer to the subchapters of the Internal Revenue Code that govern the tax treatment of the two. All corporations are subchapter C corporations by default; when a corporation is formed it is a C corporation unless the shareholders of the corporation choose to be an S corporation instead by electing to become an S corporation in their minutes and filing the required form with the Internal Revenue Service. There are very significant differences between them.
Let’s examine a C corporation against our three criteria for a business: 1) Limited liability; 2) Tax efficiency; and 3) Operating efficiency.
Limited Liability. A corporation has a limited liability shield. If the corporation is properly incorporated and properly maintained, creditors of the corporation can only attach assets owned by the corporation; the assets of the officers, shareholders and directors are safe. However, if the corporation is not properly incorporated or fails to meet certain operating requirements, a potential creditor may “pierce the corporate veil” and attach the assets of the officers, shareholders or directors. Some reasons courts may allow creditors to pierce include lack of corporate formalities (e.g. failure to hold meetings of directors and/or shareholders), mixing business and personal funds, entering into agreements in one’s own name versus the name of the corporation, failing to identify the corporation as a corporation to the public and lack of capitalization.
As an example, let's say that Sally and Janet have started making and selling quilts together. If Janet drove out to a quilting show and got in an accident, Sally could be held jointly liable with her depending on the form of entity they chose. If they had chosen a partnership, Sally could be held liable with Janet.
On the other hand, choosing a C corporation would provide limited liability protection for both Sally and Janet. That is to say, assuming the corporation is properly formed and properly maintained, a potential creditor could only attach assets owned by the corporation. A creditor could not attach Sally and Janet’s personal assets. However, there are also tax and operating efficiency considerations.
Tax Efficiency. A C corporation, unlike a S corporations, LLCS, and partnership, pays its own separate taxes. At the end of its tax year, a C corporation reports its profits to the Internal Revenue Service on Form 1120. The corporation then pays taxes on those profits at the rate as determined by the bracket the profits put it into; just like you. Then, if the corporation pays a dividend to its shareholders, the shareholder is responsible for reporting the dividend on the shareholder’s individual tax return and paying taxes on the dividend earnings. As a result, profits of a C corporation are subject to double taxation. That is, the profits are taxed the first time when the corporation reports its income and pays its taxes on that income and then the profits are taxed a second time when they are paid to the shareholders of the corporation and reported on the shareholder’s tax return. The double-taxation of profits of a C corporation is one of the biggest drawbacks to its use. That being said, there are ways of “zeroing out” the profits of the C corporation so as not to pay the double tax. There are also some significant tax planning opportunities available to the C corporation.
Dividends paid to shareholders must be in directly proportional to the percentage ownership of the corporation. So, if two shareholders own the corporation 50/50, the dividends paid must be 50/50. If the two shareholders own the corporation 80/20, the dividends paid must be 80/20.
Internal Revenue Service rules also require all corporations to have at least one employee. For most small businesses, that means that the owner MUST be an employee of their corporation. If there is more than one owner/shareholder, at LEAST ONE, but NOT all, of the owners/shareholders MUST be an employee of the corporation. The employee(s) of the corporation must be paid a salary in the form of “W-2” income. That means income from the corporation paid to the employee as an employee of the corporation gets reported on form W-2. The income is also subject to Federal Insurance Contributions Act (FICA) taxes.
Operating Efficiency. Unlike partnerships, a C corporation is a perpetual entity; it exists until it is dissolved. Dissolution of the corporation occurs when the shareholders of the corporation choose to dissolve or by operation of law (e.g. the corporation does something requiring it to be dissolved such a result of a court action, or fails to do something which dissolves it such as failing to make an annual filing).
Corporations are creatures of statute. State laws mandate the structure and operating structure of corporations. Thus, in order to start a corporation, a filing must be made with the appropriate government agency in the state in which the corporation will exist and all state requirements as to the structure and operations of the corporation must be met. In addition, most states also require annual filings and still others will require yearly filing fees to maintain the corporation. Exhibit A has an alphabetical listing of the websites for each state’s office that handles business incorporations.
Summary. A C corporation is attractive because of the limited liability protection it affords. However, administrative and compliance can be large. Lastly, profits of a C corporation are subject to double-taxation unless the owners choose to “zero-out” the profits of the corporation by paying all profits out as W-2 income to its employee(s).
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