Do Business Well

A corporation is owned by its stockholders. There may be one stockholder holding all the shares, or there may be millions of shareholders holding various amounts of shares. Without going into details that are far beyond the scope of a business this size, I should point out that it is also possible for corporations to sell various classes of shares with various rights and preferences. For the very small business, we can limit our discussion to two types of simple corporations: the regular, or “C” corporation, which is taxed directly by the IRS; and the “Sub S” corporation, where the earnings are passed through to the stockholders, who must pay the tax personally.

Both of these forms limit the financial exposure of the owners to their actual investment and any value in the corporation beyond that investment. This is the single greatest advantage of a corporation. However, the shareholders can lose this protection if they don’t completely separate the affairs of the corporation from their own personal affairs. They must also be certain that the amount of the original investment is clearly adequate to protect the public and the vendors from the likely activities of the corporation.

Let’s examine these two concepts in reverse order. When a state grants one or more individuals the privilege of opening a corporation, it is only willing to shield the individual owners from personal liability in return for an expectation that the corporation will be able to adequately cover that exposure by itself.

Take, for instance, a company with an investment by the owners of five hundred dollars that incorporates to manufacture a new drug. It is unlikely that the owners could shield their personal assets from a future lawsuit. Someone who is harmed as a result of taking the drug would very likely be able to “pierce the corporate shield,” and make a claim against the individual shareholders. This is because they have inadequately “capitalized” the business for its business purpose.

For most very small businesses, an initial investment of between five to a hundred thousand dollars would show the proper intent to adequately capitalize the firm.

The second problem is with intermingling of assets or affairs. It is perfectly legal for a sole proprietorship or partnership to run its business out of the owner’s personal checkbook, and for the owner to use personal and business assets interchangeably (as long as the percentage of use is shown for tax purposes). In the case of a corporation it is critical that the business have a separate checking account and treat all aspects of that corporation as distinct from the owner’s personal activities.

The owner must account for any financial transaction between himself and the corporation, including payment, loans, or sales of assets from one to the other. The corporation must be seen in all ways to be a separate and distinct entity from the owner. If not, there is the potential for creditors or judgment holders to “pierce the corporate veil” (show that no real separate entity existed) and go after the shareholders‘ personal assets.

Taxing authorities will also have problems with mingled accounts and assets. By failing to clearly distinguish between those things that are owned personally and those that are owned by the corporation, management risks losing depreciation allowances and other tax advantages.

Raising cash is another major advantage of the corporation. Through the sale of shares, the corporation can raise capital from outsiders at any time. Each time the company sells additional shares, the current shareholders lose a percentage of their ownership. This is referred to as dilution. However, it is not uncommon for the remaining percentage to be worth more than the larger undiluted share. This would be because of the additional capital that was raised by the sale of stock.

It isn’t possible just to sell stock in a corporation any way you see fit. There are many rules as to how to proceed. The states are the only entity that have the right to grant corporate status. Therefore, each state establishes its own rules concerning how the corporation is formed and what procedures must be followed to sell stock.

Corporations may also borrow money from institutions or individuals. Very small businesses usually document these borrowings in the same way that individuals would. They use a standard loan agreement. For larger companies or amounts, the corporation can issue bonds. As with stocks, these securities can only be issued according to rules established by the state in which the company is incorporated or in which the corporation wishes to sell the bonds.

If your business becomes successful, you’ll undoubtedly be looking for ways to deprive Uncle Sam and other taxing entities of as much of your money as you can legally achieve. The corporation is the easy winner in this department.

Later sections will detail some of the more complicated profit-sharing, pension, and retirement plans. Many of these are available only to corporations.

In regular “C” corporations, the company, not the individual, pays taxes on its earnings. If the corporate tax rate is lower than the rate the owners would have had to pay, the owners are able to shield themselves from taxation. The business may “retain” earnings up to a point that the taxing authority believes reasonable for that type of enterprise. If the company keeps holding these tax-sheltered earnings beyond this “reasonable” level, the government will treat any additional earnings as if they had been distributed to the shareholders. The corporation must then pay taxes on these amounts.

This is where the double taxation of the “C” corporation comes in. Whether the earnings are actually distributed (in the form of dividends) to the shareholders or deemed to be distributed, the shareholders must now pay taxes on this income. The corporation pays tax on the income. Now the owners are taxed on what is left.

It may seem as though this would never be a good idea. However, there are ways to avoid this double taxation. The working owners may pay themselves a “reasonable” salary and bonus. This is deductible to the corporation. You may be able to take all or almost all the profits of the “C” corporation as salary. It may be more than you think you are worth and still be seen as reasonable.

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