There are many benefits to forming a corporation, although not as many as was previously the case. For example, providing employee benefits, within certain limits, may be better with a corporation than with a sole proprietorship. A major benefit, and the reason most people form a corporation, is to create a corporate shield to protect their personal assets against debts incurred in the course of operating their business. It is also preferred over formation of a partnership when two or more people will go into business together.
However, to enjoy the protection of the corporate shield, it is necessary to understand the distinction between “I’m incorporating” and “I’m forming a corporation”. If you view “I’m incorporating” as meaning that you and the corporation operate as the same person, that is, the corporation is your alter ego, then you’ll probably loose the protection of the corporate shield and become personally liable for the debts of your business. But when you “form a corporation”, you are, in fact, creating a legal person, the corporation, which is entirely separate from you. Your ownership interest in the corporation is that of a shareholder.
This new person, the corporation, enjoys all the legal benefits of a person but is unable to do anything except through others. Those “others” are the officers and directors of the corporation. If the corporation is maintained as a separate entity, you can be protected from personal liability in most instances by the corporate shield.
There are some drawbacks to forming a corporation. As we have indicated, a corporation is a legal person. It has its own Federal Employer Identification Number; its own state sales tax number (if it’s in the business of selling taxable goods or services); and in Texas it has to annually pay franchise taxes based upon its capitalization or income, and have its own income tax filing. As you can see, your paperwork will increase significantly, but that, too, is necessary.
A corporate structure is made up of:
The shareholders, whether one or more, are the owners of the corporation. Their duties to the corporation are to elect the board of directors, and to share corporate profits in the form of dividends (but only if dividends are voted by the directors). Dividends, if any, are distributed in proportion to the shares held by the shareholders. Since dividends are paid by the corporation with after-tax dollars, and dividends are treated as income to the shareholders, there is a double tax-bite; another drawback. There are ways around that, however… Frequently the corporation will apply to the IRS to be classified as a “Subchapter S” corporation. That allows corporate profits to be distributed directly to the shareholders as if the corporation was a partnership. Distribution is proportional to shares owned. However, if the corporation needs to retain profits for future business use, the shareholders still have to pay taxes on the profits they would have received, even though they may not have received anything.
The directors are elected by the shareholders, and are directly responsible to the shareholders. These directors appoint the corporate officers for the coming year. The directors are also responsible for making major decisions concerning corporate direction, that is, the decisions that are outside of the ordinary, day-to-day operating decisions. Directors decide whether dividends, bonuses, or other distribution of corporate funds will be paid.
The officers are responsible to the directors for the corporation, and ultimately the shareholders. They look after the good order of business in day-to-day operations. If extraordinary actions are required, such as a major capital investment, the directors must make that decision which the officers then implement.
The elections of the directors are noted in the minutes of annual meeting of shareholders. The annual meeting of directors are also recorded in minutes, along with the appointment of officers. Any extraordinary actions
taken by the directors are also noted in the minutes of a special meeting of the directors.
A corporation raises capital by the sale of its shares, so shareholders have an equity ownership in the corporation. A corporation, in Texas, cannot start to do business unless it has raised the equivalent of $1,000.00 in cash, goods or services. When a sole proprietor forms a corporation to continue their business, they usually sell their business assets to the corporation for shares. If the tangible business assets have been
depreciated, and are sold to the corporation for more than book value, the proprietor will realize a taxable capital gain on the sale. Of course the basis of the shares will also substantially increase, which will reduce the capital gain upon subsequent sale or distribution. When a sole proprietor forms a corporation, they may wear all three hats; shareholder, director and officer. It’s a bit confusing. But if you fail to recognize the distinctions, and blur the lines of duty and responsibility, the courts may determine that the corporation is a sham to hide a sole proprietorship, that it is the proprietor’s alter ego, and take away the corporate shield.
When a corporation is formed, trade creditors have to be notified about the change in business entity. Bank accounts need to be changed over to the corporation. Your bank can provide a form, referred to as a Bank Resolution, to memorialize the changeover and to register the approval of the directors
in opening a corporate bank account.
The actual mechanics of forming a corporation are quite straightforward; the Articles of Incorporation are drawn up, and filed with the Secretary of State along with a filing fee. Once the Articles are properly filed, the Secretary of State will issue the Corporate Charter and the corporation will have come into being. The corporate seal, share certificates, stock ledger, and minute book are purchased items.
A CPA will frequently offer to “incorporate you” for a nominal charge or no charge, plus filing fees, and may even order the corporate seal and minute book for you. That is, they will take care of the mechanics of forming a corporation. But that’s usually where it ends. In most instances there are many other steps required, which the CPA may not be aware of or be prohibited from doing, in order to build the corporate shield and give the corporation substance.
A business lawyer, on the other hand, will usually charge at least $1,500.00, which should include the articles of incorporation, filing fees, bylaws, seal and book, publication of notice to creditors, organizational minutes, and original issue of shares with purchase and sale documents between the proprietor and the corporation. The lawyer also looks for particular snags that could affect the protection of the corporate shield. Once you have formed a corporation and that shield is built, it will be up to you, in your various capacities within the corporation, to maintain it.