Consider tax issues when you choose a corporate structure

by John McCormick | Aug 31, 2000 7:00:00 AM

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Takeaway: Incorporation may be the smartest business structure for small consultancies, especially for the advantages it offers, but different types of corporations present different tax problems. Be sure you know all the fine print before you sign the papers.

There are two kinds of corporations that concern consultants—C and S corporations. Microsoft is a C corporation, as are Ford, General Motors, and Wal-Mart. Because so many giant companies are C corporations, many people think a C corporation is so complex and expensive to operate that it's only useful for those giant companies or those that want to be listed on a stock exchange.

This simply isn't true. Because the rules governing corporations are so cut-and-dry, it can easily cost more in attorney fees to form a limited partnership or one of the new limited liability companies. However, it’s important to understand how C and S corporations differ, especially in terms of how they’re taxed.

There are a number of advantages to incorporating your business even if it's a small shop or a one-person operation. In addition to discussing C and S corporations, I’ll also focus on one specific advantage of a corporation—liability.
In his Financial IQ columns, John McCormick has discussed the numerous choices consultants must make when forming a business—including proprietorships and partnerships, limited partnerships and LLCs, and corporations.
How C and S corporations differ
The biggest difference between C and S corporations is the way they’re taxed by the Internal Revenue Service.

A C corporation files a tax return and pays the tax on its profits. If the corporation then distributes its earnings to its shareholders, the shareholders take that amount into their personal income as dividends, creating a double taxation. Because the C corporation will have to file a separate set of tax returns even if a single person actually owns the corporation, there will be twice the paperwork. It's true that if you want to "go public" (that is, issue stock and sell it to the public), you need a C corporate structure. But you don't need to sell or distribute all the stock your state corporation office will issue when you form a corporation.

With an S corporation, at the end of each fiscal year, its total net earnings are prorated to each shareholder on the basis of their equity interests, and these earnings are incorporated into their individual income tax returns. This eliminates the threat of double taxation that can come with owning shares in a C corporation. But it also means that the individual shareholders have much more complex tax returns.

Another drawback of S corporations is that they can have no more than 35 individual shareholders and no non-resident alien shareholders. Many CPAs I know cite the looser "feel" of an S corporation as being dangerous in itself. People tend to forget that it's still a corporation and let some details slide much more often than with a C corporation.
C corporation: A business that is a completely separate entity from its owners, unlike a partnership.
S corporation: A form of corporation, allowed by the Internal Revenue Service for most companies with 35 or fewer shareholders, enabling the company to enjoy the benefits of incorporation but be taxed as if it were a partnership.
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A corporate structure protects employees, but requires care
While there are tax issues to ponder when forming a corporation, there are also many advantages you can enjoy once you incorporate. One valuable advantage relates to liability. With a few exceptions involving criminal activities, fraud, and so forth, no stockholder of a corporation is ever legally liable for anything the corporation does, not even the officers. Although they’re often thought of by themselves and others as the owners, anyone who owns part of a corporation—whether it's Ford Motors or a one-person consulting business—is a stockholder. He or she may also be an officer of the corporation, but officers aren't necessarily owners.

Although a corporation protects your assets, you can lose this protection if you don't keep your corporation alive and healthy. The easiest way to remember this is to recall that a corporation is a separate entity under the law, and you must feed it and give it exercise and proper care to keep it alive.

It’s paramount to learn and follow your state's department of corporations’ rules and regulations. This will vary from state to state, but in every case you must hold formal meetings of the board of directors, have well-drafted and legal corporate bylaws, maintain minutes of meetings, formally document leases between corporate owners and the corporation, and charge interest when the corporation loans money to anyone—including the corporation's owners.

But these need not always be onerous. A great potential perk is the requirement that you hold regular meetings of the board of directors and annual stockholder meetings. Most of the expenses involved in both of these are deductible and, as far as I know, there's no legal requirement in any state that these meetings be held at the corporate headquarters. If there were, then Delaware—where many corporations are formed—would be one of the biggest convention sites in the world, instead of Las Vegas.

That brings up another point I’ll explain in detail in another column. Just because you reside and do business in one state doesn't mean that you must or even should form your corporation in the same state. You can shop around for the best location to incorporate.
When you formed your consulting business, did you choose incorporation, limited partnership, or some other business structure? Has it worked to your advantage, or are you considering a restructure? Post a comment or send us a note.

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LLC still looks better to me...jpenn  | 09/13/00