Most small businesses begin as a sole proprietorship with a single owner who is fully responsible for its operation and is liable personally for its debts and obligations. Many small businesses in Chicago and elsewhere eventually outgrow the business structure of a sole proprietorship. A popular business structure for small to medium-size companies that have outgrown the sole proprietorship structure is a corporation.
A C corporation refers to a corporation formed under state law that has not elected to be treated as an S corporation for income tax purposes. The letters “c” and “s” refer to the subchapters of the Internal Revenue Code governing tax rules for corporations and shareholders.
The law treats a corporation as a legal entity existing separate and apart from its owners. It can sue or be sued in its own name and pays taxes on the profits it earns.
A business owner in Chicago who wants to incorporate does so through the Illinois secretary of state. Articles of incorporation must be prepared and filed with the secretary of state after reserving a name for the corporation. The primary restriction on the name of a corporation is that it must include one of the following words written out or abbreviated: “corporation,” “incorporation,” “company,” or “limited.”
Corporations are formed and operate under the laws of the state in which they plan to conduct business. A Chicago corporation is a domestic corporation in Illinois where it was created, but if it desires to do business in Minnesota, it must register there as a foreign corporation.
Formation and Tax Consequences of a C Corporation
The IRS treats all corporations newly created under state law as a C corporation for income tax purposes. The corporation files a tax return each year reporting profits it earns. The corporation is responsible for payment of the income taxes on those profits.
People often refer to the tax consequences of a C-corp as akin to double taxation. This happens when a corporation distributes dividends to its shareholders. The owners must declare the dividends on their personal income tax returns. Double taxation occurs because the corporation has paid taxes on the profits it earned, and the shareholders again pay taxes on the same profits distributed to them as dividends.
Many corporations file an election with the IRS for treatment as an S corporation. This allows the corporation to pass profits and losses to the shareholders who become responsible payment of the income taxes. This avoids double taxation, but S corporations must qualify as such by meeting IRS guidelines for eligibility. S corporations that no longer meet the IRS eligibility rules revert to C corporations.