Most small businesses begin as either a sole proprietorship, where there is one owner, or as a partnership with two or more owners. As the business grows, both proprietorships and partnerships will eventually need to consider the advantages offered by forming a corporation.
Corporations, although subject to any number of federal laws and regulations, are organized (“chartered”) according to the laws of a state or the District of Columbia. Thus, many national corporations are chartered in the State of Delaware because of its “business-friendly” legal climate and taxation laws. Many businesses will, however, elect to incorporate under the laws of their home state. As an example, a landscaping company based in the city of Chicago would incorporate in Illinois even if it did a substantial amount of work in Wisconsin or Indiana.
Once a business has decided to consider incorporation, it must then consider what form of incorporation best suits its needs and the needs of its owners. When considering the type of corporation to form, it is best to think about how that corporation will be organized and how its earnings will be treated for taxation purposes.
This type of corporation is formed when the stock of a company will be sold to individual investors, or “stockholders,” who will have no direct involvement in the day-to-day business operations of the corporation. The stockholders will, however, be able to vote on matters of common interest such as the business’ board of directors and upper-level management. The earnings of C Corporations are “taxed twice,” meaning that the corporation pays a tax on its income, and any profits that it shares with its stockholders in the form of dividends are taxed again as ordinary income according to the stockholder’s income tax bracket.
S Corporations are entities where the stock of a business is issued to a small group of shareholders who are usually involved in the business’ day-to-day operations. Although there are a number of legal restrictions that are placed on S Corporations, this form of incorporation is usually selected by family owned businesses or those owned by a small group of private investors. The earnings of S Corporations are “passed through” to the stockholders as ordinary income and are not taxed at the corporate level but rather at the individual’s tax rate.
Limited Liability Company (LLC)
Limited Liability Companies combine the advantages of partnerships with those of S Corporations in that when the partners incorporate their personal liability for the corporation’s affairs is limited to their personal involvement and investment. Earnings of a Limited Liability Corporation are also “passed through” and are not subject to a corporate income tax.
The type of corporation selected will also depend on other factors that are unique to each state. As an example, the State of Illinois has numerous regulations involving state taxation payments, annual reports of business activities, and proof of compliance with local business licensing and zoning regulations before it will issue a charter of incorporation. Since these and other such regulations can be quite complex, it is always advisable to consult an experienced corporation attorney at every stage of the incorporation process in order to protect the interests of the owners and stockholders.