Corporation: Legal Attributes

A corporation is a standard legal entity type that is commonly utilized by businesses looking to foster shareholder investing by providing the haven of limited liability.  Generally, corporations are considered separate entities from their owners, who take on the role as shareholders of the corporation. Indeed, this favorable structure results in limiting the liability of shareholders strictly to the extent of their investments (i.e., Corporate Veil).  Corporations are governed by the California General Corporation Law under the California Corporations Code, Title 1.  It should be noted that corporate shares can be issued to shareholders only in return for money, property, past services, or cancelled debts/securities.

Corporation: Formalities

The formalities required to incorporate consist of filing the Articles of Incorporation with the Secretary of State, drafting Bylaws (optional but mandatory if forming a professional corporation or registering stock), holding an initial organization meeting, selecting board directors and officers, issuing shares, holding annual shareholder meetings, and maintaining minutes (documenting the meeting) for officially called meetings and board resolutions.  Notably, a statement of information must be filed within 90 days of incorporation and must be filed annually[1] thereafter (Form SI-550: Fee $25; Penalty for late filing: $250). With respect to stock issuance, a state and federal securities offering notice is typically required. Any failure to comply with the corporate formalities can result in non-recognition of the corporate entity, potentially resulting in personal liability.

Corporation: Formation Start Up Cost

The initial CA state-filing fee for the Articles of Incorporation lists at $100. For service of process, an agent must be designated that is either an individual who resides in California or a California registered corporate agent. Please use the following Comparison Chart for side by side comparison.

Corporation: Tax Attributes

Since a corporation is treated as a separate entity apart from its shareholders, a corporation is subject to double taxation; that is, corporate income is first taxed at the entity level and again when it is distributed to the shareholders.  In California, a corporation would be subject to state and federal taxation at the entity level which if subsequently distributed to shareholders would again be subject to state and federal taxation at the shareholder level–hence, double taxation.  Notably, a corporation can retain earnings instead of distributing to shareholders; effectively avoiding paying the second layer of tax on shareholder distributions.  However, for retained earnings exceeding $250,000, the IRS will closely scrutinize the corporation to determine whether there is a legitimate business purpose for the retained earnings (e.g., saving to purchase a new manufacturing plant).  In light of the fact that the burden of proof is on the corporation to show why the excess retained earnings are necessary, it would be prudent to hold a valid board meeting with respect to the necessity of the retained earnings.

At the federal level, the corporate tax rate structure ranges from a flat 15% for profits under $50,000 to a flat 34% tax rate on profits ranging from $355,000 to $10,000,000, and gradually increases to a flat rate of 35% on incomes above $18,333,333.

At the state level, California corporations are subject to 8.84% tax on income. There is one important caveat, however: after the first year of business, the corporation is subject to a minimum $800 tax (franchise tax fee) regardless of whether the corporation produced any income.

Notably, the corporate entity profits and shareholder distributions that are not attributable to employment salary are exempt from employment tax.  At a rate of 15.3%, employment tax is a serious consideration for every California business entity; a detailed discussion of employment tax will be provided in the subsequent entity sections.

Moreover, with respect to the second level of the double taxation, if any of these profits are then distributed as dividends to the shareholders, those shareholders must report the personal distributions and pay taxes using their ordinary income tax rates (again, effectively subjecting the distributions to state and federal taxes).  For qualified dividends, however, long-term capital gains rates are used to calculate the shareholders’ federal tax liability.  This rate may be 0% for shareholders in the 10% to 15% federal income brackets, 15% for shareholders in 25% to 35% brackets, and 20% for shareholders in the top federal income tax bracket of 39.6%.

In light of the double taxation arrangement, it is no surprise that most readers may be feeling rather reluctant in considering a traditional corporation (“C-corporation”).  Fear not, for subchapter “S” of the Internal Revenue Code (“IRC”) is with us.  The election under subchapter “S” provides for pass-through of profits to shareholders, effectively avoiding federal corporate tax at the entity level.  Of course, to qualify, the corporation must meet certain requirements which are discussed in the segment on the S-corporation.

It should be noted however, with respect to startups that plan on pursuing venture capital funds, the C-corporation may be the ideal form. The reason being, most venture capitalist are of the opinion that investing in an S-corporation or LLC puts them at a disadvantage. And rightfully so; there are complex tax implications for venture capitalist with respect to both the S-corporation and LLC form. Briefly speaking, the S-corporation has strict requirements as to the number and identity of shareholders (i.e., limited to 100 shareholders; all must be U.S. citizen and natural persons); VC’s cannot hold preferred stock in an S-corporation; and transferring the partnership interest of an LLC becomes problematic. Lastly, only a C-corporation can take advantage of sections 1202 and 1045 of the IRC which venture capital investors use to move money from one business venture (qualified small business stock defined by IRC as C-corporation) to the next without having to pay tax on appreciation in their initial investment. In practice, this gives a founder-investor tax deferment on the gain they realize so long as it is rolled over.

For those entrepreneurs who will ultimately pursue venture capital funds but are torn over using a C-corporation because of the double taxation hitch, here’s some real-world advice. An income generating startup that forms as a C-corporation can avoid the first layer of entity tax by using salaries to offset corporate income; effectively resulting in a single layer of tax similar to an S-corporation. Problem solved. Accordingly, contrary to the negative view associated with forming as a C-corporation, with proper planning, this entity is often the ideal vehicle for startups seeking capital venture funds.

Please use the following Entity Selection Tax Cheat Sheet to predict your tax liability.

[1] Although the initial statement of information filing must be physically mailed, the annual filing can be filed online.