This is a guest post by Shannon Nash, Esq., CPA at Register Lett, LLP (snash@registerlett.com) and an excerpt from her Small Business Guide.

The C Corporation is the time-honored business entity and is  perhaps the most well-known of all business entities. You see the terms used for this entity everywhere; such as ‘corp.,’ ‘corporation,” or ‘Inc.’ In the past, it was a surefire way to let the world know that you were a legitimate business. A C Corporation is a formal business entity that is created under a specific state statute or law.

To legally start your business, articles of incorporation must be filed with your appropriate state office (in many cases, it is the office of the Secretary of State or State Corporation Commissioner), along with a small filing fee. These articles of incorporation contain very basic information about your business; such as, the name of the corporation, name of the incorporators (many states require at least three people), purposes of the corporation, addresses, and a person who can serve as a registered agent for the company and whom the state may contact in formal proceedings (many people use a registered agent company to serve this role).

In this age of technology, most states have step-by-step information and examples on how to incorporate within their borders on its Secretary of State, or similar state agency, website. Moreover, there are companies that can incorporate your business for the low price of something that ends with 99 cents. You should start with the Small Business Administration’s website (http://www.sba.gov), then search for the Secretary of State, or similar office in your state, for more information.

Keep in mind a sole proprietorship may be considered your alter ego, but a corporation is treated as a legal entity; separate and distinct from its owner(s). A corporation is a more formal type of business entity, with various forms that must be filed, and many more people involved in the day-to-day operations and decisions of the business.

There are three primary players to consider if you want your side business to be a corporation: the corporation itself, the shareholders, and the board of directors.

• Corporation – As mentioned earlier, the corporation is required to comply with various state law provisions for annual meetings, state law filings, and other business licenses and fees.
• Shareholder — You, as the owner of the corporation, are known as the shareholder and you must decide if there will be other owners in addition to yourself. Your ownership in the corporation is evidenced by stock certificates that indicate the portion of the company actually owned by you and each of the other owners.
• Board of Directors — The Board of Directors is responsible for policy-making and governance over the business. The shareholders select and appoint the board of directors, who in turn select and hire the management and staff. In reality, especially in a small business, the owner will normally function to some degree as the shareholder, director, manager and staff.

With all of these formalities, why choose a corporation as your business entity? One of the major reasons for becoming a corporation is limiting your liability. As a corporation, the shareholder’s liability for business debts is limited to the amount he or she has invested in the business. As a shareholder, your personal assets will not be at risk. It is your investment in the corporation that may be lost. Keep in mind, however, that if you also work for your business (as is the case with most small businesses), you will still be liable for your own acts of negligence or malpractice. This liability cannot be waived, and that is why professional liability insurance exists. However, your personal assets may be protected from negligence and malpractice caused by other employees and owners of the business.

The corporation is called a “C corporation” (or regular corporation), because the tax laws that cover this area can be found in Subchapter C of the Internal Revenue Code. Under these laws, C Corporations are subject to a concept known as double taxation. This means that the corporation itself pays income taxes on its tax return (known as “at the entity level”), and the shareholders also pay taxes on their tax return when they receive a dividend (i.e., money that reflects a return on your investment). The corporation does not get a deduction on its tax return when the dividend is paid out to you. This means the dividend is subject to “double taxation:” The corporation paid a tax on this money with no deduction, and you pay a tax on your tax return when the money is received.

In many cases, C corporations are taxed at a lower rate than sole proprietorships. But when a shareholder takes money out of the corporation for personal reasons (i.e., a dividend), there could be double taxation; negating any tax advantage from the lower tax rates.  Keep in mind, money that you take out for your salary as an employee of the business (such monies that are subject to employment taxes, such as, FICA, Medicare, unemployment taxes, etc.) are not subject to this double taxation.  Instead, its the money you take out in return for being a shareholder/owner of the company (i.e., the return on your investment). Practically speaking, many small corporations avoid double taxation altogether by paying out most of the corporation’s net profits for business expenses (including to salaries to shareholders), and keeping any amount left over as retained earnings.

Most large companies are set up as C Corporations. If you are planning to have your small business lead to an Initial Public Offering (IPO) and trading on a stock exchange, you should strongly consider starting your business as a C Corporation. Why? Because it’s easier to sell interests, or stock, to investors based on federal securities laws. Practically speaking, it is nearly impossible to sell your interests in pass-through entities like limited liability companies. These interests aren’t freely transferable (meaning, you have to get approval from the owners before you transfer them; which is not a requirement with stock in a C corporation.)

Tax Forms and Publications: For more on corporations, see IRS Publication 542, Corporations. Corporations report income and losses on Form 1120 US Corporate Income Tax Return. Also, each shareholder is given a Form 1099-DIV, Dividend Income to report any dividends.