Corporate Entities in California
The Corporation is the most popular type of business entity in California and the United States. There many different kinds of corporations, including a close corporation, a professional Corporation, a nonprofit corporation, and the general business Corporation. California recognizes all of these types of corporations. The S-Corporation (explained in more further detail below) is an election with the IRS, and does not involve the Secretary of State of California.
A corporation, like a limited liability company, and like a limited partnership, is a manufacturer of the state legislature, it is a legal fiction. That said, there are many existing laws which govern the operation and management of the corporation, including how shareholders must be notified, compensated, how the transfer of ownership interest proceeds, how the corporation is governed by officers and directors, and the proper procedures for shareholder lawsuits. To form a corporate entity certain documents need to be filed with the Secretary of State.
Corporation, Directors & Shareholders
Information about the corporation, its directors & shareholders.
The authority to make decisions in a corporation is vested with the board of directors. The members of the Board of Directors are led by the chairman of the board. This is a corporation’s “centralized management”which is often complex. The members of the board of directors are elected by the shareholders. The directors appoint officers of the company who are vested with certain rights and responsibilities. Essentially the officers run the company and the directors oversee them. Shareholders may also be directors. Shareholders may also be officers of the company. Shareholders are free to recruit other independent persons to serve in those roles as well.
With some limitations, the corporate form allows for the limitation of the director’s personal liability. If the director breaches his duties to the corporation or its shareholders and action in court may be brought in the name of the corporation against the director. There are ways to protect all assets of the director, but the scope of protection determined by state law. The limitations to this obviously include intentional conduct, bad faith, improper transactions, personal benefit, and reckless disregard for the health of the corporation; in those cases the directors are almost always liable for their actions.
San Diego Corporation Attorney providing information about the California Corporation. For more information, please feel free to call me at (619) 800-0676.
Limited Liability of Shareholders
Information about the limited liability of the shareholders.
There were certain corporate formalities which must be adhered to in order for the corporate form to survive the “piercing the corporate veil.” This means that a statement of information must be filed every year, minutes must be taken religiously at every meeting, and all taxes must be paid. If the corporation is in order to shareholders are not generally liable for the debts and obligations of the company. Often individuals who are both shareholders and officers of the company are more at risk of being liable, however if the corporate form survives they will not be held liable. This means that even if they participate in managing the company as officers or directors and even if they are shareholders they enjoyed that limited liability.
Advantages of the Corporate Form
First and most obvious advantage of a Corporation is the limited liability that the shareholders enjoy. The shareholders themselves are not personally liable for the debts and obligations of the company. The only risk that the shareholders put forth other investments. Usually if it is a start up operation this doesn’t matter because banks require personal guarantees to obligate payment for things like building leases, lines of credit or if it is a distributor, the credit with the supplier.
Corporations are great for raising capital. The Board of Directors authorizes sharers, and it is easy for the company to sell shares of stock, in comparison with a sale of partnership interests. However there are situations where federal and state securities laws are applicable in the transfer of stock.
Majority shareholders for the most part enjoy the ability to control management of the company. In certain states voting rights statutorily mandated by the majority of shareholders who can elect the members of the Board of Directors, and other states like California the process involves a cumulative voting process which assures that minority shareholders have representations as to members of the Board of Directors. The majority of shares control the board in either case. Technically shareholders do not participate in the management of the corporation. In essence, the majority shareholders choose the management team. There are ways in which the original founders can retain control. For instance investors can be issued preferred shares of a non-voting class.
Disadvantages of the Corporate Form
The biggest disadvantage of incorporation, aside from the cost to create it, is that meticulous records must be kept. Corporate formalities are procedurally complex and must be adhered to. Directors must have meetings here at shareholders must have meetings. Minutes must be recorded at all meetings, and notice of the meeting must be given to all or else notice must be properly waived. Startup companies find it difficult to run a corporation because there are many corporate formalities. Partnerships and limited liability companies offer easier way to run a company.
What is a “Close” Corporation?
A close corporation is one with a limited number of shareholders, subject to certain restrictions regarding the transferability of interests. Close corporations are statutory, meaning they are a type created by the legislature, and tend to eliminate the procedural formalities which most corporations must adhere to. They are only available in certain states. To qualify as a statutory close corporation a particularly detailed shareholders agreement must be drafted which can be quite costly. Shareholders are permitted to do in less the way of the formalities but they run the risk of personal liability by acting as an officer or director, and there since there may be potential uncertainties in the interpretation of the shareholders agreement, it is important to draft a really lengthy agreement, and the drafting of the actual agreement could be quite costly compared to utilizing other business forms. San Diego Corporation Attorney providing information about close corporations and explaining what they exactly are.
How are Corporations Taxed?
C-Corporations by default are automatically taxed as separate entities. The income of the company is taxable both at the state level and at the federal level; this is referred to in Sub-chapter C of the Internal Revenue Code as the taxation of a C-Corporation. To calculate a companies taxable income the corporation conducts ordinary and necessary from the toll revenue generated. Even payments to shareholders are included in the calculation and that amount is not dockable to the corporation. This means that the funds that taxed again when they are distributed to shareholders. This is called corporate double taxation. That is, the earnings of incorporation are taxed at the corporate level, and then those same earnings are taxed again at the shareholder level after distributions of dividends. Shareholders are often carefully and reasonably compensated as employees which is deductible by the corporation.
S-Corporations are taxed differently. Any corporation or limited liability company can elect with the IRS to be treated as an S-Corporation. This will allow the company to be taxed just as a partnership. It is a flow through taxation. The taxes of the company are reported on the individual shareholders income tax returns. Each shareholder is allocated a taxable section of the company based on their total percentage ownership of the company’s stock. All losses are absorbed by the shareholders, offsetting their other income. Note that this is subject to passive loss limitations, IRS code section 469. Generally, an individual’s material participation in the business which generates any salary, wage, or income is prohibited by rule 469 from being offset by passive losses. Read more about the S-Corporation below.
Advantages of Corporate Taxation
From a tax perspective corporate taxation is often a good thing compared to sole proprietorships, and partnerships. A portion of earnings can be retained by the corporation taxed at approximately 15% and the remainder can be drawn as a reasonable salary. This of course depends on the other income of the individual. If the individual has high income from other sources it may make sense to leave the earnings in the corporation; this would make sense so long as accumulated earnings do not reach the maximum threshold. A corporation can also create a deferred compensation plan, enroll in group term life insurance, or death test plans in order to take advantage of those tax breaks.
Losses in a corporation is subject to the passive loss limitation. This means that if 50% of the the corporation is owned by less than five individuals, passive loss limitations apply. With five or fewer stockholders the ability to offset passive losses against business income is possible, so long as you are not operating as a personal service Corporation. Sometimes the owners of the company profits from other passive businesses; in this case a partnership could be the way to go because losses could be used to offset that passive income.
Disadvantages of Corporate Taxation
The biggest disadvantage to operating as a corporation is that double taxation exists. Also there is a tax imposed upon the sale of incorporation. Double taxation does not apply for the most part two small corporations because there are no earnings beyond what is taken out as a salary, bonus or benefit. Double taxation actually rarely takes place at the corporation is very small. However the other major disadvantage to running your company as a corporation is that the liquidation of the corporation is actually taxable to the shareholders themselves. If the company merges or consolidates the shareholders may also be on the hook for paying the tax of the realization event. Sometimes corporations are just big personal holding companies; they must distribute earnings and they cannot merely issue preferred stock, or else they may run afoul of sections within the Internal Revenue Code.
From a tax perspective the S-Corporation optimally combines the two aspects of a corporation and a partnership. With the Secretary of State of California a corporation is always just a corporation. The S-Corporation characterization is actually an election with the IRS. The S-Corporation status is available in certain situations where the number of shareholders does not exceed a finite number. Usually corporations are taxed twice, once at the corporate level and then again when distributions are made to shareholders. When a company elects with the IRS to be treated as an S-Corporation in avoidance of double taxation. An S-Corporation is a flow-through structure, resulting in zero tax at the corporate level. Please speak to your business attorney who will work with your CPA to accomplish an S-Corporation election.
How to Qualify for the S-Corporation?
The IRS has particular rules regarding a companies ability to elect to be treated as an S-Corporation. First these bits of corporations cannot have more than 75 stockholders. Second, each shareholder must be an individual, or a particular type of trust. Third the shareholder must be a US citizen or resident alien. The corporation electing for S-Corporation status must be a corporation in the United States of America. S-Corporation may not be used for banking purposes. Only one class of stock is permitted an S-Corporation.
Advantages of S-Corporation Taxation
San Diego S-Corporation Lawyer Association for you providing information about S-Corporation and the California corporation and the advantages and electing S-corp status with the IRS.
Usually in the early years of the company when losses are expected, the S-Corporation status is a good route to take. In contrast to family partnerships, where there aren’t many operational, legal, and procedural formalities to hereby, the S-Corporation is simple. All the losses experienced by the company can be utilized by shareholders in the S-Corporation to offset their other income. Of course this is subject to a passive loss limitation. Some losses may be imposed on inactive members.
Disdvantages of S-Corporation Taxation
What about the S-Corporation and the California corporation and the disadvantages of electing S-corp status with the IRS.
The S-Corporation certain advantages but transferring ownership is limited. In certain situations distributions to shareholders usually result in the recognition of gain, whereas a similar distribution to partners in partnership might not actually be a taxable event. Also tax deductions for benefits are limited. This means that for things like disability retirement benefits, premiums on life insurance, reimbursements for medical care, and cafeteria plans, if they are paid to a stockholder holding more than 2% interest in the Corporation, they cannot be deducted by the Corporation. Perhaps the most obvious disadvantage is that an S-Corporation’s income is taxed at the shareholder level regardless of whether the company actually distributes any funds for shareholders to pay those taxes.
Feel free to call 619-800-0676 or e-mail attorney to schedule an initial consultation with a business lawyer to discuss your interest in forming a California corporation or to make the S-Corporation election.
Article and Video By Attorney Christopher Canton