The Alphabet of Incorporating

There's a common question you'll confront if you're starting a business or if you have one that's already up and running: "What kind of business structure should I have?"

You can choose from several formats, including a sole proprietorship, a general partnership, a limited partnership, C corporation and S corporation, to do business. I'll limit today's discussion to the latter two. Next week, I'll go into partnerships and sole proprietorships, and I'll finish up in part three with a discussion of limited liability corporations, or LLCs.

I hope this will give you a starting point for an informed discussion with an attorney about the proper structure for your business. Keep in mind that these entities are governed by the laws of the state in which you set up your business. In other words, state laws govern, not federal laws.

A type of corporation you're probably most familiar with is called a C corporation. This is the corporate structure of America's best-known businesses, from McDonald's (MCD) to Microsoft (MSFT).

To establish one, you prepare and file formal articles of incorporation papers with a state agency and pay corporate filing fees and initial taxes. The corporation assumes an independent legal and tax life separate from its owners. It pays taxes at its own corporate tax rate and files its own income tax returns each year. Corporations are owned by shareholders and managed by a board of directors. It doesn't matter whether you're General Electric (GE) or Dick and Marie Johnson, the format is the same. Corporate officers are normally appointed by the board of directors to handle the day-to-day business and usually consist of a president, vice president, secretary and treasurer.

To a great extent, corporations are formed to give owners (shareholders) the benefit of limited liability. This protects personal assets from such things as lawsuits and debts of the corporation. A corporation must behave as a corporation or the Internal Revenue Service could disallow its corporate status. With a corporation, you must have an annual meeting of shareholders and periodic meetings of the board of directors. You must keep minutes of meetings, have formal written records of important discussions made during the lifetime of the corporation and keep a paper trail of all financial dealings between the corporation and its shareholders. A corporation should issue stock to its shareholders and keep adequate capital on hand to handle foreseeable business debts and liabilities.

The difference between a C corporation and an S corporation -- and the reason most small businesses are not C corporations -- is tax status. An S corporation is the most common type of organization for structuring a closely held business, one in which just a few people -- such as family members -- are involved, and there is no intent to have the public own shares. The S corporation is popular is because it provides the same limited liability as a C corporation plus a tax perk known as flow-through tax treatment.

S corporations are taxed like partnerships for federal tax purposes, which means the corporation's income and deductions flow through to the shareholders and are reported on their personal tax returns. C corporations, by contrast, are taxed twice. The C corporation pays tax on its income, then if it distributes a dividend, its shareholders pay a second tax on the same income.

Since this double taxation is avoided with an S corporation, it has become a favorite for small, closely held businesses.

Here are some of the other requirements of an S corporation:

• Individual shareholders must be U.S. citizens or have U.S. residency status. If shares fall into the hands of a foreign national (e.g. by will or divorce), the corporation would lose its S status.

• An S corporation cannot have a partnership or other corporations as shareholders. (Certain types of trusts may qualify, though.)

• There can be no more than 75 shareholders in an S corporation.

• There can be only one class of stock, but some shares can come with voting rights and others without.

• If an S corporation loses its status, it cannot become an S corporation again for five years.

Next week, I will discuss the pros and cons of an LLC compared with C and S corporations. The LLC is becoming even more popular than S corporations for small businesses. Have a great week!

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