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Small Business

 

Insider Secrets about Corporations: Or, Why Should I Incorporate?

The vast majority of people who operate small business or home-based businesses worldwide are sole proprietors or mom-and-pop shop-type partners. Yet leading authorities on small business estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using using a corporation as an essential component of their overall business structure. For generations, the wealthy have learned and benefitted from the insider secrets of using corporations to maximize and accelerate wealthbuilding. You can incorporate yourself, and even if you decide to leave the details to an attorney, it is better to do so armed with this insider information so that you can evaluate the "expert" advice you are given.

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-"Why should I incorporate? I can just do this business as a sole proprietor, right?"
-"Isn't it complicated and expensive to form a corporation?"
-"I run my business with my spouse, and we have a partnership. Why would we need to have a corporation?"

These have to be the most frequently asked questions that I--and my own financial and legal advisors--get from our clients. The vast majority of people who operate small business or home-based business are sole proprietors or mom-and-pop shop-type partners. Yet, leading authorities on small business estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using a corporation as an essential component of their overall business structure.

If this is true, why do so many entrepreneurs elect to operate as sole proprietors and general partners anyway? And why would you be better off incorporating?

The answer to the first question is usually either (1)ignorance of the tremendous risks of operating in this manner or (2) lack of familiarity with corporations and other legal entities and the ease with which they can be established. I should add that if the sole proprietorship is perilous, the partnership is more than twice as bad. This is because in the partnership is by default a general partnership, in which each partner is responsible for all actions of the company, including decisions made by the other partner in which she did not participate. Now that's frightening!

To answer the second question, we must first establish what a corporation is precisely. A corporation is an artificial legal entity that is separate from its owner/shareholders in the eyes of the law. The wealthy have learned that there are at least three major advantages that make the corporation an
essential component of your business structure.

1. Asset Protection.
The single most important benefit of the corporation is protection it affords for your personal assets.

The corporation is created when you file appropriate documents--"Articles of Incorporation" in the United States--to the appropriate state legal authorities. A corporation cannot be formed through some private agreement between the parties who elect to form it. It can only come into being by the state in which it is formed creating it, and it has the rights and obligations established by the laws of that state.

Most important here is the notion of the corporate veil--this is the shield that separates your business assets and activities from the private person and assets of the owner/shareholder(s). Because the corporation is a separate legal person, if you are a consultant or translator, for example--or own a small store--and someone claims that that they have suffered injury from your business (say, from a poor translation or a slip on your wet floor), and files a lawsuit, only the assets of your business are in jeopardy. The claimant cannot touch your personal residence or your automobile if these are owned by you and not your corporation.

There are significant differences among individual states and the degree of protection that they afford to the corporate veil. In California, for instance, there are a number of occasions--too many for comfort--in which the corporate veil has been pierced, thus allowing financial predators to seize the personal assets of an entrepreneur. This is almost never happened in Nevada, making it the state of choice for entrepreneurs seeking asset protection.

We will be devoting a separate article to the Nevada corporation in depth in a future issue of this eNewsletter. It is important to note for now that an additional advantage of the Nevada corporation for many is that Nevada has no state income tax. If you use a Nevada corporation to conduct business in your own home state outside Nevada (such as California, our own home state), you may still be subject to state income tax. Because of the superior asset protection afforded by the Nevada corporation, however, it may still be worth while for you to establish a Nevada corporation. Large numbers of entrepreneurs from other countries as well as other states establish Nevada corporations for precisely this reason.

2. The S Corporation versus the C Corporation: Know Which is Right for You

The issue of the personal service corporation only comes up with respect to the C corporation. The other type of corporation is an S corporation, which, like the limited liability company and the limited partnership is a pass-through entity. That is to say that the corporation is itself not taxed as an entity--instead the net income passes through to the shareholders (such as a husband and wife), and is taxed on the individual tax returns of the shareholders/owners.

There are situations in which establishing an S corporation would be preferable to using a C Corporation. If you have significant income from a job, for example, and you anticipate significant losses in early years and you don't anticipate that your business will earn over $150,000, an S corporation will be your best choice. However, there are limitations on who can be members of an S corporation, and there are limits on employee benefits in an S corporation.

A sophisticated business structure will probably make use of both the C and the S corporation. On the other hand, because of the nature of corporations, you will never want to use either type of corporation to hold real estate. Instead you will want to use a limited liability company or a limited partnership. However, if you are a real estate investor, there might still be room for an S- or C-Corporation in your overall business structure. For example, a corporation could be used to manage your properties held in another entity.

Or--and this is a strategy that could be used for conducting various sorts of business-the corporation could be part of another business entity. For example, if you wish to operate a limited partnership, you will need to have a general partner. But the general partner is responsible for all decisions made and all liability resulting therefrom--the general partner, in short, has unlimited liability. Thus, an intelligent option is to use an S- or C-corporation to be the general partner. This way you have a general partner with the limited liability associated with the corporation.

3. Know How to Manage Your Corporation Properly to Keep the Corporate Veil Intact

Regardless of where you establish your corporation, you will need to make sure that you observe appropriate formalities--otherwise your corporate veil can be pierced very easily, thereby defeating the entire purpose of setting it up. Even if you have an accountant who handles your bookkeeping and tax returns, it remains your responsibility to assure that you are doing this correctly.

This involves holding regular meetings and maintaining minutes in your record book, issuing stock certificates, and other formalities. We recommend that you consult one of the resources recommended on our resources pages for help in doing this (http://www.wealthstrategies202.com/resources.htm).

The Personal Service Corporation

A final issue that may arise, particularly for independent consultants, translators, and other professionals, concerns the "Personal Service Corporation." There are two separate categories of professionals who may be affected by this problem: Those, such as lawyers, accountants, psychologists, and health care professionals, who are required by their state laws to incorporate as professional corporations. These corporations are automatically classified by the IRS as personal service corporations.

In addition, the IRS has broadened the definition of "personal service" to include any work, such as translation or consulting, that is personally rendered by the owner/shareholder. This is of particular concern if you are operating on your own as an individual or as a couple. If 95% or more of your earnings come from work in that personal service activity, the corporation becomes qualified as a personal service corporation.

The reason that this is of concern is that a personal service corporation incorporated as a C corporation is subject to a flat 35 percent tax rate and to a lower ceiling ($150,000) for application of the accumulated earnings tax (normally $250,000). However, this is not an insurmountable obstacle to enjoying the benefits of incorporating:
1. First, the other advantages of incorporating still render the C corporation preferable to operating using another structure, such as the sole proprietor. It may be especially attractive if otherwise a high earning couple might be subject to a higher tax bracket.
2. Secondly, it is possible to structure your activities so that more than 5% of the activity is derived from work that falls outside the scope of personal services rendered by the owner/shareholder. For example, a translator or consultant might have a branch of the business involved in network marketing--as a medical professional might have a health food store or other income producing activity--so that the corporation is no longer qualified as a personal service corporation.

As you can see, the corporation is an extremely valuable tool, one that the wealthy have used extremely effectively. If you are operating as an independent entrepreneur and are not using a corporation or the popular alternative of the limited liability company, you are most likely handicapping yourself, limiting your profitability and paying excessive taxes. With the resources that we have available today, especially over the internet, there is no reason that the average individual cannot easily begin to take advantage of this valuable tool. We currently have 3 entities that we formed ourselves and that cost us just the cost of the various resources that we purchased plus the filing fees required by the State of California and postage to get these set up. And we have made sure to obtain the proper forms through the sources we list on our Resources page so that we can maintain the legality of these entities.

"Can't I wait and start out as a sole proprietor or partner and incorporate later?" we are often asked.

Certainly, if you don't mind exposing all your personal assets to risk, paying higher taxes, and finding yourself more likely to be subject to an IRS audit. Some people prefer to do things the hard way--but, armed with the right information and resources, there's no reason why you should have to.

Even if you decide to allow a tax attorney to help you with the formalities, it is better to do so armed with the knowledge you need to judge whether the recommendations she makes are in fact in your best interest.

At the very least, you'll know enough to head immediately for the nearest exit if any “expert” you consult tells you that you “don't need” to establish a legal entity to run your business.

Copyright 2006 Azur Pacific Associates

 

S Corporations – Filing The Election

Getting a corporation designated as an “S” can be a bit confusing. If you are committed to getting an “S” corporation, here is how you do it.

s corporation election

Getting a corporation designated as an “S” can be a bit confusing. If you are committed to getting an “S” corporation, here is how you do it.

“S” Corporation

The “S” in S corporation refers primarily to a tax designation. While electing to be an S corporation does have legal implications, such as no more than 75 shareholders, the designation really concerns pass through tax issues. Put in layman’s terms, the designation simply means the corporation will “pass through” its taxes to shareholder in proportion to their ownership interests. This allows shareholders to claim profits and losses directly on their taxes and avoid the double taxation of a C corporation.

To become an S corporation, you must file an election with the IRS. Typically, no documentation is require to be filed with any state entity, but make sure to check you particular jurisdiction. Regardless, the filing with the IRS is made using form “2553 – Election by a Small Business Corporation.”

To fill out form 2553, you will need to supply the following information:

1. The name and address of the corporation,

2. The tax year to be covered by the election,

3. The date the corporation first had shareholders or began doing business,

4. The name, address and social security number of EACH shareholder, and

5. The signature of EACH shareholder.

If you have shareholders located around the country, making an “S” election filing can be problematic. Getting everyone to sign off on the document can take time and time is not on your side.

Time Requirements

The IRS puts strict deadlines on filing “S” elections. In technical terms, the election must be filed before the 15th day of the third month of the tax year for which you are electing the status. Ah, the IRS is so poetic.

In laymen’s terms, you should file the election within 75 days of the incorporation. From a practical point of view, I suggest you get the election signed and filed as absolutely soon as possible. You should also file the election through registered mail so you have a little proof if the IRS claims a late filing.

I don’t know why, but the IRS gets cranky when it comes to S elections. If you follow the above steps and get the filing in as soon as possible, you should be okay.

 

Bylaws – The Guts of a Corporation

Most states make forming a corporation relatively painless by providing forms for practically everything. The bylaws of the corporation, however, are an area you don’t want to rely on a form.

corporation, incorporation, corporate bylaws, bylaws, incorporate, shareholders, corporate meetings

Most states make forming a corporation relatively painless by providing forms for practically everything. The bylaws of the corporation, however, are an area you don’t want to rely on a form.

What Are Bylaws?

Bylaws are the technical rules that govern how a corporation will be run. They are a private document for the corporation and are not filed with any government entity. The purpose of the bylaws is to set out how things such as meetings, voting and share transfer will occur with the business.

Provisions

Typically, the bylaws will be the biggest document in your corporate book. If you are a single shareholder entity, they tend to be fairly straightforward since there isn’t really any dispute possibility unless you have a split personality. If there are two or more shareholders, however, the document is going to be a key item because it is going to detail voting rights and so on.

Typically, the bylaws of a corporation will cover the following specific issues:

1. Board of Director Meetings – When, where and how meetings will be conducted.

2. Notice of Meetings – The form, time and how notice must be given to board members.

3. Quorums – Before a board can issue resolutions on corporate business, a certain percentage of board members must be present. This “Quorom” is set out in the bylaws.

4. Annual Meetings – The bylaws typically detail when and where the annual meeting of the entity will occur.

5. Special Meetings - The process by which special board meetings may be called when an issue arises that requires the immediate attention of the board.

6. Voting Rights – Language detailing the voting rights of shareholders and board members in relation to passing or defeating resolutions.

7. Share Transfer Rights – Language detailing share transfer issues such as right of first refusal and so on.

8. Directors – Language detailing how many board members there will be, the length of their term, compensation, etc.

9. Amendment – The process by which the bylaws can be amended to reflect the evolution of the business.

10. Removal – Language detailing when and how a board member can be involuntarily removed.

There are numerous other provisions that can and probably should go into the bylaws of a corporation. Make sure to discuss them with your attorney.




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