A corporation is a type of business entity that is owned by certain shareholders but acts as its own legal entity. In other words, a corporation is its own business, it files taxes, it can file suit, it can own property, but it is owned by certain owners called shareholders. These shareholders own stock in the corporation and appoint certain directors and officers to run the company. The primary advantage the corporation provides is that it shields the shareholders from liability the business may have.
Example of How a Corporation Works
Robert, Nathan, and Carol decide they want to open a business in Clarksville selling delicious hot chicken. They plan to open three restaurants in the area and expand rapidly to the surrounding cities. The three believe that due to the quick expansion of the company and the scale of the business that a corporate entity works best. They hire a business lawyer and he prepares the necessary paperwork to start the corporation. At the start of the corporation, Robert, Nathan, and Carol are all issued shares of stock. These shares of stock represent their ownership in the corporation. Robert issued 500 shares, Nathan gets 300, and Carol receives 200. They elect Robert as president and Nathan as secretary.
Soon after the company starts it runs into some issues with a customer who says she slip and fell inside the Clarksville restaurant because the floor was wet. The customer files suit against the corporation for this accident. Fortunately, the assets of Robert, Nathan, and Carol are protected because they are hidden behind the liability shield that the corporation provides. The customer cannot get to their personal assets.
At tax time, the company must prepare a tax return. Depending on how the corporation was set up, the company may owe taxes itself or all taxes will be owed by the shareholders themselves. If the business was incorporated as a Chapter C Corporation, the business will have to pay its own taxes and the shareholders will pay personal tax on any distribution received from the corporation. If the business was incorporated as a Chapter S Corporation, the business would not pay any taxes itself and all tax responsibility would rest with the shareholders. They would pay taxes on the income the business receives at their personal income tax rate.
Chapter C Corporations
So what is a Chapter C corporation? Chapter C corporations refer to corporations that are created under a certain federal tax code that requires the company itself to pay taxes on income the business makes. The owners are also required to file their own to be taxed separately from the income that is distributed to them from the corporation.
Features of a Chapter C Corporation
- Must Pay Corporate Taxes. Under the 2017 Tax Cut and Jobs Act, Congress lowered the federal corporate tax rate from a high of 35% to a flat rate of 21%. What that means is that at the end of each year, a corporation must file a tax return and pay the IRS a tax of 21% of the income generated.
- Easy to Add New Shareholders. Out of all business entities, a corporation is probably the easiest to bring in new owners. The corporation can authorize a certain amount of shares at its outset and only issue a certain percentage of those shares. Corporations can issue new shares to raise capital and to bring in new owners.
- Better Tax Write Offs. Chapter C Corporations are unique in that they can receive write offs for fringe benefits such as disability insurance, educational assistance programs, day-care, and health reimbursement arrangements.
- Liability Shield. As mentioned previously, the primary benefit of a corporation is the liability protection it provides its owners. If an accident or other event happens that creates liability, the owners’ personal assets are shielded.
- Limits Self Employment Tax. A Corporation itself does not pay self-employment tax. However, if the owners take a salary from the company, the self-employment tax is triggered and the owners must pay self-employment tax on their salary.
- Must pay Franchise and Excise Tax. In Tennessee, corporations must pay franchise and excise tax unless they fall within limited exceptions.
Chapter S Corporations
When a corporation is founded, it has a choice to elect to become a “pass through” entity for tax purposes. This choice is called a “Chapter S election” and it must be made within 75 days of the creation of the corporation. What “pass through” means for tax purposes is that the shareholders are taxed on the income of the business, not the corporation. The net income flows through the company to the shareholders themselves requiring the shareholders to report the business’ income on their own personal tax returns. So unlike a regular, Chapter C corporation, an S corporation never pays taxes itself.
Features of an S Corporation
- Designed for Small Businesses. If you have just a few shareholders in the corporation, an S corporation may be your best option. In fact, Congress has limited the number of shareholders to 100 in order for corporation to be allowed to elect an S Corporation.
- Avoids Corporate Tax. Chapter S corporations avoid the double taxation that comes with a Chapter C corporation. In an S Corp the entity itself is not taxed, rather the shareholders themselves pay income tax on the net income of the company based on their ownership share.
- Liability Protection. Like a C Corporation, an S corporation provides a liability shield for its owners in the event that the company faces a liability.
- Limits Self-Employment Tax. One of the best features of the S corp is that is can avoid a large part of the self employment tax. Under normal circumstances, if the total amount of net income that a business earns is distributed to owners, the owners must pay self employment tax on all of this income. However, if the owners decide to take a reasonable salary from the company, then the owners will only incur self-employment tax based upon their individual salaries. Speak with your CPA to determine whether this feature would be beneficial to you based upon your company’s projected income.
- Tennessee Franchise and Excise Tax. Unless the S corporation qualifies for an exemption under Tennessee law, the business must pay the Franchise and Excise Tax.
- Non-Citizens Cannot Be Shareholders. If you are not a citizen of the United States, federal law prohibits you from being an owner of an S Corporation.
Should You Incorporate Your Business?
There is no one-size fits all business entity. What type of business entity you create largely depends on your circumstances. If you are going to operate a small, low liability enterprise, it may be better to stay a sole proprietorship or partnership. If you are thinking of creating a business that is going to grow rapidly, have many investors, publicly trade, or work internationally, a corporation may be the right fit for you.
Nonetheless, most small business owners in and around Clarksville should generally avoid creating Chapter C Corporations due to the corporate tax the company must pay. The tax write offs and benefits that C Corporations have are generally outweighed by the double tax corporations and shareholders pay. For most small businesses in Montgomery County, S corporations are a much better alternative if you are considering creating a corporation.
How Do Your Start a Corporation?
If you are considering starting a corporation in Clarksville, it is worth consulting a business lawyer that can guide you through the process. Starting a corporation can be a complex and confusing task and having the right legal counsel can make the process go much smoother. That business lawyer should explain to you the general process that is required to start your business.
Pick a Name for the Corporation
The first place to start when thinking about starting a corporation is to the Tennessee Secretary of State’s website. Type the name you would like to use and see if it has been taken. If it has been taken try to think of a different name you like. Remember the name of your business must contain the words “company or incorporated” or the initials “Co. or Inc.”
File and Register the Corporation’s Charter
The next step in creating your corporation is to file the Charter with the Tennessee Secretary of State. The charter is sometimes called the Articles of Incorporation. The Charter sets forth:
- The name of the business
- How many shares of stock the corporation has authorized
- The principal place of business of the corporation
- Who the registered agent is and his/her address
- Who the incorporator is and his authorization creating the corporation
Obtain an Employment Identification Number (EIN)
At the time you form the corporation, make sure you get an EIN for the business. The EIN is a unique number provided by the IRS that the corporation will use for identification and tax purposes. Your banks, lenders, and even your CPA will require your corporation’s EIN.
Prepare and Execute the Bylaws for the Corporation
Bylaws are the rules by which the corporation operate. While not required, it is important for the business to have bylaws in case there is a dispute among the directors or shareholders. Bylaws set forth:
- The purpose of the business
- The function of the board of directors
- The role of the officers in the corporation
- How many shares are issued
- Voting rights
- Where and when shareholder meetings are to take place
- How the corporation can be dissolved
File a Copy of the Charter with the Register of Deeds
Once you have filed and registered the Charter with the Tennessee Secretary of State, the next step is to register the Charter in the county in which the corporation is located. If the principal office of the corporation is outside of Tennessee, you do not have to file the Charter with the Register of Deeds.
Submit Your Local Business License Applications
If your business is located in Montgomery County and Clarksville, you must register with the County and City to obtain your business license. There is a $15.00 filing fee for each application. Some businesses are exempt from registration so check with these municipalities to see if you qualify.