Like all other forms of business entities in California, when deciding on whether to form a corporation, one should focus on three (3) central issues, namely 1) taxes, 2) management / control and 3) corporate formalities. Incorporating a business before becoming familiar with these issues could have potentially far-reaching consequences.
Taxes: To understand the tax impact of incorporating, one must understand the distinction between an “S Corporation” and a “C Corporation”. S corporations are taxed similarly to the “pass through” forms of businesses referenced above. Specifically, the taxes of an S Corporations “pass through” to the corporation’s shareholders. In other words, there is only one level of taxation (at the shareholder level).
Corporations formed in California are by default taxed as C Corporations (see below). To become an S Corporation, the corporation must affirmatively elect out of the default C Corporation status by filing Form 2553 with the IRS pursuant to IRC 1362. There are, however, many rules restricting the type of corporation that can be taxed as an S Corporation and governing how and when an election can be made under Form 2553 – the majority of which are beyond the scope of this summary. Unlike S Corporations, C Corporations are not “pass through” entities.
Specifically, C Corporations are taxed at the entity level. Then, if the corporation pays dividends to its shareholders (e.g. it has profits after taxes are paid by the corporation), the shareholders are liable for paying taxes on the dividends (which are income to the shareholders). Thus, one can see why C Corporations are subject to double taxation (first at the corporate entity level, and next at the shareholder level).
That said, in certain situations, “double taxation” isn’t as onerous as it may seem. For example, a business that plans to use its profits to reinvest in its business (e.g. to expand operations), may decide not to distribute those profits to its shareholders as a dividend – thereby avoiding the 2nd tax on those profits; and if the corporate level tax rate is less than the shareholder level tax rate (which it is as of the writing of this summary), less taxes may be paid in the aggregate if the business is a C Corporation vis-à-vis one of the “pass through” entities referenced above (including an S Corporation).
Also, in determining the corporate entity level tax, the corporation may be allowed various deductions, including deductions for salaries paid to officers and/or employees. So, by paying income to shareholders/employees as salary, the double taxation issue may (with exceptions) be further mitigated. There are, of course, many further corporate tax issues that are beyond the scope of this summary.
Management / Control: Unlike most of the other forms of business entities discussed above, management and control of a corporation is separate and distinct from ownership of the entity. Whereas in a general partnership or limited liability company, for example, the default law of California is that management and control of the entity (e.g. the power to bind the entity, enter into contracts, borrow money, raise capital, acquire or sell assets) falls to the owners of the entity (i.e. the partners or members), in a corporation the business and affairs of the corporation falls under the direction of a Board of Directors, who must be elected annually by the shareholders. Specifically, in a corporation, shareholders annually elect directors (See Cal. Corp. Code 301), who in turn elect the officers (See Cal. Corp. Code 312).
Corporate Formalities: Unlike most of the other forms of business entities discussed above, unless the corporation elects to be treated as a Statutory Close Corporation under Corporations Code 158 (see Cal. Corp. Code 158), corporations are subject to very strict formalities under the California Corporations Code – and therefore, in many respects, do not have the flexibility in management that other business entities described above have. Whereas in an LLC, for example, management can be as flexible or as rigid as the members may agree in a written operating agreement, a corporation must annually hold shareholder meetings and director meetings, and the failure to do so could open the corporation’s shareholders to personal liability under a “piercing the corporate veil” theory (i.e. a creditor could potentially pierce the corporate firewall and pursue a corporate debt / judgment against a shareholder(s) personally).
