Types of Corporations

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Introduction

There are two main categories of corporations.

• “For profit” corporations that operate to make a profit, and

• Nonprofit corporations.

"For profit" corporations may be one of the following types:

1. General Business Corporations

2. Close Corporations

3. Professional Corporations

Note: Corporations are sometimes described as “C” or “S” corporations. These letters refer to subchapters of the Internal Revenue Code (IRC) and relate solely to the classification of the corporation for tax purposes. This tax classification does not alter the corporate structure nor does it have any effect on the limited liability status of the shareholders. The “C” or “S” classification choices are available to every “for profit” corporation.

Nonprofit corporations consist of three types:

1. Public benefit

2. Mutual benefit

3. Religious

The following pages will discuss the characteristics of each type of "for profit" and nonprofit corporation.

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General Business Corporations

A general business corporation refers to the regular corporation formed when Articles of Incorporation are filed with the Secretary of State (or appropriate state agency), to conduct a “for profit” business. This includes most all “for profit” corporations, whether the business operates, for example, a printing business, advertising agency, auto dealership, restaurant, or most any other type of business found in the phone book. The major businesses that are excluded from this category are businesses incorporated by certain licensed professionals that are required to incorporate as professional corporations, as they are in California. This generally includes accountants, lawyers, doctors, marriage and family counselors, physical therapists, and other such licensed professionals.

Every “for profit” corporation is automatically a “subchapter C” corporation (or “C corporation”) under the IRC when the Articles are filed. To obtain “subchapter S” tax classification, a written election form must be filed with the IRS.

“C” Corporations

A “C” corporation pays taxes on any profits, or net income, remaining at year-end. If these profits (after taxes) are then paid to the shareholders in the form of dividends, they are taxed again to the shareholder as dividend income at the shareholder’s individual tax rate. This is often referred to as the “double taxation” problem, but it is not difficult to avoid.  In most small corporations, dividends are rarely paid.  Rather, most C corporations will endeavor to eliminate any year-end taxable income through the payment of salaries (and bonuses) to shareholder-employees. As long as the compensation received by a shareholder-employee is “reasonable” in the view of the IRS, salary or bonus payments to a shareholder-employee are deductible business expenses by the corporation that effectively “shift” much of the taxable income to the shareholders of the corporation, thus avoiding “double taxation.” Let’s look at a hypothetical example to see how this works in a C corporation.

Example 1: Solving The Problem of Double Taxation in a C Corporation Let’s assume that Paul Prescott is the sole shareholder of Paul’s Printing, Inc. (“PPI” for short), a C Corporation. As of December 31, when PPI closes its books for the year, it has $20,000 in profits, that is, taxable income. The result is that PPI will pay tax on the $20,000 at corporate tax rates. Let’s say the tax amounts to $2,000, leaving $18,000. If this sum is paid to Paul as a dividend, it will be income to Paul for which he will pay personal income tax. Since the payment of a dividend by PPI does not reduce its taxable income, the $20,000 profit is taxed twice. If, instead, the remaining $18.000 is paid to Paul as salary in the following year, the same result occurs: double taxation. Let’s change this example. We’ll now have PPI pay Paul a bonus on December 31 in the amount of $20,000. This is a tax-deductible payment by the corporation that reduces its taxable income to zero. The corporation would pay no tax since it has no taxable income. Paul will report the $20,000 as income on his personal tax return and pay the tax as an individual, of course, but this action eliminates the problem of “double taxation.”

“S” Corporations

An alternative for avoiding the “double taxation” pitfall is electing to be treated as a Subchapter S corporation (“S corporation” for short). The S corporation is a special election under the Internal Revenue Code for the purpose of having the corporation be treated as a partnership for tax purposes. Thus, in an S corporation, the corporation as an entity does not pay federal income tax.  Like a partnership, all corporate profits and losses are “passed through” to the shareholders and reported as income or loss only on the shareholders’ personal tax returns.  Each shareholder reports profits or losses in the same proportion as his ownership of the corporation.

Example 2: Solving Double Taxation By Electing S Corporation Status Let’s now assume that Paul and his brother Peter are equal owners of Paul’s Printing, Inc. (“PPI), and that the corporation has elected to be an S Corporation. How does this change the treatment of the corporation’s $20,000 taxable income in Example 1, above? By making the S election, PPI will pay no federal income tax on the $20,000 profits. Rather, the profits will “pass through” to Paul and Peter. As 50% equal owners, Paul and Peter will automatically report half, or $10,000, of the corporation’s taxable income on their personal tax returns and each will pay the tax on that $10,000 separately at their particular individual income tax rates. Paul are Peter are not permitted to claim percentages of the taxable income on their individual tax returns that are different from their actual ownership interests in the corporation.  Further, Paul and Peter are required to pay the tax on their portion of the taxable income whether or not the corporation actually writes a check to distribute the profits, or any portion of it, to them.

Note: The states different in their treatment of S corporations for purposes of any state corporate income tax. Many accept a federal S election and similarly treat the S corporation as a pass through entity for state income tax purposes. Others, like California, impose a nominal tax on the taxable income of the corporation that is passed through to the shareholders.

S corporations are formed in the same manner as C corporations (that is, by filing Articles of Incorporation with the Secretary of State or appropriate state agency). The Articles do not make any reference to whether the corporation is a "C" or "S" corporation, because the distinction is a creation of federal tax law, for tax purposes, not of state corporate law (specifically, Subchapter S of the Internal Revenue Code; IRC §§ 1361-79).

A corporation has 75 days after the date the Articles of Incorporation are filed in which to make an “S” election for its first tax year, by completing IRS Form 2553 (instructions are here). If an “S” election is not made for the corporation's first tax year, an “S” election may be made during the first 75 days of any later tax year. Similarly, if a corporation makes an “S” election and determines that it is no longer advantageous to continue this classification, it may deselect or revoke “S” status and revert to a “C” classification during the first 75 days of any tax year.

Requirements for an S Corporation

A corporation must meet all of the following requirements in order to make an S election:           

• It is a domestic corporation (“domestic” meaning formed within one of the 50 states).

• It has no more than 75 shareholders.  A husband and wife (and their estates) are treated as one shareholder for this requirement; all other persons are treated as separate.

• It has only one class of stock. Generally, a corporation is treated as having only one class of stock if all outstanding shares of stock (i.e., those already issued) confer identical rights to distribution and liquidation proceeds.

• It has a permitted tax year (defined as a “tax year ending December 31, or any other tax year for which the corporation establishes a business purpose to the satisfaction of the IRS”).

• All shareholders must consent to make the “S” election.

• All shareholders must be

An S corporation may involuntarily lose its status, for example, by transfer of stock to an ineligible shareholder (or exceeding 75 shareholders). It may also voluntarily “de-select” its status, by filing the requisite statement with the IRS. Such a corporation may not reelect S corporation status again for five years.

Tax Considerations

S corporation shareholders cannot receive special allocations of profits and losses. That is, profits and losses must “pass through” from the corporation to the shareholders based on the same percentage as their stock ownership. Unlike partnerships and limited liability companies, shareholders in an S corporation cannot allocate losses according to one set of percentages and profits according to a different set of percentages, nor can they allocate profits on their personal tax returns in a different percentage than their actual ownership percentage in the corporation.

The states differ significantly in their treatment of S corporations. Some states, for example, do not recognize S status for state income tax purposes. Some states that recognize S status require a separate S election to be made for state income tax purposes, while other states simply recognize the federal S election (and may require that a copy of the federal election to be forwarded to the state). California accepts the federal S election status without requiring a further filing with the state.

Advantages of an S Corporation

• Lower federal taxes. If the business generates net income, the corporation may pay lower federal taxes than the shareholder/owner. However, take note of the potential limitations of this advantage and its drawbacks as discussed below.

• A C corporation is subject to entity-level federal income tax on its taxable income. The applicable tax rates are as follows:

Taxable Income			Tax Rate
$          0	To	$     50,000	15%
$     50,001	To	$     75,000	25%
$     75,001	To	$    100,000	34%
$ 10,000,000	And over		35%

• The federal taxes that would be paid by a C corporation for at least the first $100,000 of taxable income are lower than the taxes that would be paid by an individual for the same income.  For instance, based on tax rates in effect for 2003, a corporation having profits of $75,000 would pay federal taxes of $13,750. An individual with income of $75,000 would pay federal income tax of $16,816, $3,066 more than the corporation. For profits of $100,000, the corporation would still pay $2,066 less in federal taxes.

• Thus, income tax savings may be achieved by operating a business as a C corporation if its taxable income does not greatly exceed $100,000 and its earnings are retained, rather than distributed to its shareholders, to avoid the problem of “double taxation.”  It is important to understand that if the corporation does not have a specific business purpose for accumulating its earnings, or if it intends to distribute any significant portion of the retained earnings to shareholder-employees, or if the taxable income is substantially higher than $100,000, this advantage of a lower federal tax rate is quickly eliminated.

Here’s an example to show the potential federal tax savings of a C corporation over an S corporation at this taxable income level: Paul’s Printing, Inc. is a corporation that generated $75,000 of income (after paying reasonable salaries to shareholder-employees), and its earnings were retained in the business. Assuming that the shareholder-employees are in the 31% tax bracket, and that Paul’s Printing, Inc. would not be subject to corporate-level taxation if operated as an S corporation, the after tax income may be compared: C corporation S corporation Taxable income $75,000 $75,000 Corporate tax $13,750 -0- Shareholder-employee level tax -0- $16,816 After-tax income available for use in the business $61,250 $58,184 In this case, operating as a C corporation and not distributing net earnings yielded Paul’s Printing, Inc. a federal income tax savings of $3,066. State tax implications, however, must also be considered.

• A corporation does not, however, have complete flexibility to accumulate its income to avoid the second level of tax at the shareholder level.  A corporation that accumulates (rather than distributes) its income may be subject to penalty taxes.  For example, a C corporation that accumulates earnings beyond reasonable business needs may be subject to the accumulate earnings tax (AET), which is a penalty tax assessed at the rate of 39.6% on a corporation’s “accumulated taxable income” in excess of its business needs. But even if the penalty taxes do not apply to the corporation, any current income savings tax that can be generated by operating as a C corporation must be weighed against the fact that a shareholder-level tax is imposed when the earnings are distributed to the shareholders as dividends or salaries.
  
  
  

Using the above example, let’s see how the tax impact would change if the after-tax earnings were distributed to the shareholder-employees: C corporation S corporation Taxable income $75,000.00 $75,000.00 Corporate tax $13,750.00 -0- Shareholder-employee personal tax $12,884.00 $16,816.00 After-tax income available for use in the business $48,366.00 $58,184.00 This example shows that under these circumstances, greater federal income tax savings are yielded when the business is operated as an S corporation.

Now let’s compare the impact of C corporation taxation and S corporation taxation where a higher taxable income is involved.

Suppose Paul’s Printing, Inc. is a larger corporation earning a substantially greater annual profit: $500,000. The tax savings for various levels of distributions of earnings are presented in the table below. This example assumes that no corporate-level taxes would be imposed if the business operated as an S corporation.  The Shareholder tax is based on actual 2003 individual tax rates. State income taxes are not considered in this example since the rates and S tax treatment vary from state to state.

C corporation					S corporation
Entity taxable income	Various Distribution Amounts	Corporate tax	Shareholder tax on Distribution	Total tax	Shareholder tax on $500,000	Tax savings
$500,000	-0-	$170,000	-0-	$170,000	$169,200	$800
$500,000	$50,000	$170,000	$15,500	$185,500	$169,200	$16,300
$500,000	$100,000	$170,000	$31,000	$201,000	$169,200	$31,800
$500,000	$150,000	$170,000	$46,500	$216,500	$169,200	$47,300
$500,000	$200,000	$170,000	$62,000	$232,000	$169,200	$62,800
$500,000	$250,000	$170,000	$77,500	$247,500	$169,200	$78,300

What this table shows is that when a higher taxable income is involved, the lower federal tax rate for corporations at lower amounts is no longer an advantage. Rather, there is now a disadvantage of higher corporate tax rates than individual tax rates. There is a tax savings at this income level by being an S corporation and having the taxable income “passed through” to the shareholders and taxed only once at the individual level. This tax savings only increases as greater amounts of the C corporation’s taxable income are distributed to shareholder-employees and taxed again.

• No double taxation. S corporations are “pass-through” entities, i.e., conduits through which all items of income, loss, deduction, gain, or credit are passed through to the shareholders; they are not separate taxable entities as are C corporations.
  
  

• An S corporation does not pay tax on net income, as a C corporation does; and
  

• Dividends are not deductible by a C corporation and are therefore taxed twice, once at the corporate level and once at the shareholder or individual level.
  

• Exception: California imposes a small 1.5% tax on the S corporation net income passed through to shareholders (please refer to Disadvantages of an S corporation, below)
  

• Exception: S corporations that were formerly C corporations are subject to tax on certain items at the corporate level.

• No IRS disallowance of deduction for shareholder-employee salary. The IRS will not challenge payments to shareholder-employees as unreasonable compensation because:
  

• S corporation shareholders are taxable on a pro rata portion of the entire corporate taxable income; and
  

• The amount deemed compensation for services is therefore irrelevant, except if the IRS is challenging social security or employment tax withholding.

• Generally, no extra corporate taxes.  S corporation shareholders are taxed on net corporate income. Therefore, certain additional federal income taxes cannot apply, such as:
  
  

• Corporate alternative minimum tax
  

• Personal holding company tax
  

• Accumulated earnings tax

• Ability to offset corporate losses against individual income. Subject to certain limitations, shareholders can use S corporation losses to offset income on their personal returns.

Disadvantages of an S Corporation

• Limited availability. Only corporations meeting eligibility requirements may elect S status (refer to Requirements for an S corporation, above). S corporations must strictly comply with the eligibility rules and requirements to avoid inadvertent termination of S status. In most small corporations, these requirements are easily satisfied.

• Fringe benefits to shareholder-employees limited.  If certain tax-deductible fringe benefits are provided to shareholder-employees owning more than 2% of the S corporation's stock, each shareholder-employee must report the value of the benefit as taxable income on his personal tax return. This includes qualified accident and health plans, medical reimbursement plans, and group term life insurance.

In a C corporation, these benefits would normally not be included in the shareholder-employee’s taxable income. The impact of this disadvantage must then be weighed against the advantages of avoiding double taxation as well as potential payroll tax savings when evaluating the corporation’s tax classification that is most advantageous for the shareholder-employees.

• Limited choice of accounting periods. An S corporation usually must choose a calendar year end (December 31) because it is the only automatically permitted year, whereas C corporations generally may choose any fiscal year end (essentially, any other month-end date). The IRS may grant exceptions to calendar year ends if an S corporation demonstrates that it meets the “natural business year” requirements. A form must be filed with the IRS requesting approval for a fiscal year end. However, it is difficult to obtain approval for other than a calendar tax year.

The advantage of a fiscal year is that it may be possible in certain cases to accrue a bonus payment to shareholder-employees in the latter part of the year so that the corporation can take it as a tax deduction in its current fiscal year, but the payment to the shareholder-employee is delayed until the following calendar year so that the personal tax on that income will not have to be paid for perhaps 16 months.

• Possible extra corporate taxes. While S corporations receive full pass-through treatment of taxable income for federal tax purposes and therefore pay no federal corporate income taxes, California currently imposes a 1.5% tax on the income of S corporations passed through to shareholders.  However, California corporations in general (whether C or S corporations) are subject to an annual minimum franchise tax of $800 (after their initial tax year), and this minimum franchise tax is credited against the 1.5% tax on the taxable net income of S corporations.

Let’s look at some examples to see how this California tax works:

Example 1: Paul’s Printing, Inc., a California S corporation, had net profits of $40,000 in 1999.  As an S corporation, Paul’s Printing, Inc. pays no federal tax, but is subject to the state minimum franchise tax of $800 for 1999. The California 1.5% tax rate on S corporations subjects Paul’s Printing, Inc. to a tax of $600, but since the $800 minimum franchise tax is credited against this amount, no additional corporate tax is due.

Example 2: Paul’s Printing, Inc. had a banner year in 2000, with net profits of $100,000. The California 1.5% tax rate subjects Paul’s Printing, Inc. to $1,500 in state corporate tax for 2000.  The $800 franchise tax, which must be paid by April 15th each year, is credited against this amount. Therefore, Paul’s Printing, Inc. pays the difference of $700 when it files its tax return for calendar year 2000.

Note: The “break-even point” for California S corporations (at which point the 1.5% tax equals to the minimum franchise tax of $800) is approximately $53,500 in net profits. The 1.5% tax on profits below that amount will not result in any tax beyond the minimum $800 franchise tax paid by all California corporations.

Capital Considerations in an S Corporation

Because all shareholders of an S corporation generally must be individuals, an S corporation cannot raise funds from venture capital funds, corporations or institutional investors. The one-class-of-stock requirement prevents an S corporation from offering key employees certain types of stock options.

Most corporations that raise money from outside sources will issue two classes of stock: convertible preferred stock for investors and common stock for the employees. Common stock is often issued at a small fraction of the price of the preferred stock because it lacks the liquidation, dividend, voting and other preferences of preferred stock. Thus, S corporations are most commonly used for family or other closely owned businesses that get their capital from their individual shareholders and/or debt from outside sources.

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Statutory Close Corporations

Overview

In California, certain “closely held” corporations may elect “close corporation” status. A close corporation may dispense with many of the corporate formalities and record keeping requirements.  It also has greater flexibility in distributing profits to shareholders, which may be done disproportionately to ownership percentages.

A close corporation may not have more than 10 shareholders, and its Articles of Incorporation must contain the statement: “This corporation is a close corporation,” as well as a restriction on the number of shareholders.

The main vehicle for achieving “close corporation” status is a written agreement unanimously adopted by the shareholders.

Close corporations are seldom used today because the disadvantages generally outweigh their benefits, as discussed below.

Advantages

Under a close corporation Shareholder Agreement, the corporation is permitted to deviate from the normal statutory rules concerning voting rights, management meetings and the economic rights of the participants. This permissible deviation is the main reason for electing statutory close corporation status.

Thus, the statutory close corporation may dispense with certain corporate formalities such as board of directors’ and shareholders’ meetings and keeping corporate minutes, and this omission may not be considered as a factor by a court in determining whether to disregard the limited liability of the shareholders and hold them personally liable for corporate obligations.

Disadvantages

Despite its flexibility, the statutory close corporation is considered to be a risky and undesirable corporation structure except in a few very narrow situations. This is due to the following drawbacks:

• Personal liability problems: Management and control of the corporation by shareholders who are not directors, under a Shareholder Agreement, may subject those shareholders to the same liability risks faced by directors.  In California, for example, a shareholder who is party to an agreement controlling the discretion or power of the board of directors is liable for the acts of the directors under this agreement – even if he is not one of the shareholders who actually manage the corporation.

• Risks of dissolution: In a general business corporation, shareholders must hold at least 33% of the total outstanding shares to be able to seek involuntary dissolution of the corporation. However, in a close corporation, any shareholder may file a complaint seeking to dissolve the corporation, regardless of the percentage of stock he owns.

• Tax Problems: As noted above (see Requirements for an S Corporation, above), a corporation with more than one class of stock may not elect Subchapter S status. If a close corporation’s Shareholder Agreement provides substantially different economic rights for different shareholders, the IRS may determine that the corporation in fact has more than one class of stock – and is therefore not eligible for Subchapter S treatment.

• In addition to the above factors, there are also the difficulties and expense inherent in negotiating and drafting the Shareholder Agreement if the parties have differing interests.

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Professional Corporations

Certain professions are required to incorporate as professional corporations rather than as general business corporations. The professions affected vary somewhat from state to state, but typically include those listed below. Most states have separate statutory provisions regulating the formation and operation of professional corporations. Additionally, professionals are subject to any regulations adopted by their licensing board or agency in operating as a corporation. This may include specific requirements or restrictions on the corporate name that may be used, registration of the corporation with the licensing agency and payment of a fee, and complying with minimum errors and omissions (malpractice) insurance requirements. If your profession is listed, be sure to contact your licensing agency before you file your Articles of Incorporation.