Business Attorney Tips: Forming a Corporation to Organize Your Business

Even in an age in which so many new companies have the letters “LLC” after their names, corporations still play an important role. Structuring your business as a corporation has advantages and disadvantages. Your Massachusetts business lawyer can help.

Background:

  • A corporation is a created by filing a document with the state in which it is organized that meets specified statutory requirements. The name of this filing varies depending on the state and type of corporation. For instance, it is a Certificate of Incorporation for a Delaware business corporation, but Articles of Organization for a Massachusetts not-for-profit corporation.
  • If most of its business and investors will be local, it is often less expensive to file in the state in which it is located. However, if it will have institutional investors or investors who are not local, it may make sense to incur the extra cost to incorporate in Delaware.
  • Different states use the terms “shareholder” or “stockholder” for owners. For instance, Delaware corporations have stockholders, while Massachusetts corporations have shareholders.
  • Corporations are often simpler and less expensive to set up than other kinds of entities.

Liability and Operations:

  • The liability of the shareholders is typically limited to the amount they invested in the corporation, except for certain taxes and sometimes wages. While there is a legal doctrine called “piercing the corporate veil” that allows general business creditors to go after individual shareholders, the law sets a very high bar for this kind of suit.
  • Management is straightforward. The CEO runs the company, subject to the oversight and direction of the board of directors. All other employees report directly or indirectly to the CEO (or president, depending on how it is set up). The Board is not involved in day-to-day management of business corporations.
  • Corporations have the flexibility to create different classes of stock, with different voting rights and different rights to receive dividends and distributions.
  • The owners of a corporation can enter into a shareholders agreement that requires them to vote for certain directors and places restrictions on transfer of shares (including so-called “buy-sell agreements”), leading to more certainty in the management and ownership of the business. The forms provided by on-line services often do not reflect what the business owners would intend if they were writing the agreement from scratch.

Taxes

The choice of entity is often driven by the tax treatment.

  • Corporations are taxed on their income. In order for investors to get money out of a corporation, either (i) the investors must be paid as employees or independent contractors of the business or (ii) the corporation must declare dividends. Dividends are typically taxable, creating a so-called double layer of taxation. In other words, the tax treatment often makes corporations more expensive than other types of entity.
  • If the ownership and structure of a corporation meets certain guidelines, the owners can file with the IRS to create something called an “S corporation” (a regular corporation is a “C corporation”). An S corporation is taxed like a partnership, with only one layer of taxation – that is, for tax purposes it is as if the individual owners earned income and generated losses directly.
  • It can sometimes be difficult to have as much flexibility as a partnership or limited liability company with regard to how cash is distributed and, in the case of an S corporation, how income and losses are allocated for tax purposes.
  • For non-US shareholders seeking to avoid income that is “effectively connected to a trade or business” in the US for tax purposes, operating a business through a C corporation is often the best option.

A Massachusetts business lawyer can help guide you through the process for deciding on choice of entity as well as other matters that arise when you are starting a new business.