Your Entity Menu : Part 5

Own Your Own Corporation : Why the Rich Own Their Own Companies and Everyone Else Works for Them
by Garrett Sutton, Esq.

(Page 5 of 11)

As luck would have it, the English Flyer was lost near the Bermuda Triangle. The promoters had leased the boat, provided their own captain, and were now responsible to the owners for its loss. The promoters and 90 percent of the general partners did not have as much money as Master John Fowles did. As we learned in Louise's case, and as has been the case for centuries, creditors will go after the easiest target with the deepest pockets. As so Master John Fowles, only a 10 percent general partner, was sued and held responsible for the entire loss of the English Flyer. He learned the hard way what happens when your ship does not come in, and you are responsible for it.

As Sir Richard Starkey's luck would have it, the English Rose did well on each side of the Atlantic and provided a huge return to its investors. Unlike Master John Fowles, Sir Richard Starkey was willing to lose £250 and no more. By using a corporation instead of a partnership he was able to establish his downside risk, while allowing for his upside advantage to be unlimited.

Sir Richard Starkey and other knowledgeable and sophisticated investors have used corporations, and other good entities, to limit their liability for centuries.

Forming a corporation is simple. Essentially, you file a document that creates an independent legal entity with a life of its own. It has its own name, business purpose, and tax identity with the IRS. As such, it - the corporation - is responsible for the activities of the business. In this way, the owners, or shareholders, are protected. The owners' liability is limited to the monies they used to start the corporation, not all of their other personal assets. If an entity is to be sued it is the corporation, not the individuals behind this legal entity.

A corporation is organized by one or more shareholders. Depending upon each state's law, it may allow one person to serve as all officers and directors. In certain states, to protect the owners' privacy, nominee officers and directors may be utilized. A corporation's first filing, the articles of incorporation, is signed by the incorporator. The incorporator may be any individual involved in the company, including, frequently, the company's attorney.

The articles of incorporation set out the company's name, the initial board of directors, the authorized number of shares, and other major items. Because it is a matter of public record, specific, detailed, or confidential information about the corporation should not be included in the articles of incorporation. The corporation is governed by rules found in its bylaws. Its decisions are recorded in meeting minutes, which are kept in the corporate minute book.

When the corporation is formed, the shareholders take over the company from the incorporator. The shareholders elect the directors to oversee the company. The directors in turn appoint the officers to carry out day-to-day management.

The shareholders, directors, and officers of the company must remember to follow corporate formalities. They must treat the corporation as a separate and independent legal entity, which includes holding regularly scheduled meetings, conducting banking through a separate corporate bank account, filing a separate corporate tax return, and filing corporate papers with the state on a timely basis.

Failure to follow such formalities may allow a creditor to disregard the corporate veil and seek personal liability against the corporate officers, directors, and shareholders. This is known as "piercing the corporate veil" - a legal maneuver in which the creditor tries to establish that the corporation failed to operate as a separate and distinct entity; if this is the case, then the veil of corporate protection is pierced and the individuals involved are held personally liable. Adhering to corporate formalities is not at all difficult or particularly time-consuming. In fact, if you have your attorney handle the corporate filings and preparation of annual minutes and direct your accountant to prepare the corporate tax return, you should spend no extra time at it with only a very slight increase in cost. The point is that if you spend the extra money to form a corporation in order to gain limited liability it makes sense to spend the extra, and minimal, time and money to ensure that protection is achieved.

One disadvantage of utilizing a regular, (or C) corporation to do business is that its earnings may be taxed twice. This generally happens at the end of the corporation's fiscal year. If the corporation earns a profit it pays a tax on the gain. If it then decides to pay a dividend to its shareholders, the shareholders are taxed once again. To avoid the double tax of a C corporation, most C corporation owners make sure there are no profits at the end of the year. Instead, they use all the write-offs allowed to reduce their net income.

The potential for double taxation does not occur with the other good entities, a limited liability company or a limited partnership. In those entities profits and losses flow through the entity directly to the owner. Thus, there is no entity tax but instead there is a tax obligation on your individual return. Depending on your situation, an LLC or LP with flow-through taxation may be to your advantage or disadvantage. Again, one size does not fit all.

It should be noted here that a corporation with flow-through taxation features does exist. The Subchapter S corporation (S corporation), named after the IRS code section allowing it, is a flow-through corporate entity. By filing Form 2553, "Election by a Small Business Corporation," the corporation is not treated as a distinct entity for tax purposes. As a result, profits and losses flow through to the shareholders as in a partnership.

While a Subchapter S corporation is the entity of choice for certain small businesses, it does have some limits. It can only have seventy-five or fewer shareholders. All shareholders must be American citizens. Corporations, limited partnerships, limited liability companies, and other entities, including certain trusts, may not be shareholders. A Subchapter S corporation may have only one class of stock.

Copyright © 2001 by Garrett Sutton, Esq.

About the Author

Garrett Sutton, Esq. has over twenty five years experience assisting and advising entrepreneurs, families and business in selecting the appropriate corporate structures to limit their liability, protect their assets, build their credit and advance their personal and financial goals through real estate investments and other means of wealth creation. Sutton is the owner of Sutton Law Center, Sutton Law which has offices in Reno, Nevada, Jackson Hole, Wyoming and Sacramento California.