What is a Corporation?

by Team ZenBusiness

- December 26, 2018 10:37 am

Even though corporations affect almost every aspect of your daily life, if we put you on the spot and asked you to define “corporation,” how well would you do? You may say that it’s a company that has some sort of status apart from the owner or owners, but how exactly does the law see it? How does your accountant see it? Why do so many businesses exist as corporations? Why are we putting you on the spot like this?

Legal Entity and Tax Entity

To explain what a corporation is, especially regarding how it compares to other types of businesses you could form like a sole proprietorship or LLC, let’s talk about a couple of important terms: legal entity and tax entity.

“Legal entity” is its own person in the eyes of the State and the law. It can incur and pay debts, be liable for its own actions, enter into contracts, be sued, and generally be treated as a flesh-and-blood person. Business owners often choose to form a corporation or limited liability company (LLC) because it allows the company to create a legal entity that is separate from themselves. Thus, if the business is sued or incurs debt, those seeking payment or reimbursement will go after the business instead of the business owner.

“Tax entity” refers to how the business is taxed. A C corporation, for example, incurs “double taxation” in that both the corporation and the owner are taxed. The corporation is taxed as its own legal entity—when the C corporation makes income, it pays taxes on that income. When shareholders of the C-corporation receive their share of that income, they pay taxes on it on an individual basis.

Corporation Defined

A corporation is a company that is its own legal entity in the eyes of the State and is owned by “shareholders,” individuals who own a percentage of the company. These shareholders may be made up of those who founded the corporation as well as individual investors. The shareholders share in the corporation’s profits without taking on the liability or debt of the corporation. Shareholders elect a board of directors to oversee the day-to-day operations of the company.

To further define what a corporation is, it helps to contrast it with another popular business model, the LLC. The following chart shows the pros and cons of each:

Benefits of a Corporation

Let’s review some of the key benefits to forming a corporation:

  • Protects Your Personal Assets – Having a corporation puts a protective barrier between your personal assets and the liabilities and risks of your business. If someone slips in your restaurant and sues, they can only go after the corporation’s money instead of your kid’s college fund. And if the corporation goes bankrupt, debtors are limited to seeking reimbursement from the corporation’s bank account, not your personal account.
  • Establishes an Official Business – Forming a corporation also establishes an official business, which is good not only in the eyes of the State, but also potential customers. Let’s face it: People are generally not as comfortable doing business with Bob Smith as they are Smith, Inc.
  • Recognized Outside the U.S. – The official business standing carries beyond the boundaries of the United States, allowing you to more easily do business in other countries.
  • Allows Stock to Be Issued – The shareholder structure of a corporation allows for unlimited owners, and this ability to sell shares of stock makes it easier to attract investors.  This is ideal for start-ups that need to raise a lot of money at the outset to get their business off the ground.

Disadvantages of a Corporation

There are also substantial disadvantages to having a corporation:

  • Double Taxation – One of the bigger disadvantages of a corporation—most notably the C corporation—is double taxation. When the corporation makes profit, that income is first taxed at the corporate level. If that profit is distributed to the shareholders as dividends, they must pay taxes on it, as well.
  • Rigid Management Structure – Corporations are also more rigid in terms of how they’re owned and run. Each shareholder owns a percentage of the company corresponding to the number of shares they own. A corporation must elect a Board of Directors to oversee the company (however, there are one-person corporations in which a single person serves as the entire board).
  • More Reporting and Bookkeeping – The rigid structure of a corporation requires more reporting and bookkeeping. These requirements vary by state, but are almost always more strict than other business types. Almost all states require an annual report, and some require you to keep minutes on the meetings of shareholders as well as the Board of Directors.

Different Types of Corporations

It’s important to know the differences between the three most common types of corporations when deciding which is best for your needs:

  • C corporation – This is the most common type of corporation; the business entity itself is taxed, and the individual owners are taxed separately on money they receive from the business.
  • S corporation – This is considered a “pass-through entity,” meaning it doesn’t pay income tax on the corporate level; instead, the profits pass through to the shareholders’ personal tax returns (thus avoiding double taxation).
  • B corporation (or “Benefit corporation”) – The B corp differentiates itself from other types of corporations in that its purpose, in addition to profit, is to be of benefit to society, its workers, the community, and/or the environment.

Now that you can answer the question “What is a corporation?” when someone asks, maybe you can better decide whether it’s the right business model for your company. Also, see our blog post “What Is an LLC?” for more information.

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