How do I form a corporation?

There are several steps required to legally create a corporation. The first is filing a short document called "articles of incorporation" with the corporations division of your state government. (Some states refer to this organizational document as a "certificate of incorporation," a "certificate of formation," or a "charter.") You'll have to pay a filing fee that ranges from about $100 to $800, depending on the rules of the state where you file. This document contains basic information such as:

• the name of your corporation
• the corporation's address
• the name and address of your "registered agent" (the person to be contacted by any member of the public who needs to speak to someone about the corporation), and
• in some states, the names of the corporation's directors.

When forming your corporation, you must also create "corporate bylaws," a longer document that sets out the rules that govern your corporation, including decision-making procedures and voting rights.

Finally, before you start doing business, you must hold an initial meeting of your board of directors to take care of some formalities, and you need to issue shares of stock to the initial owners (shareholders).

Does running a corporation involve more paperwork than running other types of businesses?

Yes. Corporations must comply with statutory rules that unincorporated businesses, such as limited liability companies (LLCs), partnerships, and sole proprietorships, do not. For instance, corporations must observe corporate formalities such as holding and taking minutes of annual shareholder and director meetings and documenting important decisions. Also, corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping system to record business transactions, complete with daily journals and a general ledger.

How is corporate income taxed?

Unlike sole proprietors and owners of partnerships and LLCs, a corporation's owners do not pay individual taxes on all business profits. The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends. (Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.) The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings").

Note that this taxation scheme does not apply to S corporations, which are corporations that have elected partnership-style taxation. (Regular corporations, discussed above, are called C corporations.) If your corporation elects to be taxed as an S corporation, all of the corporation's profits and losses will "pass through" to the owners, who will report them on their individual income tax returns.

What is double taxation? Does it mean that corporate income is taxed twice?

Many people have heard that corporate income is taxed twice: once to the corporation itself and then a second time when earnings are paid out to the corporation's owners (shareholders). This is true only for earnings paid out to shareholders in the form of dividends -- that is, profits paid by the corporation to its shareholders in return for their investment in the company.

In practice, this sort of double taxation seldom occurs in a small corporation. The reason is simple: Shareholders rarely pay themselves dividends. Instead, they work for the corporation and pay themselves salaries and bonuses. Because the corporation can deduct salaries and bonuses as ordinary and necessary business expenses, it doesn't have to pay corporate tax on them. (Dividends, on the other hand, are not a tax-deductible corporate expense, so both the corporation and the shareholder must pay tax.) As long as you work for your corporation, even in a part-time or consulting capacity, you can avoid double taxation by taking home profits in the form of a salary and bonuses rather than dividends.

What is a professional corporation?

A professional corporation is a special kind of corporation that only members of certain professions, such as lawyers, doctors, and healthcare workers, can create. By forming a professional corporation, professionals can limit their personal liability for the malpractice of their associates.

Do I need to worry about securities laws when I issue stock in my corporation?

Securities laws are meant to protect investors from unscrupulous business owners. These laws require corporations to jump through some hoops before accepting investments in exchange for shares of stock (the "securities"). Technically, a corporation is required to register the sale of shares with the federal Securities and Exchange Commission (SEC) and its state securities agency before granting stock to the initial corporate owners (shareholders). Registration takes time and typically involves extra legal and accounting fees.

Fortunately, many small corporations can skip the registration process because of exemptions provided by both federal and state laws. For example, SEC rules don't require a corporation to register a "private offering," which is a non-advertised sale of stock to either:

• a limited number of people (generally 35 or fewer), or
• those who, because of their net worth or income earning capacity, can reasonably be expected to take care of themselves in the investment process.

Most states have enacted their own versions of this popular federal exemption.

If you and a few associates are setting up a corporation that you'll actively manage, you will no doubt qualify for an exemption, and you will not have to file any paperwork. For more information about federal exemptions, visit the SEC website at www.sec.gov. For more information on your state's exemption rules, go to your secretary of state's website; you can find links to each state's site at the website of the National Association of Secretaries of State, www.nass.org.