What is a corporation?

What sets the corporation apart from all other types of businesses is that a corporation is an independent legal entity, separate from the people who own, control, and manage it. In other words, corporation and tax laws view the corporation as a legal "person" that can enter into contracts, incur debts, and pay taxes apart from its owners. Other important characteristics also result from the corporation's separate existence: A corporation does not dissolve when its owners (shareholders) change or die, and the owners of a corporation have limited liability -- that is, they are not personally responsible for the corporation's debts.

What is "limited liability" and why is it important?

If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and obligations of the corporation. In other words, if the corporation is sued, only the assets of the business are at risk, not the owners' (shareholders) personal assets, such as their houses or cars. The corporation's owners must comply with certain corporate formalities, keep up with paperwork requirements, and adequately fund ("capitalize") their business to maintain this limited liability privilege.

Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating. However, other business structures, such as limited liability companies (LLCs), now offer this limited personal liability to business owners. Sole proprietorships and general partnerships do not.

How are corporations different from partnerships, sole proprietorships, and LLCs?

Unlike corporations, partnerships and sole proprietorships do not provide limited personal liability for business debts. This means that creditors of those businesses can go after the owners' personal assets to collect what's due. However, organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, because no formal paperwork is required.

A limited liability company (LLC), on the other hand, does offer limited personal liability, like a corporation. And while formal paperwork is required to form an LLC, running an LLC is less complicated than running a corporation. LLC owners do not have to hold regular ownership and management meetings or follow other corporate formalities, for example.

Corporations also differ from other business structures in the way they are taxed. The corporation itself must pay corporate income taxes on its profits -- whatever is left over after paying salaries, bonuses, and other deductible expenses. In contrast, partnerships, sole proprietorships, and LLCs are not taxed on business profits; instead, the profits "pass through" the business to the owners, who report business income or losses on their personal tax returns.

Who should form a corporation?

Because of the expense and formalities involved in setting up a corporation and issuing stock (shares in the corporation), you should form a corporation only if you have good reason to do so. If you merely want to limit your personal liability for business debts, forming a limited liability company (LLC) is probably smarter, because LLCs cost less to form and are easier to run. But here are some situations in which incorporating your business instead of forming an LLC might make sense:

• Your business needs the ability to issue stock or stock options to attract key employees or outside investment capital.
• Your business is so profitable that you can save significant income tax dollars by keeping some profits in the corporation each year. This strategy, called "income splitting," takes advantage of the lower tax rates on corporate income of up to $75,000.
• You own a family business and you want to begin making gifts of ownership to your family as part of your financial or estate plan or to plan for the next generation of owners. You can easily make gifts of shares in your corporation without necessarily giving up management control and, if it's done correctly, without paying gift tax.
• Others insist that you incorporate your business. For example, if you are an independent contractor, companies you want to work for may ask you to incorporate before they will sign contracts for your services. These companies don't want the IRS or another government agency to reclassify you as an employee, which is very unlikely if you are incorporated.