A corporation is a legal entity separate and distinct from its owners. It is considered a limited liability entity, as none of the owners (i.e., shareholders) are typically liable for the corporation's debts by virtue of being a shareholder. A "C" corporation is a corporation that has not made an election to be an "S" corporation. Operating your business as a sole proprietor or general partnership puts your personal assets at risk. One innocent mistake and you can lose everything. In order to protect you and your family, it is essential that you conduct your business using an entity such as a corporation or LLC. While a C corporation is taxed at the corporate level and at the shareholder level, resulting in "double taxation," there are many useful tax deductions available to the C corporation. Although holding real estate using a C corporation is not recommended, a properly designed C corporation can provide excellent benefits.

Forming a corporation requires filing articles of incorporation with the Secretary of State, electing directors, appointing officers, preparing and adopting bylaws, and issuing stock to the shareholders. Obviously, forming a corporation involves many formalities. Detailed agreements or specially drafted articles of incorporation may also be necessary if the parties wish to provide for different classes of stock or restrict the transferability or voting rights of corporate stock. However, forming a corporation can sometimes be more straightforward than negotiating a complex and detailed partnership agreement.

Corporations follow the principle of centralized management. In the simplest and most common corporate structure, shareholders elect the board of directors, who in turn appoint officers over whom the shareholders have no direct control. The board of directors is responsible for managing the business and affairs of the corporation with day-to-day control resting with the officers. The shareholders have no right to participate in the day-to-day management of the business. In the context of a small business, the same person may simultaneously be a director, officer and shareholder.

While corporate officers, directors and shareholders enjoy limited liability up to the amount they invested; the corporation itself is liable for corporate debts and other obligations as a separate legal entity. However, individuals may be held liable: (1) to the extent they personally guarantee corporate debts; (2) to the extent they receive improper distributions; (3) if a court "pierces the corporate veil" due to fraud, inadequate capitalization, or failure to follow corporate formalities; or (4) if a director, officer, or controlling shareholder breaches a duty to the other shareholders.

Shares of corporate stock, which represent ownership interests, are very readily transferable. Shareholders may freely transfer shares to anyone at anytime without the consent of the other shareholders. Certain reasonable restrictions may be set forth in the shareholder agreement. A conspicuous reference to any restrictions contained in the shareholders agreement must be contained on the shares themselves.

Corporations have perpetual existence. Because they have an independent existence, the death or withdrawal of an officer, director or shareholder does not usually terminate the corporation. The corporation's perpetual existence may be contractually modified in the articles of incorporation.

A corporation is a taxpayer in its own right, separate and distinct from its shareholders, and is taxed at the corporate tax rate. The individual shareholders are also taxed on dividends received from the corporation with no corresponding deduction to the corporation. This results in double taxation (the same money is taxed twice). This double taxation may be minimized by the payment of salaries to shareholders and by the use of shareholder loans. However, corporations issuing excessive or unreasonable salaries to their shareholders often face penalties from the IRS. Losses and deductions of a C corporation can be used, if at all, only to offset corporate income and gain, and cannot be deducted by the shareholders. One of the benefits of a corporation is having it provide lucrative employee benefits that are deductible by the corporation and tax free to the employees. Medical, life insurance, education, childcare, and retirement plans are just a few of the types of benefits available.

• Limited liability: The primary advantage of a corporation is limiting the liability of its owners. Unless (1) a member personally guarantees a debt; (2) the LLC fails to have a separate bank account and personal funds are commingled with LLC funds; (3) the LLC is undercapitalized; or (4) the LLC fails to pay state taxes or otherwise violates state law, the owners are not liable for the debts and obligations of the corporation. In a partnership or sole proprietorship, creditors may seize personal assets of the participants to pay debts of the business.
• 15% tax on corporate profits/income shifting: The ability to split income between a corporation and its shareholders in a manner that lowers overall taxes is referred to as Income Shifting. This practice is by far one of the greatest benefits of incorporating a business. Profitable small businesses with shareholders in higher tax brackets stand to benefit the most from the practice of income shifting. However, paying out ALL profits may not be viable for a corporation who plans to retain earnings to expand its product line or increase its advertising budget next year. Fortunately, profits retained within a corporation are taxed at the initial tax rate of only 15%. It is this ability to retain earnings within the business, without imputing tax liability to shareholders that provides an invaluable tax advantage to growing corporations that is not available to S corporations and unincorporated business entities. It is important to note, however, that certain "personal service corporations" are subject to a flat tax of 35% regardless of their income.
• Deductible fringe benefits: One of the benefits of a corporation is having it provide lucrative employee benefits that are deductible by the corporation and tax free to the employees. Medical, life insurance, education, childcare, and retirement plans are just a few of the types of benefits available.
• Ability to deduct business operating losses: Corporations have very few restrictions on the amount of capital or operating losses that a corporation may carry back or forward to subsequent tax years. Unincorporated entities, however, face more stringent rules regarding corporate losses. For example, an individual owning a sole proprietorship cannot claim a capital loss greater than $3,000 unless he or she has offsetting capital gains.
• Lower chance of IRS audit: IRS Form 1040, Schedule C (Profit or Loss from a Business), which is used by sole proprietors to report the businesses income and expenses, is the target of many IRS audits. The audit rates of similar businesses that have incorporated are much lower.

• Double taxation: The primary disadvantage to a C corporation is double taxation. Profits of a corporation are taxed twice when the profits are distributed to shareholders as dividends. They are taxed first as income to the corporation, then as income to the shareholder. All reasonable business expenses such as salaries are deductions against corporate income and can minimize the double tax. This double tax, however, can easily be eliminated by making an S corporation election.
• Shareholders of C corporations cannot deduct operating losses: Members who are active participants in the business of an LLC are able to deduct operating losses of the S Corp against their regular income to the extent permitted by law. Shareholders of an S corporation are also able to deduct operating losses, but not shareholders of a C corporation.
• More corporate formalities: Corporations must hold regular meetings of the board of directors and shareholders and keep written corporate minutes. Members and managers of an LLC need not hold regular meetings.

The difference between a "C" and "S" corporation has to do with taxes. An "S" corporation is a corporation that has made an election with the IRS to be treated for tax purposes as a "pass-through entity." This means that corporate profits and losses are passed through to the shareholders (owners) who report them on their own personal tax returns and pay the tax at the individual level. The corporation pays no federal income tax at the corporate level. The main factor drawing business owners to the S corporation is pass-through tax treatment. For entrepreneurs interested in the benefits of limited liability protection and flow through taxation, an S Corporation is an excellent entity for conducting business operations. S corporations are not desirable for real estate holdings but are extremely useful entities for start-ups where initial losses can flow through to the owners as well as for businesses with good cash flow. If you are in business as a sole proprietor or general partner you should immediately begin protecting yourself with an S corporation.

Formation requires filing an "S election" with the Internal Revenue Service. This election effectively makes the corporation a pass-through entity for Federal and California tax purposes, but does not change the nature of the entity for state corporate law purposes.

Corporations follow the principle of centralized management. In the simplest and most common corporate structure, shareholders elect the board of directors, who in turn appoint officers over whom the shareholders have no direct control. The board of directors is responsible for managing the business and affairs of the corporation with day-to-day control resting with the officers. The shareholders have no right to participate in the day-to-day management of the business. In the context of a small business, the same person may simultaneously be a director, officer and shareholder.

While corporate officers, directors and shareholders enjoy limited liability up to the amount they invested; the corporation itself is liable for corporate debts and other obligations as a separate legal entity. However, individuals may be held liable: (1) to the extent they personally guarantee corporate debts; (2) to the extent they receive improper distributions; (3) if a court "pierces the corporate veil" due to fraud, inadequate capitalization, or failure to follow corporate formalities; or (4) if a director, officer, or controlling shareholder breaches a duty to the other shareholders.

Shares of corporate stock, which represent ownership interests, are very readily transferable. Shareholders may freely transfer shares to anyone at anytime without the consent of the other shareholders. Certain reasonable restrictions may be set forth in the shareholder agreement. A conspicuous reference to any restrictions contained in the shareholders agreement must be contained on the shares themselves.

Corporations have perpetual existence. Because they have an independent existence, the death or withdrawal of an officer, director or shareholder does not usually terminate the corporation. The corporation's perpetual existence may be contractually modified in the articles of incorporation.

One of the main advantages of S-corporation status is that it avoids the double taxation that occurs with a regular C-corporation. In a C-corporation, the corporation pays income tax on its profits and, if those profits are distributed to shareholders, the shareholders pay income tax on the distribution. Another advantage of the S-corporation is that only the earnings actually paid out to you as salary are subject to self-employment taxes; money left in the business is not subject to payroll taxes. All income passes through, but its tax status depends on whether it is classified as salary or ordinary income. Here's an example: If you had net income of $60,000 and paid yourself $40,000 in salary, leaving $20,000 in the business, as a sole proprietor or LLC member, you would pay self-employment tax on the full $60,000 ($60,000 x 15.3% = $9,180). But as an S-corporation, you would only owe self-employment tax on the $40,000 in salary ($40,000 x 15.3% = $6,120), resulting in a savings of $3,060. This is a distinct disadvantage if you want to let earnings accumulate in the corporation, free of self-employment taxes, which is not possible in an LLC at this time.

S corporations offer numerous advantages. Among them are:

• Limited liability: The primary advantage of a corporation is limiting the liability of its owners. Unless (1) a member personally guarantees a debt; (2) the LLC fails to have a separate bank account and personal funds are commingled with LLC funds; (3) the LLC is undercapitalized; or (4) the LLC fails to pay state taxes or otherwise violates state law, the owners are not liable for the debts and obligations of the corporation. In a partnership or sole proprietorship, creditors may seize personal assets of the participants to pay debts of the business.
• No double taxation: One of the main advantages of S corporation status is that it avoids the double taxation that occurs with a regular C corporation. In a C corporation, the corporation pays income tax on its profits and, if those profits are distributed to shareholders, the shareholders pay income tax on the distribution.
• Self-employment tax savings: By electing S corporation status, only the earnings actually paid out to you as salary are subject to payroll taxes; money left in the business is not subject to payroll taxes or self-employment tax. All income passes through, but its tax status depends on whether it is classified as salary or ordinary income. Here's an example: If you had net income of $60,000 and paid yourself $40,000 in salary, leaving $20,000 in the business, as a sole proprietor or LLC member, you would pay self-employment tax on the full $60,000 ($60,000 x 15.3% = $9,180). But as an S corporation, you would only owe self-employment tax on the $40,000 in salary ($40,000 x 15.3% = $6,120), resulting in a savings of $3,060. This is a distinct disadvantage if you want to let earnings accumulate in the corporation, free of self-employment taxes, which is not possible in an LLC at this time.
• Loss deductions: The availability of losses. Shareholders of an S corporation generally may deduct their share of the corporation's net operating loss on their individual tax returns in the year the loss occurs. Losses of a C corporation, however, may offset only the corporation's earnings. This pass-through of an S corporation's losses to its shareholders makes the S corporation form particularly suitable for start-up businesses that are expected to generate losses during their initial stages. The shareholders of an S Corporation are limited in the amount they can deduct as a result of business losses, in rough terms to the amount of their "basis" or investment in the corporation. Even though losses pass through to shareholders in an S corporation, those losses aren't deductible by shareholders who don't materially participate in the business.
• Lower chance of IRS audit: IRS Form 1040, Schedule C (Profit or Loss from a Business), which is used by sole proprietors to report the businesses income and expenses, is the target of many IRS audits, however. The audit rates of similar businesses that have incorporated are much lower.

• Ownership restrictions: S corporations cannot have more than 100 stockholders, and each stockholder must be an individual who is a resident or citizen of the United States. If, for any reason, shares are somehow sold or transferred (even by will, divorce, or other means) to a shareholder who is a foreign national, the corporation will lose its S corporation status and be treated as a C corporation. Also, it is difficult to place shares of an S corporation into a living trust. None of these restrictions or difficulties apply to an LLC.
• Income recognition: Passing income through to shareholders can be a disadvantage in some instances. If the business is profitable, shareholders will be required to pay income tax on their share of the profits, even if that money is not distributed to them. In a C corporation, profits can be used to expand the business and shareholders are not required to pay taxes until distributions are made.
• Fringe benefits: Reasonable salaries paid to employees are deductible business expenses for S corporations as well as for C corporations. However, in an S corporation, fringe benefits may snot be deductible as they would be in a C corporation.