As luck would have it, the English Flyer was lost near the Bermuda Triangle. The promoters had leased the ship, 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. And 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 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. (And know that piercing the veil is successful in almost half of all cases!) 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 (also known as the S corporation or S corp), 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. A copy of Form 2553 (and other useful tax forms) is found at http://www.corporatedirect.com/start-your-own-corporation/.
With the timely filing of Form 2553, 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 one hundred or fewer shareholders. All shareholders must be American citizens or resident aliens, who are foreign citizens working and paying taxes in America. Individuals may list their revocable living trust as a shareholder. That said, corporations, limited partnerships, multiple member limited liability companies, and other entities, including certain trusts, may not be S corporation shareholders. A Subchapter S corporation may have only one class of stock.
In fact, it was the above-named limitations that led in part to the creation of the limited liability company. Because many shareholders wanted the protection of a corporation with flow-through taxation but could not live within the shareholder limitations of a Subchapter S corporation, the limited liability company was authorized.
The Subchapter S corporation requires the filing of Form 2553 by the 15th day or the third month of its tax year for the flow-through tax election to become effective. A limited liability company or limited partnership receives this treatment without the necessity of such a filing.
Another issue with the Subchapter S corporation is that flow-through taxation can be lost when one shareholder sells his stock to a nonpermitted owner, such as a foreign individual or trust. By so terminating the Subchapter S election, the business is then taxed as a C corporation and the company cannot reelect S status for a period of five years. (At http://www.corporatedirect.com/start-your-own-corporation/ is a form that Sub S Shareholders can sign stating that they won’t transfer their shares to a non-permitted shareholder). If you are worried about losing your S corporation status and flow through taxation, the problem can be eliminated by using a limited liability company.
Still, there are plenty of good reasons to use an S corporation, including the minimization of self-employment taxes, as we will explore in Chapter 4.
Both C and S corporations require that stock be issued to their shareholders. While limited liability companies may issue membership interests and limited partnerships may issue partnership interests, they do not feature the same transferability and liquidity (or ease of selling) of corporate shares. Neither limited liability companies nor limited partnerships have the ability to offer an ownership incentive akin to stock options. Neither