Both incorporating and dissolving your corporation later, either when you are ready to retire or earlier, are especially easy if you are the only stockholder and officer. The one-person corporation is legal in every state.
Once you decide to incorporate, the first, crucial step is creating a corporate name.
If I had a specialty catering company, I’d be tempted to call it “Just Desserts.” And if I were starting an upmarket cleaning service, I’d probably want to call it “Maid in Heaven.” Both with an “Inc.” after them; all corporations must have a word such as “Company,” “Corporation,” “Incorporated,” or their abbreviations in their titles. Wit and memorability can turn your corporate name into a valuable asset: your clients and potential clients will remember it easily. Here are some I’ve come across recently: Daily Grind and Bean of Existence (coffeehouses), Wild Thyme (Middle Eastern restaurant), All Washed Up (launderette), and Michael and Angelo (contract painters).
Another strategy—naming your company after yourself—has two other advantages. First, business contacts will link you to your company more easily; it’s brand recognition. Second, if you have an unusual name or your name has an unusual spelling, you may be able to avoid making a corporate name search to make sure that your corporate name is available when you Inc. Yourself. In fact, after I checked the New York City phone directories for a Judith McQuown and found no others, I decided that I was safe in skipping the corporate-search step when I incorporated.
lf you plan to do business primarily in your own state, and perhaps deal with clients in other states occasionally, a name search in your own state will suffice. All states will do a name search free; most charge $25 to $150 for reserving your corporate name for two to six months.
However, if you plan to set up your business in more than one state, you have some work to do in order to ensure that the corporate name you have chosen is available for you to use in each of those states.
Just one horror story should persuade you to treat this process carefully. In April 1998, financial giants Citicorp and Travelers Group announced “the biggest merger in corporate history” to be named “‘Citigroup.” However, as CNBC reported a week later, that name was already in use. Citigroup was an Internet startup company owned by New York City entrepreneur Renata McGriff. Although Citicorp demonstrated prior use of other “Citi” names, its spokespeople admitted that the company had announced the merger and its new corporate name so quickly that it had not had the time to research whether “Citigroup” was available. Result: Citcorp says that the name problem was “resolved amicably.” Translation: Ms. McGriff sold her company’s name for thousands of dollars.
Now you’re ready to apply to the IRS for an Employer Identification Number. You will not be able to open corporate savings or checking accounts without it.
If you already have an Employer Identification Number (that is, for your Keogh plan account), it’s no good; you’ll need to apply for another one in the corporate name—even if you’re just adding “Inc.” to your own name. In the eyes of the IRS, the corporation is a separate “person” and must have a separate number. Think of your Employer Identification Number as your corporation’s Social Security number.
You can now download IRS Form SS-4, “Application for Employer Identification Number,” fill it out, and call the Tele-TIN number for your state listed under “Where to Apply.” An IRS representative will establish your corporation’s account and assign it an EIN. Write that number in the upper right-hand corner of the form, sign and date it, and mail or fax it within 24 hours to the Tele-TIN Unit at the IRS service center address for your state.
If you have already chosen to be an S corporation, check “Other corporation” on line 9a and write in “S corporation.” If you make this decision later, you will have to file IRS Form 2553 “Election by a Small Business Corporation” (see pages 112–114). (It’s called an S corporation, but you still choose Subchapter S status.) This form must be postmarked no later than the 15th day of the third month of your corporation’s existing tax year. If your corporation is on a calendar year, your deadline is March 15. The IRS will accept no excuses for even one day’s lateness. Your corporation will not receive S corporation treatment until the following year.
If you choose to be a limited liability company, check “LLC” on line 8a.
If you have chosen to be a C corporation and have only one or two owner-employees, check “personal service corporation.” Larger corporations should check “Other corporation” and write in “C corporation.”
When you are filing these first forms that are crucial to your corporation’s existence, it is a good idea to employ the good old “belt-and-suspenders” strategy of dealing with the IRS. Send all forms by certified mail, return receipt requested, so that you will have proof that you filed them before the deadline. Enclose a copy of the form, a self-addressed stamped envelope, and a note asking that your form be stamped “Received” by the IRS and returned to you. Paranoid? Perhaps. But anyone who has ever had problems proving to the IRS that forms were sent on time will agree that being super-cautious is better than being sorry.
Make or order your corporate stationery and business cards now so that you will have them on hand before January 1. You may wish to have cards printed and sent to your clients and customers announcing that on January 1 your business or profession will be conducted under your new corporate name:
Now you’re ready for the big step: applying for your Certificate of Incorporation. This procedure varies from state to state; the different state requirements, forms, and fees are shown in Appendix A. In any case, your first step would be writing to the secretary of state or appropriate department or agency for your state, as shown in Appendix A.
For purposes of illustration in this chapter, I will walk you through the procedure of incorporation using New York State laws, procedures, and forms. (Many of the states will differ in detail, but New York State is fairly representative.)
In New York State, the Certificate of Incorporation forms can be bought for approximately $2 each at most commercial stationers. Ask for Form A 234, “Certificate of Incorporation, Business Corporation Law § (Section) 402,” and get several blanks. You’ll be sending one copy to Albany, you’ll want a duplicate for your files, and you may want one or two forms to practice on.
Following is a sample Certificate of Incorporation. Of course, the purpose of your corporation may be different from the one shown; for the wording you need, consult §§ (Sections) 202 and 402 of the Business Corporation Law. For most small corporations, the broad language already on the form revised in late 1987 and shown here is all that is necessary.*
In New York State, this form is sent to New York State Division of Corporations, One Commerce Plaza, 99 Washington Street, Albany, New York 12231, along with a money order or bank cashier’s check for $135. Unless you are a lawyer, New York State will not accept your personal check.
You will note that the IRS Request for Employer Identification Number and the New York State Certificate of Incorporation both ask for your fiscal year.
In the first five editions of Inc. Yourself, the recommendations made were very different from the suggestions many tax experts are making now. Back then, the KISS (Keep It Simple, Sweetheart) strategy, which recommended electing a calendar year in order to file fewer tax forms during the first year of incorporation, outweighed the benefits of choosing a different fiscal year in order to implement more sophisticated tax planning.
Since 1987, however, it’s quite clear that the highly profitable deferral strategies available through choosing a fiscal year that differs from the calendar year make it well worth the few hours of extra paperwork in your corporation’s first year of life.
Choosing a fiscal year that ends on January 31 will give you the maximum tax-deferral advantage. If your corporation pays your salary annually or semiannually, it can pay you a good part—or all—of your salary in January 2014. The corporation takes its salary deduction for fiscal 2013, which ends on January 31, 2014. But because you, as an individual, are on a calendar year, you will not owe income tax on the salary you received in January 2014 until April 2015. That’s a 15-month deferral for some people. If you are paying estimated taxes, the actual deferral time may be shorter, but you will still have 15 months to do your tax planning.
Unfortunately, the Tax Reform Act of 1986 made it very difficult for certain personal service corporations—defined as those whose principal function is “services in the fields of law, health, engineering, architecture, accounting, actuarial science, performing arts, or consulting”—to elect a fiscal year other than a calendar year. Now, personal service corporations, such as S corporations, partnerships, and sole proprietorships, must use a calendar year—unless your corporation receives special permission, granted by the District Director of the Internal Revenue Service, to use a fiscal year. Here’s how to try for it: you need a clear, documented business reason. If your corporation makes gingerbread houses and most of its income is received in January for sales made in December, you have an excellent business reason for choosing a January fiscal year in order that your corporation’s income and expenses will fall in the same year.
Even if your services aren’t as seasonal as those of a maker of gingerbread houses, you may still have a good chance of convincing the Internal Revenue Service if you can show that a good chunk of your income is received in January. Here’s an argument that may work: “My corporation gets paid in January for work it has done in the preceding year. I have to wait until my clients receive their Christmas bonuses and pay their bills before I know the corporation’s income for the year, how many full or partial payments are coming in, and so on. In fact, nearly half of my corporation’s income is received in January. Accordingly, it makes both economic and tax sense not to separate the time period in which the income was received from the time period in which the work was done.”
Obviously, this line of reasoning is perfectly logical. You may find that you’ll need a more sophisticated argument and up-to-date books whose receivables prove your point if the IRS ever comes knocking at your door; if so, consult your accountant or tax lawyer. However, this argument is the core, and it may very well work for you.
To apply for a fiscal year, file IRS Form 1128 in triplicate (shown on pages 51–54) and cross your fingers. You should receive an answer in six to eight weeks.
The Revenue Act of 1987 gave targeted personal service corporations another alternative, which may be a better choice for some owners. Under certain circumstances, it may be advantageous (and permissible) to elect a fiscal year that gives you up to a three-month deferral—that is, a September 30 fiscal year. Consult your tax advisor for details and specific advice. Ask about the enhanced-estimated tax-payments system.
Most states’ Certificate of Incorporation forms ask whether the corporation plans to issue par-value stock or no-par-value stock, as in the preceding illustration. Par value (sometimes called face value) means the value or price at which the corporation’s stock is issued; if a share of stock has a par value of $10, there must be $10 in the treasury to back it when the stock is initially sold or transferred. An entering stockholder would have to pay $1,000 for 100 shares, and the $1,000 would go into the corporate treasury to back the shares of stock ($10 per share).
No-par-value stock has no money behind the shares; no stockholder investment is necessary. Usually, in an ongoing sole proprietorship, the assets and liabilities of the proprietorship are transferred to the corporation in exchange for the corporation’s stock.
Generally, if you are offered the option, issue no-par-value stock rather than par-value stock. No-par-value stock is easier to set up, is cheaper, and requires less paperwork. Some states assess taxes based on the par value of the issued and outstanding stock; if you have 100 shares of $100 par-value stock issued and outstanding, your total par value is $10,000. If those 100 shares have no par value, your total par value is $0.
In most states, corporations that deal in services can choose either par-value or no-par-value stock; only those businesses that use a great deal of capital (that is, manufacturing) may not be given the choice and may have to issue par-value stock, so that the corporation would start with substantial cash assets.
If you incorporate in New York State, shortly after you submit your Certificate of Incorporation and cashier’s check or money order for $135 to the Division of Corporations, you will receive a filing receipt. Now you are able to proceed to the next step: ordering a set of corporate records and a corporation seal at a commercial stationer; both of these are required by law.* Depending on where you live, it may take one to three weeks for you to receive your order. You must present your filing receipt to the stationer, or your order will not be accepted.
The simplest and cheapest corporate record set is a loose-leaf binder (approximately $85, including corporation seal) that contains stock certificates, a stock transfer ledger in which the shareholders’ names and addresses are recorded, pages to which you attach the filing receipt and a copy of the Certificate of Incorporation, and sample minutes of meetings and bylaws that are set up so that you can just fill in the blanks. (A sample set of corporate minutes and bylaws is shown in Appendix B.) Even if you are the sole stockholder, officer, and employee of your corporation, alas, it is necessary to go through this paperwork. Or, if you put a higher value on your time than on your money, you can have your lawyer set up your corporation.
However, as lawyers’ going rate for setting up a one- or two-person corporation is $500 to more than $1,000 and you can fill out all the forms in a couple of hours, wouldn’t you rather do it yourself and “pay” yourself $250 to $500 an hour?
After you receive your new Employer Identification Number and your corporate seal, you will be able to open your new corporate bank accounts. I find it best to keep both a savings account and a checking account. Both types of accounts may require the impression of your corporate seal.
The following is a typical commercial bank checking account corporate resolution, to which you would sign and affix the corporate seal. Because a savings bank corporate resolution is much less detailed, a sample is not given.
On the date on which you begin corporate life, you can either cut off your sole proprietorship and start afresh, or transfer the proprietorship’s assets and liabilities to the new corporation. Note that these are assets and liabilities—such as office equipment, and accounts receivable and payable—not earnings and profits from the proprietorship. In general, a corporation’s assumption of the proprietorship’s liabilities is beneficial. A dentist who had ordered silver would rather have the corporation pay the bill than pay it out of his or her own pocket.
When partners in a partnership decide to incorporate, there are theoretically three ways in which the incorporation may take place. Therefore it seems advisable, where substantial sums are involved, that the partners either seek professional advice or use the simplest method, which I describe here. (The other two are more complex and require the assistance of a lawyer.) Under this method, the partnership transfers all its assets to the newly formed corporation in exchange for all the outstanding stock of the corporation. The partnership would then terminate, distributing all the stock to its partners in proportion to their partnership interests.
The only danger—in terms of federal tax—is transferring more liabilities than assets, which can lead to unnecessary taxes. This situation can be avoided fairly easily; you can always throw in a personal asset to equalize the balance, even if it’s only another chair for your office or a few more reams of paper.
The asset/liability balance is probably a question of magnitude. If the liabilities exceed the assets by $50, it is unlikely that the IRS would bother with your case. If they exceed the assets by $5,000, that’s another story. Just to be on the safe side, however, get your accountant’s advice; theoretically, even a difference of $100 could get you in trouble with the IRS.
Whether you transfer your sole proprietorship’s assets and liabilities to your new corporation or close down everything and start from scratch, there will probably be a period of a month or two in which the corporation will need some kind of seed money until funds start coming into the corporation. Usually this would be money for new stationery, petty cash, one month’s operating capital, and similar expenses.
Of course, the simplest—but also the most expensive—route would be taking out a 30-, 60-, or 90-day bank loan. But it is possible for you to lend the corporation money as long as the amount of money you are lending the corporation is not too great and as long as the corporation repays you within a short period of time. The IRS suggests that if you choose to lend money to the corporation for startup expenses, you should limit the loan to no more than about $10,000 and the corporation should repay you within three to six months.
Whether you should charge your corporation interest on the loan or make it an interest-free loan depends on several considerations. Your decision probably will involve less than $300 in interest (a maximum of $10,000 × 12 percent × 3 months), so it really isn’t crucial. Among the factors you should consider are whether your corporation will be very successful in its first year, your income from other sources, and whether you need interest income to offset interest you are paying on loans or on your margin account at a brokerage house.
The IRS points out some possible pitfalls in your lending money to the corporation. If the loan is on the corporation’s books for an extended period of time and if there is no provision for interest, the IRS could maintain that this money is not really a loan—that instead it is equity capital (money that the corporation must have to stay alive). If the IRS can prove that you need all that money for a fairly long time to keep your business afloat, then, whether you call it a loan or not, the IRS will hold that the money is equity capital.
If the IRS does establish that the loan really is equity capital, then when the loan is repaid, it may be deemed a dividend (and therefore taxable to you) rather than a repayment of the loan. You would be distributing part of that equity capital to yourself, and such a distribution is considered a dividend.
However, this problem generally affects only companies that need a great deal of capital. Small business and professional corporations can usually stay within the loan-size and repayment-time limitations that satisfy the IRS.
When I incorporated, I had to handle the problem of seed money for my corporation. Because I had to wait for my Employer Identification Number, I paid some corporate expenses with personal checks and then reimbursed myself when the corporate checking account was activated. I delayed paying myself salary until corporate income could be transferred to the checking account, and then paid myself back salary and reimbursed expenses in two large lump-sum checks: one for salary and one for expenses. This procedure might well work for you and your new corporation.
Shortly after you incorporate, you will have to decide whether you want an S corporation and/or whether you want to issue §1244 stock. These are independent choices; you may choose either, both, or neither. Do not make either decision without consulting a lawyer and/or accountant.
Limited liability companies (LLCs) have increased dramatically since the eighth edition of Inc. Yourself and are covered in Chapter 6, “Limited Liability Companies (LLCs).” The LLC is a non-corporate form that combines the limited liability of the corporation with the flow-through tax treatment of the partnership. Every state permits only one member, as their owners are called. For a comparison of the advantages and disadvantages of LLCs and S corporations, see Chapter 6.
The Revenue Act of 1987 had a dramatic impact on some entrepreneurs’ and professionals’ decisions to choose Subchapter S as their corporate form. In an S corporation, profits and losses flow through to the individual shareholder(s) and profits are taxed as personal income. In a C (general business) corporation, you choose whether corporate profits remain in your corporation or are paid to you.
The key provision of the 1987 act has made Subchapter S election even more attractive to many people than the 1986 act had made it. This provision states that “certain personal service corporations” (most professional corporations and corporations whose chief source of income is consulting or the performing arts) would be taxed at a flat 34 percent instead of the graduated rates of 15 percent for income under $50,000, and 25 percent for income between $50,000 and $75,000. By forming an S corporation, professionals, consultants, and performers whose net income is $50,000 would be in the 15-percent bracket for part of their income and 21 percent for the remainder, rather than the mandated 34 percent.
As a result of the 1986 and 1987 acts, S corporations have become so important that I have devoted an entire chapter to them. In fact, if you think that your corporation might be one of those “certain personal service corporations,” finish this overview section and then skip immediately to Chapter 7, “How to Profit From Your S Corporation.” Deciding whether you should choose an S corporation or a C corporation can be the most important business and tax decision that you make for your new corporation. Obviously, you’ll want to consult your tax lawyer and/or accountant before choosing between an S corporation and a C corporation.
If the officers of a corporation decide to issue §1244 stock—a decision that must be made and recorded before the stock is issued—any shareholder who subsequently sells or exchanges that stock at a loss can take the loss as an ordinary loss, as opposed to the less-favorable capital loss, on his or her personal income tax return (up to $50,000 per year if you are single, up to $100,000 per year if you are married and filing jointly). The rules governing this tax shelter are too technical to describe in detail in a general book like this one, and it is very unlikely that small business owners will choose §1244. However, if you feel that issuing §1244 stock might benefit your stockholders and your corporation (usually only if you think that at some point outsiders may buy your stock or if you plan to take your company public), you should consult your lawyer and/or accountant.
Appendix B consists of a sample set of minutes and bylaws for a corporation registered in New York State. They include minutes of the organizational meeting, the bylaws, minutes of a board of directors’ meeting, minutes of a shareholders’ meeting, and minutes of a special meeting of the board of directors to elect a January fiscal year. Minutes of a special meeting of the board of directors to approve a medical care reimbursement plan and the plan itself are found in Chapter 11, “Medical Benefits.”
______ |
Choose corporate name. |
|
______ Check its availability. |
|
______ Reserve name. |
______ |
Choose calendar year or fiscal year. |
______ |
Get Employer Identification Number (IRS Form SS-4). |
______ |
Decide whether your corporation will be an S corporation; if so, and you did not check the box on IRS Form SS-4, file IRS Form 2553. |
______ |
File Certificate of Incorporation with the state you choose. |
______ |
File IRS Form 1128 if you have chosen a fiscal year. |
______ |
Design and order: |
|
______Corporate stationery. |
|
______Business cards. |
|
______Announcement cards. |
______ |
Decide whether to transfer your sole proprietorship’s assets and liabilities to your new corporation. |
______ |
Open corporate bank account(s). |
______ |
Calculate startup/seed money for approximately three months and how you will obtain it. |
______ |
Decide whether to issue §1244 stock. |
______ |
File corporate minutes and bylaws. |
______ |
Decide whether to set up medical care reimbursement plan. |
* Plus disbursements. Charges for expedited searches (1 to 3 days) are approximately double.
* For the purpose of this book, I have transferred the material on my original Certificate of Incorporation to this new form.
* Although some states no longer require a corporate seal, virtually all banks and brokerage houses still require your corporate seal on documents.
