Choice of Entity for Sole Business Owners Part II

This is a continuation of a series about choosing an business entity for sole business owners. Here's my first post, about Sole Proprietorships.

Corporations (Corp., Inc., Ltd.)

At the opposite end of the spectrum from Sole Proprietorships are corporations. Corporations are treated as separate from the individuals who own, manage, and operate them. The defining feature of a corporation is the governance structure: it’s owned by shareholders, who elect directors, who appoint officers. Officers typically manage day to day operations, while directors often handle broader strategic decisions, such as whether to reinvest profits or declare dividends. For our purposes, though, you’ll be the sole shareholder, director, and possibly the sole officer. Unlike sole proprietorships (and partnerships), the corporation survives the death of its owners.

Corporations provide “limited liability” to their shareholders, meaning that the shareholders are generally not responsible for the debts, liabilities, and obligations of the corporation. However, the limited liability protection does not shield professionals, such as doctors, lawyers, architects, engineers, etc., from liability for committing malpractice. Additionally, a claimant suing a corporation may seek to “disregard the corporate form” (commonly called “piercing the corporate veil”) in order to hold the shareholders personally liable. Owners of one-person corporations can be at particularly high risk if they don’t carefully comply with all formalities and record keeping.

For example: If Dr. Shanika Thomas from our last post formed “Thomas Healthcare Center, Inc.,” it defaulted on a small business loan, and the lender sued to collect, Thomas Healthcare Center, Inc. would be responsible for the debt, not Dr. Thomas. However, if Dr. Thomas was the sole shareholder, director, President, Treasurer, and Secretary, the lender could seek to “pierce the veil” and hold Dr. Thomas personally liable for the debt on the grounds that she is essentially a sole proprietor.

Forming a Massachusetts corporation is fairly straightforward. Simply submit your Articles of Organization with the Secretary of the Commonwealth. As of this post, the filing fee is $275, which allows you to issue up to 275,000 shares of stock. Every additional 100,000 shares costs an extra $100. Note that in Massachusetts, business filings are public record and freely searchable at the Secretary’s website.

In addition to Articles of Organization, you should also enact corporate bylaws, even if you’re the sole shareholder, director, and officer. The bylaws set forth how the corporation will be governed. Not only is it generally wise to have bylaws to guide you in managing your company, but they also lend documentary support to your claim of limited liability. Bylaws should also establish how the corporation will carry on in the event that owners and directors die, become incapacitated, or otherwise depart from the corporation. The bylaws are not filed with the Secretary of the Commonwealth.

You must also elect your directors and appoint your officers, even if you’re a sole-shareholder corporation. The Articles of Organization require you to name your initial directors and officers, and during the life of your corporation, you must hold shareholder meetings to elect or reelect the directors, and director meetings to appoint or reappoint the officers. It may sound silly, especially if you run your business out of your own home, but holding shareholder meetings, elections, and director meetings, and carefully documenting the minutes of these meetings can help support your claim of limited liability in the event that a claimant attempts to hold you personally liable.

In order to keep your corporation in good standing, you must file an Annual Report with the Secretary of the Commonwealth. The current annual report filing fee is $125.

Corporations can come in a variety of flavors depending on ownership and tax treatment. Here, I’ll stick to some basic distinctions: the C Corporation, the S Corporation, and the Professional Corporation.

C Corporation

The main distinguishing feature of a C Corporation is tax treatment. You’ve likely heard the phrase “double taxation” regarding C corporations. This is because C corporations are taxed on their income at two levels. First, the corporation itself pays annual income tax just as an ordinary person would. Second, if the corporation distributes dividends to the shareholders, the shareholders pay income tax on those dividends. If a corporation earns a profit or has a surplus, the directors may decide to declare a dividend, in which case the corporation distributes the profits to the shareholders, typically proportionate with the amount of shares owned.

As you might imagine, this usually isn’t very appealing to the sole owner of a small business. Indeed, C corporations are often preferred by larger, more sophisticated businesses. The reason is a little technical. A corporation can’t necessarily decide when it will incur taxable income at the first level – its annual income will likely depend on the external factors such as the market and consumer demand. However, the corporation can decide when to declare a dividend, and thus when to incur a taxable event at the second level. This can be a very powerful tool for tax planning. Of course, there are reasonable limits: the IRS (and likely the Massachusetts Division of Revenue) will penalize a profitable corporation that refuses to declare a dividend solely because it doesn’t want to incur taxes.

In sum:

  • + Limited liability protection
  • + Allows for easy growth
  • + Can defer taxable event
  • - Certain formalities required to sustain liability protection
  • - Incorporation fee and annual report fees
  • - Double taxation

S Corporation

S Corporations are a popular alternative for small businesses. The shareholders still enjoy the same limited liability protection, but the profits and losses are “passed-through” to the shareholders, which they report on their personal income tax returns and pay taxes on at their personal income tax rate. The tax treatment offered by the S corporation tends to be appealing to small business owners.

The flip side is that there are a number of eligibility requirements for S corporation status: there must be no more than 100 “eligible” shareholders (individuals, certain trusts, and estates), the corporation may issue only one class of stock, and certain corporations are ineligible. For many sole-shareholder corporations, the favorable tax treatment may nevertheless strongly outweigh burden of complying with the eligibility requirements.

To form a Massachusetts S Corporation, you follow the same steps as with a C Corporation, except that once you’ve filed your Articles of Organization, you must file IRS Form 2553 (Instructions here) electing S corporation status.

In Sum:

  • + Pass-through taxation
  • + Limited liability protection
  • - Same formalities to sustain liability protection
  • - Can’t issue multiple shares of stock
  • - May have limited number of shareholders
  • - Certain businesses ineligible
  • - Incorporation and annual report filing fees

Professional Corporation (P.C.)

Professional Corporations are a unique type of corporation available exclusively to licensed professionals. Functionally, a professional corporation can be either a C corporation or S corporation, so the same advantages and disadvantages apply. Just as with any other limited liability entity, the professional corporation doesn’t shield shareholders from personal liability for their own individual negligence or malpractice. However, the distinct advantage of a professional corporation is that it does shield shareholders from liability for malpractice caused by other shareholders.

For example: Suppose Dr. Thomas incorporated “Thomas Healthcare Center, P.C.,” where she was the sole shareholder, director, and officer. Wanting to serve patients at all ages, she brings on her classmate, Jackie Wu, a pediatrician, as another shareholder. If a patient sues Dr. Wu for malpractice, then Dr. Thomas is shielded from personal liability as long as she did not participate in the treatment of the aggrieved patient.

In exchange for this added protection, there are certain ownership and governance restrictions on Massachusetts professional corporations. All incorporators, all shareholders, a majority of the directors, and the president and vice president of the corporation must be licensed professionals. Additionally, either the Articles of Organization, bylaws, or a shareholder agreement must include a “corporate share redemption provision” requiring the corporation to redeem the shares of a shareholder who dies, becomes unable to practice (due to incapacity or disciplinary action), or transfers their shares to a non-licensed individual. See Massachusetts Professional Corporation Law § 12, Mass. Gen. Laws ch. 156A, § 12.

To form a professional corporation, you must file Articles of Organization with the Secretary of the Commonwealth, and, unlike non-professional corporations, you must explicitly state the professional services your corporation will provide. Additionally, you must also include a certificate signed by the relevant licensing board stating the name of the corporation and listing the incorporators, officers, directors, and shareholders. Otherwise, formation and maintenance parallels that of a C corporation or S corporation.

A professional corporation is a worthwhile consideration for a licensed professional who finds the corporate entity appealing. A professional corporation might be particularly appealing to professionals hoping to establish a solely owned company while leaving room for potential growth.

In sum:

  • + Limited liability protection
  • + Insulated from liability for other shareholders’ malpractice
  • + Allows for growth
  • - Only available to licensed professionals
  • - Certain formalities required to sustain liability protection
  • - Incorporation fee and annual report fees
  • - Additional incorporation and reporting requirements

Massachusetts Corporation Resources

Corporate Forms (Standard Domestic)

Corporate Forms (P.C.)

Massachusetts Business Corporation Act, Mass. Gen. Laws ch. 156D

Massachusetts Professional Corporation Act, Mass. Gen. Laws ch. 156A

S Corporation Summary (IRS)

This concludes Part II of my three-part miniseries on choice of entity for sole business owners. Look forward to Limited Liability Companies next week!

As always, if you have any questions, leave a comment or contact me!