A corporation is a legal entity that the state recognizes as entirely separate from its owners. This is not true of a sole proprietorship or a partnership.

To get this recognition, the organizers of the corporation must apply to the state for a charter, sometimes called a certificate of incorporation. You have to file articles of incorporation that state the purpose of your corporation and outline its powers. You pay a fee when you incorporate and you pay franchise taxes ever after. These are modest compared to income tax, property tax and sales tax, but they are the price you pay for being incorporated.

In addition, you must adhere to certain formalities to maintain your corporate separateness:

* You transfer capital to the corporation in exchange for shares.
* Shareholders vote annually for a board of directors.
* The board of directors sets policy for the corporation and hires employees to manage it and do its business.

If you are incorporating a solo business, you may be the only shareholder and only employee of the corporation. Some states require others to serve on the board of directors and be corporate officers. Some states let one person do it all.

Limited liability

The most celebrated benefit you get from incorporation is protection from lawsuits if you are a shareholder. The most a shareholder can lose in his or her investment in the shares of the corporation. In small corporations, however, this is cold comfort, for a number of reasons:

* Lenders often make you co-sign debts of the corporation. If the corporation defaults, you are still on the hook—not as a shareholder, but as a co-signer.
* Suits for negligence or other torts are always based on the action (or failure to act) of a human being. If you are the human being, the plaintiff will sue both you and the corporation. Again, you’re still on the hook—not as the shareholder, but as the person who was negligent.
* Then let’s say the protection works. You’re not personally negligent and you didn’t co-sign anything. The plaintiff wins and takes everything the corporation owns. You’re out of a job and your most valuable asset is worthless. Are you happy?

Of course, these are the worst cases. There are many instances when the protection is helpful. And it becomes more and more helpful as you grow and add employees. But in most circumstances insurance is also a good idea.

How you make money in a corporation

Money earned by a business organized as a corporation can be paid to its owners in two basic ways: as compensation for services and as dividends.

Dividends are paid to shareholders, normally in proportion to the number of shares they own. Dividends are paid out of earnings that are left after all expenses (including compensation) have been paid. Many businesses retain some of the earnings in order to have working capital for the business.

Corporations in which the key employees are also the major shareholders pay little in the way of dividends. Salaries and other forms of compensation receive more favorable tax treatment than dividends. It’s only when the IRS would consider the compensation unreasonably large that dividends would be paid.

Corporate shares are transferable

Shares in a corporation are theoretically transferable. This has a number of consequences.

First, it makes it easier to separate the people who contribute capital to the business from people who contribute labor. What does this mean? It means that you can work hard in your business and at the same time raise capital by selling shares to people who will never set foot in your establishment.

Second, the business doesn’t depend on your corporeal survival in order to continue. A shareholder can die, and the shares are passed on and the business keeps on rolling.

Now, this transferability is limited. You can’t make a public offering of shares unless you comply with federal and state securities regulations. And some corporations deliberately structure their stock offerings with stock purchase agreements that provide that if a shareholder wants to get out, the other shareholder have the right to buy the shares.

But even with these restrictions, the transferability is a major benefit of being a corporation because of the power in helping a business raise money.

Copyright 2006, Chicago Tribune