Key Takeaways

  • A small business corporation is a domestic corporation that meets specific IRS and statutory requirements, such as a limited number of shareholders and one class of stock.
  • These corporations provide limited liability protection and can exist independently from their owners, entering contracts, taking on debt, and paying taxes in their own name.
  • Small business corporations differ from partnerships, sole proprietorships, and LLCs in their tax structure, regulatory requirements, and ownership rules.
  • Benefits include attracting investors, offering stock options, tax advantages for highly profitable businesses, and smoother succession planning in family businesses.
  • Formation typically requires filing articles of incorporation, creating bylaws, issuing stock, and adhering to state and federal compliance requirements.
  • Electing S corporation status can help avoid double taxation, but requires meeting eligibility criteria such as shareholder limits and U.S. residency.
  • Some small business corporations may qualify for special tax benefits, including deductions for business losses and potential capital gains exemptions.

The requirements for small business corporations are crucial for you to understand if you are planning on forming one. Understanding the caveats of forming a corporation versus forming other entity types will allow you to make the best decision.

Small Corporation Business Definition

There are several definitions of a small business.

  • According to the IRS Subchapter S election guideline, a small business must have less than 100 shares to make a subchapter S election.
  • A Small Business Corporation is also defined as a corporation which raises money from investors and have a paid-in surplus totaling no more than $1,0000,000  and meets all other guidelines outlined in the Internal Revenue Code (26 USCS § 1244 (c)). This code allows shareholders to claim ordinary losses on valueless stock.
  • According to USCS § 1361, a small business corporation is a domestic corporation who is not owned by another corporation or a non-US citizen and only has one class of stock.

Eligibility Criteria for a Small Business Corporation

To qualify as a small business corporation under IRS rules, a company must meet several requirements:

  • Be a domestic corporation incorporated in the United States.
  • Have no more than 100 shareholders.
  • Issue only one class of stock.
  • Ensure that shareholders are individuals, certain trusts, or estates—not partnerships, other corporations, or nonresident aliens.

For Canadian tax purposes, a small business corporation may also be defined differently, often as a Canadian-controlled private corporation where all or substantially all (90% or more) of the fair market value of its assets is used in an active business in Canada.

What Exactly Is a Corporation?

The difference between other business entities and a corporation is that a corporation legally stands on its own. Thus, a corporation is a separate entity from its owners. In other words, a corporation is its own "person" and therefore can do the following:

  • Create contracts
  • Acquire debt
  • File taxes
  • Exist after the original owners die

Moreover, business owners who form a corporation have limited liability protection within a corporation. 

Types of Small Business Corporations

Small business corporations can take different forms depending on tax elections and jurisdiction:

  • C Corporations (C Corps): Default corporate form, taxed separately from owners. Profits may be subject to double taxation, once at the corporate level and again when distributed as dividends.
  • S Corporations (S Corps): Special tax status that allows profits and certain losses to pass through to shareholders, avoiding double taxation. Requires filing Form 2553 with the IRS and meeting shareholder and stock restrictions.
  • Professional Corporations (PCs): Formed by licensed professionals (e.g., attorneys, doctors) and may have additional state-level regulations.

What Is Limited Liability and Why Is it Important?

Limited liability means that a corporate shareholder does not risk being personally liable for the corporation's debt. It is important because in most cases, an owner cannot be personally held liable his company's debts and liabilities. Suppose a corporation is sued for a debt and the creditor wins the suit. The creditor can only go after the corporation's assets.

Keep in mind that the corporation must adhere to certain guidelines to maintain shareholder protection. Furthermore, owners must show that the corporation indeed works as its own entity.

Maintaining Limited Liability Status

Limited liability protection can be lost if corporate formalities are not followed, a situation known as “piercing the corporate veil.” To protect personal assets:

  • Keep corporate and personal finances separate.
  • Maintain accurate corporate records and hold required meetings.
  • Operate within the scope of corporate authority and comply with state filings.

Failure to observe these rules can expose shareholders to personal liability for corporate debts and obligations.

Are Corporations Different from Partnerships, Sole Proprietorships, or LLCs?

Corporations are different because they offer a protection you can't get from a partnership and sole proprietorship.  A corporation offers a special kind of protection. The corporate status shields your personal assets from corporate liabilities and debt.

The only other entity that offers this type of protection is a limited liability company (LLC). LLCs also offer their owners limited personal liability protection. While it requires paperwork to form, it is easier to maintain your LLC status compared to a corporation. For instance, LLC owners are not subject to strict corporate mandates like holding regular shareholder meetings.

Still, the biggest difference between corporations and other business entities is how they are taxed. Since a corporation is treated as a "person," it is subject to taxes. Corporations pay taxes on profits less all expenses including salaries, bonuses, overhead and other expenses. LLCs, partnerships, and sole proprietorships, on the other hand, are not taxed. Instead, the taxes pass through to the owners. Hence, the owners file their portion of profits or losses on their own tax returns.

Tax Advantages of a Small Business Corporation

Small business corporations—especially those electing S corporation status—can enjoy several tax benefits:

  • Pass-through taxation for S corporations, meaning profits and certain losses are reported on shareholders’ personal tax returns.
  • Potential for deducting business losses against other income, subject to IRS rules.
  • For qualified Canadian small business corporations, shareholders may benefit from a lifetime capital gains exemption on the sale of shares, up to a certain limit.
  • Ability to retain earnings in a C corporation for reinvestment at corporate tax rates.

Who Would Benefit from Forming a Corporation?

You should not form a corporation for the limited liability benefits since you get those same benefits if you form an LLC. However, you may benefit from forming a corporation in the following situations:

  • You want to attract and retain highly skilled employees by offering them stock options.
  • Your business is highly profitable, and you want to save on taxes.
  • You are running a family business and want to gift shares without losing ownership or control of your business.
  • You have an opportunity to have strategic partnerships or high-revenue generating clients, but they require you to have a corporate status.

When an S Corporation Election Makes Sense

An S corporation election may be advantageous when:

  • The business generates consistent profits that can be distributed without being taxed twice.
  • Shareholders want to avoid self-employment tax on distributions, while still paying themselves reasonable salaries subject to payroll tax.
  • Owners want to attract investors but still operate with pass-through taxation benefits.

However, an S corporation election is not always ideal for businesses planning to issue multiple classes of stock or seek significant outside investment from entities not eligible as shareholders.

How to Form a Small Business Corporation

  • File your articles of incorporation with your states Secretary of State's office or the governing body that handles entity formation in your state.
  • Make sure to include your business's legal address as well as the information for your corporation's registered agent.
  • Create your corporate by-laws which govern how you run your business and meet with your shareholders to issue stock before you open for business.

Ongoing Compliance Requirements

Once formed, a small business corporation must comply with ongoing obligations, which may include:

  • Filing annual reports with the state.
  • Holding annual shareholder and director meetings and keeping minutes.
  • Filing federal and state corporate tax returns.
  • Maintaining accurate corporate records and updated bylaws.

Failure to meet these requirements can result in penalties, loss of good standing, or dissolution of the corporation.

Frequently Asked Questions

1. What qualifies as a small business corporation in the U.S.?

A domestic corporation with no more than 100 shareholders, one class of stock, and only eligible shareholders such as individuals, certain trusts, or estates.

2. How does an S corporation differ from a C corporation?

An S corporation offers pass-through taxation, while a C corporation is taxed separately from its owners and may face double taxation.

3. Can non-U.S. citizens own shares in a small business corporation?

Not if the corporation elects S corporation status; only U.S. citizens or resident aliens may be shareholders in an S corporation.

4. What are the main tax benefits of an S corporation?

Avoiding double taxation, potential savings on self-employment taxes, and deducting certain business losses.

5. What ongoing requirements must a small business corporation meet?

Maintaining corporate records, filing annual reports, holding required meetings, and complying with state and federal tax filings.

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