Basic Characteristics of the C Corporation
C corporations protect personal assets from business liabilities
Forming a C corporation, or any business entity, is a fundamental way to help protect personal assets of the owners from the farm business’s liabilities. The C corporation offers farm operation owners peace of mind in keeping the risks of their business separate from their personal assets. As long as corporate formalities are upheld, the shareholders–which is the C corporation term for the business owners–are not at risk of losing personal assets if another person or business secures a court judgment against the shareholder. The shareholders can, however, lose up to the amount they have invested in the company. Whatever cash, property or other resources a shareholder invests in the C corporation is considered their equity investment; it reflects their risk or stake in the business, so to speak. The potential gain is a return on the investment in the form of profits based on their ownership percentage or equity in the company. The potential loss is losing all that they invested, no more, no less. That’s because once a shareholder transfers ownership of the cash or property invested, it is thereafter owned by the C corporation itself.
Running a farm operation is not easy, and there’s no guarantee it will succeed. Equipment breakdown, crop failure, unpredictable weather or a number of other events could lead to no profit or even a loss in a given season. If the farm doesn’t turn a profit and uses up all the company’s money or capital in the process, the owners of the C corporation won’t even get their equity investment back. There’s nothing left. Taking it a step further, let’s say the C corporation had taken out a loan to pay for some farm equipment and is no longer able to pay on its debt. It won’t be long before the creditors come knocking on the farm business’s door. However, given the C corporation protects shareholders from personal liability, the shareholders do not have to worry so much that creditors will come knocking on their doors and snatch up their lake house or their boat if the farm business starts going south. The creditor could still lay claim to any remaining assets of the C corporation, but nothing more. This is one advantage of creating a business entity such as a C corporation.
The C corporation protection on personal assets requires adherence to certain principles
In return for this privilege, state corporation statutes require business owners to follow certain rules and procedures. Each state has its own corporation statute, which establishes what is required to form and maintain a C corporation in that state. The rules and procedures a C corporation must follow vary from state to state; however, they all require the business owners to follow some fundamental principles.
C corporations require a strict governance structure: shareholders, directors and officers
All state C corporation statutes require a very strict governance structure, which includes having shareholders, a board of directors and officers. Each of these titles carries its own roles and responsibilities.
Shareholders are those who contribute assets–or an equity investment–to fund the farm operation. They are the owners. They generally have little say or right to run the day-to-day operations of the company. However, they get to elect the board of directors and have the right to remove directors as they wish. The board of directors is elected by the shareholders each year at the annual meeting. The directors may or may not be shareholders themselves. The directors have high-level responsibilities for running the business, including making certain big decisions such as whether the company should take on a major financial liability like a loan to buy farmland, start a new business segment like value-added products or sell off a significant part of the farm operation. Another key role of the board of directors is to appoint the corporation’s officers. Like the directors, the officers may or may not be directors or shareholders. The officers of a corporation are the ones on the ground running the day-to-day operation of the business and making management decisions. The officers include the president or chief executive officer (CEO), vice president or chief operations officer (COO), treasurer or chief financial officer (CFO), and secretary. One person can hold multiple positions, or even all of them. This might sound silly, but acting with these separate hats is an essential formality that must be upheld to maintain the integrity of a C corporation entity. We’ll discuss each of these positions in a bit more detail later.
What if you have just one or a few business owners?
It is of note that one person can fill all the roles of the shareholder, board and officer(s). If this were the case, that person would make decisions in different capacities. For example, let’s say a mother and daughter decide to form a business entity for an organic goat cheese operation they’ve gone in on together. They call it Mother Earth Farm, Inc. It’s just the two of them, and they need to figure out how they will fill all of these roles. Let’s say they both invest some cash as an equity investment, so they are both shareholders. As shareholders, they elect the board of directors. They elect each other! Then, as directors, they decide who will be the officers. Together they agree that mom will serve as president and treasurer and daughter will serve as vice president and secretary. As officers, they now get to decide day-to-day matters such as how many goats to have, what types of cheese to make and so on. Any big decisions such as getting a substantial loan to buy farmland would need to be made as directors. If they decide the company needs more money for a new milking parlor, they would act as shareholders when writing a personal check to the business as an equity investment.
Be sure the farm operation has enough money, and keep the C corporation’s financial affairs separate from the shareholders’ financial affairs
In addition, like the LLC, the owners of the farm operation must also abide by certain principles to maintain the C corporation’s protection from personal liability. If the farm business does not follow certain standards, then the courts can go around the C corporation’s personal liability shield and allow creditors to access the individual owners’ personal assets. Just as for an LLC, the two essential ways to protect the shareholders’ personal assets are to adequately capitalize the C corporation and to keep the C corporation’s financial affairs separate from the owners’ personal financial affairs.
First, as a basic rule of thumb, a company is adequately capitalized if it can make due on its debts, or pay its monthly bills, so to speak. Anything less would be undercapitalized. In other words, if you start incurring more debt than you can reasonably pay off based on estimated revenue, the C corporation will be considered undercapitalized. As a result, the shareholders may be personally liable to cover the business’s debt. The directors and officers need to be smart about how much debt they allow the C corporation to take on.
Courts are also able to access personal assets if the shareholders fail to keep the business separate from their personal affairs. This includes commingling funds such as drawing on business assets to pay for personal expenses or not keeping separate business and personal bank accounts. The takeaway here is that just as business assets are available for business liabilities, personal assets are available for personal liabilities–each needs to remain separate and not be commingled. Be sure to keep separate bank accounts, credit cards and accounting records for the business entity, and to keep these all distinct from the personal financial affairs of the shareholders. For example, do not use the business’s assets to pay a shareholder’s personal bills, including credit card bills and rent payments.
Also keep in mind that even if the C corporation is properly maintained, some creditors may require shareholders to personally guarantee farm debt. Creditors know that if there’s nothing left in the business entity there will be nothing left for them. What this means is that creditors may require the shareholders to commit to loan payments as individuals, not just as shareholders to the C corporation. Shareholders will have to negotiate whether and to what extent a personal guarantee is required with creditors on a case-by-case basis.
C corporations do not substitute for insurance or reduce the likelihood of liabilities
Forming a C corporation or any business entity is not a substitute for insurance. Some farmers mistakenly believe creating a C corporation reduces the likelihood of liability. Creating a C corporation does nothing to change the landscape of a farm’s potential liability; it only limits the assets available to satisfy that liability, should it materialize, to business assets. All the farm’s assets are entirely available to anyone with a successful claim against a C corporation. Good liability insurance provides the farm with a defense in court and a source of funds to pay out on a court claim if it is successful. Farm Commons strongly urges any farm business, no matter what business entity it adopts, to maintain adequate insurance coverage.
How the C Corporation Compares to the LLC and the S Corporation: Which to Choose?
This is a good question that many farmers ask. For all intents and purposes, the liability protection offered by an LLC and a corporation are the same. Comparing some of the key characteristics of the C corporation and LLC may help you decide which option better matches your needs.
Flexibility versus formality
In practice, the statutory flexibility of the LLC with respect to how the entity is governed may lead many to mismanage it, degrading the protection it is meant to offer. For example, LLC statutes do not require separate directors and officers with such defined roles and responsibilities, though an LLC can certainly appoint individuals with such authority. Also, most state LLC statutes do not require the owners to hold an annual meeting. State C corporation statutes require the owners to hold an annual shareholder meeting, which provides an opportunity for everyone to review the financials and elect next year’s board of directors.
The board of directors must also meet annually to appoint the officers. The formality of annual meetings helps keep the board and the officers in check. As stated above, liability protection can be lost through mismanagement, including undercapitalization or the commingling of business and personal financial affairs. The formalities of a C corporation, including its strict governance structure and required annual meetings, may make mismanagement less likely. However, to non-lawyers, the formalities involved with a C corporation can look like too much pageantry. To many, the formalized processes of decision-making and authority are unwelcome. To these folks, the statutory obligations of a C corporation are a detraction. They may prefer an LLC.
Newness versus tradition
On the other hand, while the LLC has been around for over 35 years and is a very stable entity in the eyes of the law, the reality is that C corporations have been around a lot longer. The courts’ interpretation and application of laws governing corporations are very well detailed. Now, much of this case law or precedent on corporations is being applied to LLCs, which lends further credibility to the LLC entity. Nevertheless, some farmers feel more comfortable with the traditional C corporation. This is also why some folks set up their LLC exactly like a corporation–with a similar governance structure and required annual meetings–even though it’s not required. They want to rest assured that they will have the benefits of the stable, thorough body of law controlling corporate governance. Ultimately, the decision may come down to personal inclination and comfort with what they are used to seeing in their family, town or region.
Some other factors to consider in the choice between an LLC or C corporation relate to financial issues. First, if a farm operation anticipates it will need to raise a large amount of capital that exceeds what they can or want to get a loan for and is more than what the initial farm operation owners can afford, it may be beneficial to form a C corporation. This will preserve the option to raise capital from venture capitalists and angel investors. These are individuals with a significant amount of money who invest in small businesses in hopes of making a profit. Venture capitalists and angel investors typically prefer the formal C corporation structure and may even require it before making an investment. Also, if you think that your company will go public by advertising and offering ownership shares to the public at large through what’s called an initial public offering (IPO), then the law requires a C corporation structure. Conducting an IPO is a very costly and time-consuming process that involves very complex securities law. It is typically done by multi- million dollar companies like Google and Amazon, for example. But maybe your farm operation has the next big idea! Of note, both a C corporation and an LLC can advertise and offer ownership interests directly to members of the public with whom they have a connection–like customers or suppliers. This is called a DPO. However, the LLC’s choices on what it can offer through a DPO are a bit more limited than the C corporation.
These financing issues are beyond the scope of this chapter. The point here is that these types of considerations can certainly come into play in the decision of which entity to choose, especially if the farm operation is considering a creative financing option to raise additional capital at the outset or in the future.
Finally, there are significant tax differences between a C corporation and an LLC. The LLC is a pass-through entity, so the entity itself does not have to pay federal income taxes. Instead the individual members report their share of the LLC’s income on their individual tax returns. The C corporation, on the other hand, is subject to double taxation. The entity first pays corporate tax on the business’s taxable income, and then the owners have to pay taxes on any earnings or profits they receive from the company. Granted, the individual owners are taxed at the dividend tax rate, which is currently less than the rate for ordinary income. But the total taxes paid on business income for some small business owners can be astronomically high. Many small farm operations see this as a huge pitfall of a C corporation and a reason to form an LLC.
Should I choose a C corporation or an S corporation?
If you decide you prefer the assurance of the formalities and stability of the C corporation, you still have an option to circumvent the double taxation dilemma. Unlike the LLC or the C corporation, the S corporation is actually not a separate entity created at the state level. The S corporation is simply a federal tax status issued by the IRS. In effect, either an LLC or a C corporation can become an S corporation for federal tax purposes. Basically, the S corporation tax status allows the entity to be taxed as a pass-through entity, just like an LLC. It also provides some potential tax benefits related to self-employment taxes that neither the C corporation nor LLC provide on their own right.
With S corporation tax status, if the corporation has just a single shareholder, the entity would be taxed as if it was a sole proprietorship. If there are multiple shareholders, it would be taxed as if it were a general partnership. Each shareholder would report the company’s earnings and pay applicable taxes through his or her own individual tax return. Accordingly, the farm operation owners will end up paying different tax rates depending on their overall financial situation. This could be very advantageous to certain farm business owners.
The IRS requires an entity to meet certain criteria to be eligible for the S corporation tax status and to complete annual tax documents to maintain the status. To be eligible, the entity must have fewer than 100 owners; all owners must be U.S. citizens; no owners can be for-profit entities such as an LLC or a C corporation (must be human beings, estates, tax-exempt entities or certain qualified trusts); and the entity can only have one class of owners. Review Chapter 6 on S corporations for more details on eligibility criteria, annual tax form requirements and how to elect S corporation tax status.
Forming a C Corporation
Now that we’ve provided some basic background and characteristics of the C the initial directors, filing the articles of incorporation, creating the bylaws, appointing the officers and issuing shares to the initial shareholders. This section should be read in conjunction with the Creating a C Corporation Checklist that is part of the “Dive Deeper” section of this chapter.
Who can form a C corporation?
Most state corporation statutes allow C corporations to be created by a single person or multiple people. There are no restrictions on how many people may participate. Another business entity, such as an LLC or a trust, could be a shareholder.
Appoint the initial directors, the deciders of big decisions
One of the first steps a new C corporation will take is to appoint the members of its board of directors. This is a bit tricky, as it needs to happen before the entity is actually formed. Usually, initial directors are identified in the “articles of incorporation,” which is the formation document filed with the state. Often the initial directors are selected in the interim by the person who takes the initial step of incorporating the business (sometimes called the “incorporator”). Once the corporation is up and running, directors are typically elected by shareholders at annual meetings.
The directors do what their name says: they direct the corporation along its path and make big decisions that impact the financial affairs of the company. This includes approving contracts and agreements, making decisions about significant purchases such as land or expensive farm equipment, and approving overarching corporate policies including employee handbooks and such. The directors also decide when and whether to pay dividends to the shareholders. Dividends are payments made to the shareholders when the business makes a profit. Dividends reflect the shareholder’s return on investment, or bang for their buck. The handing out of profit to the shareholders is not automatic; it’s ultimately a significant business decision. That’s why it’s left for the directors to decide. The directors may very well decide that it’s in the best interest of the farm operation to keep all or a part of the profits in the company. This way they can better grow the farm business, like investing in more equipment or capital, such as a greenhouse or a new parcel of farmland.
The board of directors is also fundamentally on the legal hook, so to speak, for the corporation’s actions. First and foremost, the board of directors is accountable to the shareholders. They also have what’s called a “fiduciary duty” to the corporation, which includes both a duty of care and a duty of loyalty. A duty of care is to diligently act on behalf of the best interests of the corporation. For example, if the farm operation wants to buy a piece of property, the directors need to really look into their options. Are there sufficient water rights? What is the going rate for a similar parcel? What’s the quality of soil like? They need to take special care that the decision they make is not at all arbitrary and is in the best interest of the corporation. A duty of loyalty is to put the interest of the corporation above their own personal interest. So, for example, if a director owns a piece of land that they want to sell to the corporation, they need to realize that this presents a conflict of interest. As a landowner, they have an interest to sell the property at the highest price possible. As a director of the corporation that is a potential buyer, they need to get the best deal possible. In actuality, to fully abide by their duty of loyalty, they should really refrain from voting on the matter. The same goes for a director or officer making a decision on their own salary. It can be helpful to keep all of this in mind when appointing your directors.
How many directors should there be? You can have as many or as few as you want. The ideal number usually depends on the size of the farm operation. A small farm operation might have just one director, who also serves as the sole owner or shareholder and plays the roles of all the officers. A larger farm operation may have more directors. It’s generally recommended to have an odd number, as that will ensure there are no deadlocks on voting. Many recommend having fewer than 10 directors, as it can be unwieldy to manage the opinions of a lot of directors. However, it’s entirely up to you.
Draft and file the articles of incorporation with your state
Once the initial board of directors is appointed, the next step in creating a C corporation is filing the “articles of incorporation.” This is done at the state level, usually through the state’s secretary of state office. Many states provide a form that can be easily downloaded or even filed online. Other states simply list the information required, in which case you can create your own document that includes this information. An internet search for “file a corporation and [your state’s name]” should bring up a form and more information. Each state charges different fees, which vary from $25 to $1,000. Once your articles of incorporation and fee are filed and processed, you’ll get a confirmation from the filing agency that your C corporation is now recognized as an official business entity in your state.
A few key terms you’ll need to know when filing the articles of incorporation are the “registered agent” and the “incorporator.” The registered agent is basically the person who receives “service of process,” which is an official notice that the C corporation is being sued. It does not in any way mean this individual is liable or responsible for the outcome. It simply means that the agent is required to pass on the notice to the other shareholders of the corporation so that the corporation is officially on notice. Some businesses select a shareholder to be the agent. Others choose to work with one of the many independent businesses that provide agent of process services for a small fee. An incorporator is an individual who organizes and arranges for the articles of incorporation to be filed with the secretary of state. The incorporator must verify that all the included information is true and correct, and must sign the articles of incorporation. This could be a shareholder; it’s often the entity’s attorney.
Annual Fee: Note that most states also require an annual fee. It’s a good idea to find out upfront whether your state charges an annual fee and, if so, how much. The amount of the fee may be a factor in your decision on whether to form a C corporation.
Draft the bylaws
In addition to the articles of incorporation, state corporation statutes require corporations to have bylaws. The bylaws set the ground rules among the shareholders, directors and officers for how the corporation must be governed. They include baseline procedural guidelines for corporate governance. State corporation statutes often set specific parameters for certain governance matters that are to be included in bylaws, such as when and how shareholders must be informed about annual meetings, items that must be voted on at annual meetings, how voting must take place, and restrictions on who can decide what, etc. These details can vary from state to state. So, if you decide to draft your own bylaws, be sure to check your state’s corporation statute or consult with an attorney who is familiar with your state’s statute to ensure that your bylaws are fully in compliance with state law. The bylaws don’t need to be filed with the state; however, they must be officially adopted by the board of directors. For more information about bylaws and examples of common language used with explanations, see the Sample Bylaws for Mother Earth Farm, Inc. included in the “Dive Deeper” section of this chapter.
Hold an organizational meeting
After you have filed the articles of incorporation and drafted the bylaws, the board of directors should hold an organizational meeting. At this meeting, the directors should first officially adopt the bylaws. All directors should have read them and agreed to them by this point. It’s important to document the board’s approval of the bylaws in the minutes of the organizational meeting.
Next, the directors should elect officers, if they haven’t already done so. The officers are responsible for the day-to-day management of the company. The board is responsible for appointing them and designating their salary. Officer positions include a president or chief executive officer (CEO), a vice president or chief operations officer (COO), a treasurer or chief financial officer (CFO), and a secretary. The president has ultimate responsibility for the corporation’s activities. The president reports to the board of directors; however, he or she generally has the authority to sign contracts and other legally binding actions on behalf of the corporation. The vice president is optional, depending on the size of the farm operation. Typically, a vice president is charged with managing the corporation’s day-to-day affairs. There can be multiple vice presidents if there are multiple segments of the business. Or, if the business is small and streamlined, this role is oftentimes filled by the president. The treasurer is responsible for the corporation’s financial matters, including keeping the farm’s accounting system up to date and in check. The secretary is in charge of maintaining the corporation’s records, documents and “minutes” from shareholder and board meetings. Note that a director can serve as an officer and that one person can serve multiple offices. Like directors, the officers owe a fiduciary duty to the company (i.e., a duty of care and a duty of loyalty). Be sure to keep this in mind when deciding who the initial officers will be.
Approve issuance of stock
The directors should also officially approve the issuance of shares or stock in the company. Let’s say that the articles of incorporation specified that the corporation is authorized to issue 10 million shares. The board could decide to issue all the shares to the founding shareholders. Or, they could decide to set some shares aside, say 1 million for future investors or stock option benefits for employees. These are decisions that have financial implications for the company and should be made in consultation with a corporate attorney or a tax accountant.
Decide whether to elect S corporation federal tax status
In addition, if the corporation will be an S corporation (i.e., elect S corporation federal tax status), the directors should approve the election at this time. Be sure to follow the voting parameters set forth in your bylaws when voting on these matters. Also, written minutes must be kept for this organizational meeting and all meetings held by the board of directors and shareholders to evidence what happened, should a dispute or issue ever arise.
Before engaging in any business activity as the corporation, the corporation needs to formally issue the shares authorized by the board to the founding shareholders. This is the formal process of dividing up the ownership in the company. It is also required by law if you are doing business as a corporation. Again, issuing stock can be complicated. Farm Commons strongly recommends that you have an attorney who is familiar with corporate and securities law handle the stock issuance for you.
First, both federal and state securities laws may apply. Unless you qualify for an exemption at both the federal and state level, you will have to file a securities registration. Fortunately, most small farm operations will qualify for an exemption. For example, the Securities Exchange Commission (SEC) rules and most state securities laws provide a “private offering” exemption. This basically means that you’ll likely be exempt from securities filings if you don’t advertise investment opportunities in your company to the general public and you only have a small number of people investing who are actively participating in running the business. Be sure to confirm with your attorney whether this or any other exemption applies. Security filings can be very time consuming and expensive. The stakes are high if you do not comply, as you could face fines and potentially be required to give investments back in full to the shareholders.
When you’re ready to issue the actual shares to your founding shareholders, you’ll need to put the following in writing: the initial shareholders’ names and mailing addresses, the number of shares each shareholder will purchase and how each shareholder will pay for their shares, which can be cash, property and services (also known as “sweat equity”). Keep in mind that most states have a minimum amount of stock that can be issued. Note also that if you plan on electing S corporation tax status, you can only issue one class of stock, which is generally common stock, meaning one vote per share. This information should be included in your bylaws.
Next, you can prepare and issue stock certificates. A stock certificate is a way to document stock ownership and is given to the shareholder. This step is not actually necessary, as most states no longer require corporations to issue actual stock certificates. However, shareholders have come to expect it, and it provides another layer of evidence of who owns how many shares. If you do issue a stock certificate, states generally require that you include the following information on the face of the certificate: the name of the corporation, the state where the corporation was formed, the name and number of shares issued to the shareholder, and a signature authenticating the document. Finally, some states require that you file a “notice of stock transaction” with your state’s business agency or secretary of state. This is typically a simple form, but it’s important that you file it if it’s required. Otherwise you risk the state saying that the issuance of shares is invalid.
Create a shareholder agreement if the shareholders want one
While shareholder agreements are not required, they can be useful to set forth specific terms that all shareholders must abide by and follow among each other. A shareholder agreement provides even more detail than the bylaws on how the corporation will be run. Shareholder agreements can be particularly important in closely held corporations where the shares are held between a small group of people and are not offered to the general public. In addition, shareholder agreements can be a useful way to protect minority shareholders, who may fear that their voice will be overpowered on everything. For example, the shareholder agreement could require that certain decisions be agreed to by all the shareholders. Shareholder agreements also often include procedures for dispute resolution, which can help keep matters out of court, as well as restrictions to prevent unwanted parties or strangers from acquiring shares in the company.
Implementing Best Business Practices for Your C Corporation
Now that you’ve formed your C corporation (by filing the articles of organization) and have established the governing rules (by finalizing and officially adopting your bylaws), you now must follow through by acting like you have a separate business. This means upholding best business practices by keeping your business affairs separate from your personal affairs, abiding by the provisions of your bylaws, filing applicable annual maintenance fees with the state and filing your taxes.
Keep your business and personal financial affairs separate
It is essential that you maintain a clear and distinct level of separation between the C corporation’s business affairs and each of your shareholder’s personal affairs. Primarily, this means maintaining separate bank accounts and accounting records. This also includes not paying your personal debts or bills with the business assets. Of course, shareholders can pay for legitimate expenses related to the C corporation with their personal funds so long as they account for and properly record these expenses and record them as business expenses. Be sure to keep all the receipts in case of an audit. The shareholder can either write these “business expenses” off on their individual tax return or they can request to be reimbursed directly by the C corporation. If the company reimburses the expense, then they cannot also write it off. That would be a sure way of abusing the integrity and separation of the business entity!
Another key requirement for keeping the business affairs separate is to properly allocate assets to the C corporation. Any land, equipment or other asset that is contributed to the C corporation as shareholders’ equity investment needs to be formally transferred over. Officially allocating assets in this way helps make absolutely clear who owns what; it also clarifies the extent of each shareholder’s liability if the farm operation turns sour. Recall that if the C corporation upholds best business practices, each shareholder’s liability extends only to the value of his or her equity investment. If the lines aren’t clear, the courts can go around the business entity and access personal assets.
Follow your bylaws and hold annual meetings
Be sure to follow what the bylaws say, as well as any shareholder agreements should you decide to enter into them. Legally speaking, these are contracts that all the shareholders are now bound by. You should make copies or make it available in electronic form so that every shareholder, director and officer has it and can refer to it as needed. Following the rules and procedures your bylaws set gives the business legitimacy in court.
For example, your bylaws should designate a general time and place for an annual shareholder meeting as well as specify particular requirements for how and when to let shareholders know about the details of the meeting. Be sure to follow these procedures, otherwise anything that’s conducted at a meeting could be deemed invalid by a court. You should take minutes to record what happened. The minutes don’t have to be elaborate, just enough for the shareholders present to recall what was discussed and decided, and for anyone not present to understand what happened. A sample of minutes from a shareholder’s meeting is included in the “Dive Deeper” section of this chapter for a guide.
Also, if you decide to make changes to your bylaws, you’ll need to follow the procedure it sets for making amendments. If the shareholders or board of directors properly agree to an amendment, be sure to document it in the minutes.
It’s a good idea to keep your bylaws, any shareholder agreements, all meeting minutes and any amendments in one binder so that everything is readily available. This also helps prove the legitimacy of your C corporation by showing you are taking the separate entity seriously. Whenever you have a doubt about what’s required for making a decision or how to deal with a specific scenario when it arises, refer to your bylaws or shareholder agreements for guidance.
Pay your state’s annual maintenance fees
This is simple, but it’s amazing how many business entities fail to follow up. Most states require an annual fee to continue to operate as a C corporation. Be sure you pay this fee each year, on time. Otherwise, you could incur late fees. Or, at worst, your C corporation could be administratively dissolved. You would then have to start the whole process over again, which no farmer has time to do.
Designate your tax status
As a C corporation, you can choose to be taxed as a C corporation or an S corporation. While this Guide is not intended to provide tax advice, we will provide a brief overview to help with basic understanding as you work with your accountant or tax attorney to decide what designation is best for your farm operation.
The default federal tax status for a C corporation is to pay corporate taxes. Basically, the farm operation will be taxed separately from the owners. Any profit remaining in the company at the end of its tax year will be taxed at corporate tax rates. If the corporation distributes profits to the shareholders, the shareholders will also have to report the dividends as income on their individual tax returns. Many say this is disadvantageous, as the owners end up paying double the taxes. First, they pay corporate taxes on the net earnings of the company and then they pay taxes on any profits they get from the corporation in the form of dividends.
Another option is to elect the S corporation tax status with the IRS. It’s simple to do: You just have to fill out and file IRS Form 2553, “Election by a Small Business Corporation.” The S corporation tax status allows the C corporation to be taxed as a pass-through entity, just like the LLC. Instead of the entity paying corporate taxes, all earnings of the company are reported by the shareholders on their individual tax returns in accordance with their equity share in the company. The shareholders then pay taxes on the company’s income based on their individual tax rate.
In addition, the S corporation tax status handles self-employment taxes slightly differently than any other entity. Basically, in addition to a “reasonable” salary that can be paid to the owners or shareholders of the farm operation, the owners can also receive income in the form of “distributions.” Distributions are taxed at a lower rate and are free from self-employment taxes including Social Security and Medicare taxation. This can equate to about 15 percent savings in federal taxes. Distributions can of course only be made if there are sufficient profits in your farm operation. Otherwise, your company will be considered undercapitalized. Recall that if this happens, the shareholders may be personally liable to cover the business’s debt.
To be eligible for S corporation tax status, the entity has to meet certain criteria. In addition, while the C corporation doesn’t have to pay taxes, it does have to distribute tax forms to the shareholders each year and file certain forms with the IRS, including Form 1120S. This is the informational tax document used to report the income, losses and dividends of S corporation shareholders.
Deciding on salaries of owners
Farmers may be motivated to keep their salary as low as possible so that the remainder is taxed at a lower rate. If you elect S corporation tax status, keep in mind that the IRS does not look fondly on artificially low salaries and can reclassify dividends as salary. The IRS will look at many different factors in determining what a reasonable salary should be. Anything above that could be reclassified and taxed as dividends. Factors the IRS will consider include the following:
- training and experience
- duties and responsibilities
- time and effort devoted to the business
- dividend history
- payments to non-shareholder employees
- timing and manner of paying bonuses to key people
- what comparable businesses pay for similar services
- compensation agreements
- the use of a formula to determine compensation
This begs the question, what is a reasonable salary for a farmer? Where do we draw the line? According to the Bureau of Labor Statistics, in 2014, the average annual income for supervisors of farms and farmworkers was $47,540. If you own and run your own farm operation, which includes supervisory duties, the IRS may consider this as the baseline. Let’s say an owner of a C corporation with net annual income of $50,000 tried to claim that just $20,000 of that was a reasonable salary in hopes of getting a tax break on the remaining $30,000. You might have an uphill battle convincing the IRS that a farmer of similar skill and responsibilities could only reasonably expect $20,000.
Tax designation choices for the C corporation
- Do nothing. The default will apply. The entity will be required to file and pay its own corporate taxes. The shareholders will have to report and pay taxes on any dividends they receive from the company.
- File IRS Form 8832, “Entity Classification Election,” and elect corporation, and then file IRS tax Form 2553, “Election by a Small Business Corporation.” You will be taxed as an S corporation. The income of the corporation passes through to the shareholders, who each report and pay taxes based on their individual tax rate.
Note that this is simply for federal tax status. You will still need to pay any applicable corporate taxes in your state!
Fulfill your tax obligations
Once you decide on your tax designation and file the appropriate forms, you’ll then need to be sure the entity and each of its shareholders fulfill the annual tax obligations. This includes distributing forms, filing forms and, of course, paying taxes when due. The following provides a basic breakdown of what is required based on the tax status you choose for your farm operation. Again, Farm Commons strongly recommends that you seek guidance from your accountant or tax attorney come tax season. Tax law is very particular. Working with a tax expert will help guarantee you’re doing everything properly; it could also end up saving you money by finding ways to minimize your tax burden.
If you go with the default tax status, the C corporation will have to file Form 1120, “U.S. Corporation Income Tax Return,” and pay its own taxes. In addition, the shareholders will each have to individually report and pay taxes on any dividends they receive.
If you elect to be taxed as an S corporation, you’ll have to file the annual Form 1120S with the IRS. This is an informational tax document used to report the income, losses and dividends of S corporation shareholders. The entity itself will not have to pay taxes, as it passes through to the individual shareholders. In addition, the company will have to provide each of the shareholders with a Schedule K-1. The Schedule K-1 is similar to a W-2, the end-of-year wage statement that employees receive from their employers. The Schedule K-1 shows the self-employment income each of the shareholders receives from the company. The company must also submit a copy of Schedule K-1 to the IRS for each shareholder. This allows the IRS to be sure that each shareholder is properly reporting any self-employment income he or she receives from the corporation.
Tax forms a C corporation must file and distribute based on tax status
- C corporation status: File Form 1120, “U.S. Corporation Income Tax Return,” with the IRS and pay taxes as a corporation. Each shareholder will report and pay taxes on any income (i.e., salary and distribution of profits) he or she received from the entity on his or her individual income tax return.
- C corporation with S corporation tax status: File Form 1120S with the IRS, which is purely informational. Distribute Schedule K-1 to each shareholder and file Schedule K-1 for each shareholder with the IRS. Each shareholder reports and pays taxes on the individual tax return for his or her share of the corporation’s income.
Maintain accurate accounting records
Finally, the business and all shareholders need to keep good records of the business’s financial affairs, including all receipts of business expenses in case of an audit. It’s also advisable that you use a reliable accounting system such as QuickBooks or hire an accountant to handle your accounting and taxes for you.