Reading Financial Reports For Dummies. Lita Epstein

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or find ways to avoid them by using deductions. Two types of corporate structures exist:

       S corporations: These corporations have fewer than 100 shareholders and function like partnerships but give owners additional legal protection.

       C corporations: These corporations are separate legal entities formed for the purpose of operating a business. They're actually treated in the courts as individual entities, just like people. Incorporation allows owners to limit their liability from the corporation's actions. Owners must split their ownership by using shares of stock, which is a requirement specified as part of corporate law. As an investor, you're most likely to be a shareholder in a C corporation.

      Paying taxes the corporate way

      If a company organizes as an S corporation, it can avoid corporate taxation but still keep its legal protection. S corporations are essentially treated as partnerships for tax purposes, with profits and losses passed through to the shareholders, who then report the income or loss on their personal tax returns.

      The biggest disadvantage of the S corporation is the way profits and losses are distributed. Although a partnership has a lot of flexibility in divvying up profits and losses among the partners, S corporations must divide them based on the amount of stock each shareholder owns. This structure can be a big problem if one of the owners has primarily given cash and bought stock while another owner is primarily responsible for day-to-day business operations. Because the owner responsible for operations didn't purchase stock, they aren’t eligible for the profits unless they receive stock ownership as part of their contract with the company.

Only relatively small businesses can avoid taxation as a corporation. After a corporation has more than 100 shareholders, it loses its status as an S corporation. In addition, only U.S. residents can hold S corporation stock. Nonresident aliens (that is, citizens of another country) and nonhuman entities (such as other corporations or partnerships) don't qualify as owners. However, some tax-exempt organizations — including pension plans, profit-sharing plans, and stock bonus plans — can be shareholders in an S corporation.

      One big disadvantage of the C corporation is that its profits are taxed twice — once through the corporate entity and once as dividends paid to its owners. C corporation owners can get profits only through dividends, but they can pay themselves a salary.

      

Unlike S corporations, partnerships, and sole proprietorships, which pass any profits and losses to their owners, who then report them on their personal income tax forms, C corporations must file their own tax forms and pay taxes on any profits. At the time of this writing, the corporate income tax rate was 21% plus any additional state income taxes. But there was consideration in Congress of raising that rate to 25 percent or 28 percent.

      Many corporations avoid taxes completely by taking advantage of loopholes and deductions in the tax code. Most major corporations have an entire tax department whose sole responsibility is to find ways to avoid taxation.

      Getting familiar with reporting requirements

      A company must meet several requirements to keep its corporate veil of protection in place. For example, corporations must hold board meetings, and the minutes from those meetings detail the actions the company must take to prove it's operating as a corporation. The actions that must be shown in the minutes include:

       Establishment of banking associations and any changes to those arrangements

       Loans from either shareholders or third parties

       The sale or redemption of stock shares

       The payment of dividends

       Authorization of salaries or bonuses for officers and key executives (Yep, those multimillion-dollar bonuses you've been hearing about as major corporate scandals must be voted on in board meetings. The actual list of salaries doesn't have to be in the minutes but can be included as an attachment.)

       Any purchases, sales, or leases of corporate assets

       The purchase of another company

       Any merger with another company

       Changes to the Articles of Incorporation or bylaws

       Election of corporate officers and directors

      

These corporate minutes are official records of the company, and the IRS, state taxing authorities, and courts can review them. If a company and its owners are sued and the company wants to invoke the veil of corporate protection, it must have these board minutes in place to prove that it operated as a corporation.

      If a C corporation's ownership is kept among family and friends, it can be flexible about its reporting requirements. However, many C corporations have outside investors and creditors who require formal financial reporting that meets GAAP standards (for more on this topic, see Chapter 17). Also, most C corporations must have their financial reports audited. I talk more about the auditing process in Chapter 17.

Chapter 3

      Public or Private: How Company Structure Affects the Books

      IN THIS CHAPTER

      

Looking at the private side of business

      

Checking out the public world of corporations

      

Filing government and shareholder reports

      

Seeing what happens when a company decides to go public

      Not every company wants to be under public scrutiny. Although some firms operate in the public arena by selling shares to the general public on the open market, others prefer to keep ownership within a closed circle of friends or investors. When company owners contemplate whether to keep their business private or to take it public, they're making a decision that can permanently change the company's direction.

      In this chapter, I explain the differences between public and private companies, the advantages and disadvantages of each, and how the decision about whether to go public or stay private impacts a company's financial reporting requirements. I also describe the process involved when company owners decide to take their business public.

Investigating Private Companies

      Private companies don't sell

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