If liability protection is what you seek, then your ISP business should consider incorporating—be it S Corp, C Corp, or just plain-old Corp.

by Mark E. Battersby [April 4, 2001]

An incorporated ISP, like any business other than a sole proprietorship or a single-member limited liability corporation (in states where permitted), is usually formed by business associates to conduct a business venture and divide the profits among investors. A corporation is an independent legal entity, separate from its owners, and as such, it means complying with more regulations and tax requirements.

The biggest benefit for any small business owner who decides to incorporate is the liability protection he or she receives. After all, an incorporated ISP's debt is not considered that of its owners, so if the business is organized as a corporation, the owner or owners are not putting their personal assets at risk.

From a legal perspective, the protection from liability offered by the corporate status can be greatly reduced in those situations where the incorporated ISP is not truly separate from that of its shareholders. A separate bank account for the ISP business, documented business decisions, a board of directors and simply doing business in the name of the corporation, rather than as Joe Smith funneling income and bills through a corporate "shell," go a long way toward avoiding the piercing of the corporate entity, making the shareholders liable.

Another plus is the ability of a corporation to raise money. A corporation can sell stock, either common or preferred, to raise funds. As owners of the incorporated ISP, common stockholders assume the primary risk if business is poor, realize the greater return in the event of success and elect the board of directors that controls the company. Preferred stock owners have prior claim on any dividends to be paid and, in the event of liquidation, to the distribution of the corporation's assets.

Although corporations continue indefinitely (even if one of the shareholders dies, sells the shares, or becomes disabled) there are also downsides to the corporate structure. A major one, for example, is higher costs.

Corporate costs
Corporations are formed under the laws of a state and each state has its own set of regulations. Because a corporation must follow more complex rules and regulations than a partnership or a sole proprietorship, it requires more accounting and tax preparation services.

Another drawback—owners of the corporation pay a double tax on the ISP business's earnings. Not only are corporations subject to corporate income tax at both the federal and state levels, but any earnings distributed to shareholders in the form of dividends are taxed at individual rates on their personal income tax returns.

Of course, to avoid that double taxation, the profits could be paid out as salaries to the ISP owner and other shareholders. No incorporated ISP is required to pay tax on earnings paid as reasonable compensation while that compensation is a tax deductible business expense. However, remember that what is reasonable to an ISP may not appear reasonable to a low-paid Internal Revenue Service auditor.

In the beginning
Although professional assistance is strongly recommended, forming a corporation is a pretty straightforward process. A corporation files a charter or articles of incorporation in a state or a U.S. possession. It prepares by-laws, has its business affairs overseen by a board of directors and issues stock.

Under the so-called check-the-box regulations, entities formed under a corporate statute are automatically classified as corporations for federal tax purposes. What's more, other entities with more than one member are allowed to elect corporate status on Form 8832, Entity Classification Election.

A corporation is formed by the transfer of money or property from shareholders to the corporate entity in return for corporate stock. If one or more shareholders transfer money or property to a corporation solely in exchange for stock of that corporation and if the shareholders control the corporation immediately after the exchange—neither the shareholders nor the corporation recognize any taxable gain or loss.

Final thoughts
Businesses that are engaged in operations that are considered "risky" or subject to frequent lawsuits are often encouraged by their legal advisors to incorporate. Using a corporate structure can, as mentioned, also make it much easier to obtain investment capital, to sell the ISP operation, or to pass the business along to the owner's heirs upon death or retirement.

Keep in mind, however, that from a tax perspective, there are two options for corporations under our federal tax laws. "C" corporations are what we normally consider "regular" corporations and are subject to the corporate income tax. "S" corporations, on the other hand, are corporations that have filed a special election with the IRS. They are not subject to corporate income tax but are treated in similar (but not identical) manner to partnerships for tax purposes. Ask your professional advisor for further details.

Obviously, tax strategies should not govern the day-to-day operations of your ISP business. While a good game plan for taxes may not help your ISP operation add new subscribers or grow profits, a well-planned tax scheme could insure that more profit remains in your pocket.

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