The main advantage of a corporation is the liability protection it provides its owners or shareholders. Liability is limited because the corporation is a legal entity separate from its shareholder owners. One of the best-known and most widely used business entity forms is the corporation.
Traditionally, corporations are viewed as having four identifying characteristics:
- continuity of life,
- centralization of management,
- limited liability, and
- free transferability of interests.
As a separate legal entity, the corporation has a perpetual life. Also, as a separate legal entity, the corporation is liable for its own debts and can only be held liable to the extent of the corporation's assets.
The assets of a shareholder are personal assets that cannot be reached by corporate creditors, unless the "veil" of corporate limited liability is "pierced." The corporate veil is pierced when the required corporate formalities, such as having annual directors' and shareholders' meetings, etc., aren't followed. In effect, the corporate veil will be pierced (by a court when a lawsuit is filed against the corporation and its shareholders) when the corporate form is a mere sham that exists to enable shareholders to avoid personal liability. If the veil is pierced, the shareholders will be liable for the obligations of the corporation.
Although the corporate form generally results in limited liability, lenders usually require the shareholders of small, closely held corporations to personally guarantee corporate loans. If you personally guarantee the loans, you will have to pay the lender if the corporation is unable to pay.
Advantages of a corporation.
There are many advantages to operating as a corporation. Chief among them are:
- Earnings can be retained. The corporation can retain its earnings for future investment or dividends.
- Limited liability. Corporate shareholders are generally not responsible for the debts and obligations of the corporation.
- Ease of formation. Forming a corporation is generally a mechanical process dictated by state law.
- Tax planning advantages. There are many tax strategies that can only be employed by a corporation. In addition, a corporation provides opportunities to retain or pass along earnings in ways that are not allowed in partnerships, sole proprietorships or even LLCs.
Disadvantages of a corporation.
Every form of business also has disadvantages. Some of those for corporations include:
- Formalities required. A corporation must follow certain formalities dictated by law to maintain its corporate status.
- Administration. The administration of a corporation is complicated since certain federal and state tax procedures are necessary and certain accounting methods may not be available.
- Cost. The cost to incorporate an entity can be considerable, and there are annual filing fees that must be paid in most states. Also, the administrative costs of accounting and tax preparation may be expensive due to the complexity of complying with corporate laws.
- More complicated tax compliance. A corporation is a separate taxable entity. Sound tax advice is needed to minimize the impact of double taxation of your revenue--at the corporate level and when it is passed only to you as dividends or salaries.
Steps to forming a corporation
Forming a corporation is more complicated and more expensive than forming a sole proprietorship or a simple partnership because you must file paperwork with the Secretary of State in the formation state. (This is also true if you operate as a limited liability company.)
However, the formation process is not that difficult. To form a corporation, articles of incorporation must be filed with the secretary of state's office in the state in which the corporation is being organized. If the secretary of state's office accepts the articles of incorporation, it will send a certificate of incorporation. Many states require that a copy of the certificate of incorporation be recorded in the local recorder's office where the corporation resides.
A corporation does not have to be organized in the state in which it is going to do business. It can be organized in any state. Many corporations organize in Delaware or Nevada to take advantage of favorable corporate laws. (See our article, "Key Issues in Selecting Formation State," for more information.)
However, corporations must register as "foreign" corporations in any states in which they do business, outside of the state in which they were organized. And specific steps must be followed, including the selection of a registered agent. Both organization and foreign registration entail the payment of initial and annual fees which can add up to substantial amounts of money over time.
A corporation's name must be unique. If the name is already in use by another corporation, the incorporation documents will be rejected. Save time and effort by determining whether the proposed corporate name is available before filing the incorporation documents.
In fact, you should register the name as soon as you know what it will be. Call your state's secretary of state's office and ask them to reserve the name for you. If the name already exists, they'll tell you.
Operating a corporation
A corporation is owned by its shareholders. However, the shareholders don't have any control over the day-to-day operations of the business directly. Instead, the shareholders are responsible for electing directors of the corporation. The directors oversee the operation of the corporation and make major corporate decisions, such as appointing the officers of the corporation. The directors meet at least annually to assess the past performance of the corporation and to plan for the future. The officers of the corporation are responsible for the day-to-day operations of the company.
Once the directors are elected and the corporate officers are appointed, the corporation can begin to operate. However, it is important that the corporation observe all the formalities of being a corporation. The formalities include:
- adopting bylaws
- issuing stock certificates to the shareholders
- holding annual meetings--and complying with meeting notice provisions
- electing directors or ratifying the status of existing directors and
- recording the minutes of the meetings in the corporate register.
Observing all the corporate formalities provides evidence that the corporation is a separate legal entity rather than an extension of the shareholders. The reason it is necessary to enforce the notion that the corporation is a separate legal entity is to protect the limited liability of the shareholders.
In small, closely-held corporations, take extra precautions to see that all corporate formalities are observed. If the corporate formalities are not observed, someone suing the corporation may be able to show that the corporation is not a separate entity from its shareholders. The shareholders will then be liable for the corporation's debts.