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.
Tips for drafting corporate bylaws
While corporate bylaws do not need to be filed with the state Secretary of State’s office, they are an essential element in insuring that your corporation is respected as a separate entity for both tax and asset protection purposes. Corporate bylaws must be tailored to meet the specific needs of your business. One size truly does not fit all. However, your bylaws should address the following key areas:
Shareholder rights and responsibilities
- information regarding the annual meeting, as well as provisions governing special meetings
- notice provisions – including provisions for waiver of notice – for both annual and special meetings
- rules for fixing the record date and determining list of shareholder’s qualified to vote
- quorum requirements for shareholder meetings
- voting requirements, including the margin required to elect directors and take other actions
- provisions allowing consent of the shareholders in lieu of annual meeting
- description of stock certificates
- provisions for stock transfers and nominees
- actions required for lost or destroyed certificates
- treatment of fractional shares
Board of Directors
- definition of the number and term of office
- enumeration of powers of directors
- rules for increasing/decreasing number of directors
- provisions for vacancies and removals
- provisions for meetings—regular and special—including "teleconference" meetings
- rules regarding notice and waiver of notice
- quorum requirements for directors’ meetings
- provisions allowing consent in lieu of meeting
- process for creation of committees
- allowance for remuneration
- policy regarding loans to directors
- qualifications, election and term of office
- duties of each officer (e.g., president, vice-president, secretary, treasurer)
- delegation of duties
- provisions regarding vacancies and removal of officers
- policies regarding loans to officers, requirement of bonds, and officer salaries
- how declared & when paid (Warning: an S corporation can have only one class of stock, so if you are going to make an S corporation, be careful that you do not inadvertently create problems)
- authority to execute documents binding corporation
- authority to sign checks or notes
- indemnification of directors & officers
- governing law that should be applied
- provisions for amending by-laws
As you can see from this list of topics, a significant amount of thought must go into defining your corporate structure.
What’s more, your documentation burden does not stop once your bylaws are adopted. In order to avoid the risk of having your corporation disregarded, you need to document meetings of shareholders and directors.
You also must document financial dealings between the corporation and its shareholder, directors and officers. For example, a loan made to or from the corporation should be evidenced by a corporate resolution.
Regular corporations are separate taxpayers
In general, corporations are separate taxable entities that are subject to federal and state taxation. Corporate income is taxed at the corporate level. When that income is passed on to the shareholders as a distribution or dividend, it is taxed again on the shareholder's individual tax return. Double taxation may be partially or completely avoided in a small business by paying a salary to the employee shareholder. However, the tax laws governing this area are complex and should be discussed with your accountant or your attorney.
Also, be aware of the tax consequences upon dissolution of a corporation. With all forms of business entity except a C corporation, dissolution and distribution of the business's assets to the owners is, at worst, a single taxable event. In a C corporation, a double tax may be due; the corporation may owe a capital gains tax on liquidation and the individual shareholders also must recognize a gain upon the transfer of proceeds from the corporate entity to the individual recipient. Consequently, dissolving a C corporation can have serious tax ramifications, so think carefully about incorporating in this form if you anticipate a short-term business opportunity.
Protective measures. A corporation with two or more shareholders may require the efforts of all of the shareholders to succeed, especially in the early life of the business. If one shareholder withdraws or dies, the existence of the corporation may be threatened. To protect the corporation and the remaining shareholders, consider buy/sell agreements and key man life insurance policies on the shareholders.
A buy/sell agreement specifies how the value of a shareholder's interest will be determined if a shareholder wants to leave the corporation. Having a buy/sell agreement in place minimizes disputes over the company value and facilitates the purchase of the withdrawing shareholder's interest by the corporation or other shareholders.
Key person life insurance is a life insurance policy on the life of key members of an organization to provide cash in the event of the death of a key member. The beneficiaries of a key person policy are the organization or the organization members. In a corporation, key person life insurance can be purchased on the life of all shareholders or on some designated class such as corporate officers. The life insurance proceeds can be used by the corporation to keep the business going in the absence of a key shareholder or officer. The proceeds can also be used to buy out a deceased shareholder's interest pursuant to a buy/sell agreement.
Forming a close corporation
Some states allow a type of corporation called a close corporation, which may appeal to small business owners. A close corporation is one that is managed by its shareholders. Directors do not have to be elected and officers do not have to be appointed. In addition to these formalities being eliminated, the laws usually streamline some of the other meeting and voting requirements. The intent is to relieve some of the administrative burdens to the small corporation owner. If a close corporation appeals to you, consult an attorney in the state you are incorporating in to determine if a close corporation statute exists.
Forming a professional corporation
The corporate form can also be used for professional service providers. The main advantage of incorporating is that professionals in the corporation are not liable for the malpractice of others in the corporation, but they still remain liable for their own individual acts. Incorporating a professional corporation is essentially the same as incorporating any other corporation. A professional corporation however, must identify itself as such by including the following in its name: P.C., P.A., chartered, or incorporated.
Once created, only professionals can own shares of the corporation. The corporation can only provide one form of service, i.e., a professional corporation of lawyers who are also accountants can provide legal services but not accounting services. There are many other aspects of professional corporations that should be addressed before you venture into this form of entity. Your attorney or accountant can advise you as to whether the professional corporation is right for your situation.
There are different issues to consider when forming a nonprofit corporation.