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C Corporations Explained

20. What are the main characteristics of a “corporation”?

A corporation is one of the earliest forms of legally recognized business entity. Corporations exist under every state’s laws. The corporation is the most formalized and developed form of business entity. Its structure is developed to optimize the relationship between owners (shareholders), high-level decision makers (directors), and operational managers (executives). The main characteristics of a corporation are as follows:

•    Creation and Maintenance – Corporations arise by filing articles of incorporation with a state government. The state issues a charter upon the application of individuals known as “incorporators”. Once the corporate charter is issued, the incorporator must take actions to form the board of directors. Once the board is formed, it must act to ratify the incorporator’s actions, adopt the bylaws, and approve a variety of corporate actions (including the distribution of stock to owners). Once all of these actions are taken, the corporation exists and is ready to carry on business. The articles of organization establish the ownership structure of the corporation and the primary rights of shareholders. The “bylaws” control the internal governance of the corporation. Corporations require a considerable amount of maintenance and the amount of formality associated with corporate maintenance increases with the size of the business. The purpose of corporate maintenance is to protect the interests of shareholders and third parties dealing with the corporation. Maintenance formalities include keeping detailed records of all actions taken. This is normally done through director and shareholder meetings or through “written consents”. Both directors and shareholders must hold annual meetings. Special meetings are used for special or pressing topics. Written consents are actions approved in writing by directors or shareholders outside of meetings. Most states require that directors undertake major actions of the corporation during an annual or special meeting. Directors generally hold special meetings throughout the year to deal with special issues. At meetings directors and shareholders act through resolutions that are documented by the corporate secretary.

⁃    Note: The maintenance and governance requirements are covered in more detail in the Corporate Governance chapter.

⁃    Example: William and Jan decide to form a corporation. They prepare the registration documents and the articles of incorporation to be filed with the Secretary of State’s office. Once the state issues a certificate of incorporation, William and Jan hold a meeting of incorporators and distribute shares to themselves as initial stockholders. They also vote to appoint themselves as CEO and Secretary, respectively. They then proceed to have a shareholder’s meeting to vote and confirm themselves as directors. As directors, William and Jan vote to adopt the corporate bylaws and to undertake a laundry list of other corporate actions. The bylaws will contain all of the corporate governance requirements. At the end of the meeting, the corporation is formed and the corporation has established responsibility for complying with the state-required maintenance and the requirements of the bylaws.

•    Continuity – A corporation exists independently of its owners. Unless the owners undertake an act of dissolution, the corporation will continue to exist. Notably, dissociation by shareholders, directors, or officers of a corporation is not grounds for dissolution. Generally, shareholders may sell or exchange their corporate interest and the business entity continues to exist. Unlike other forms of business entity, corporations have continuity by default.

⁃    Note: If desired, shareholders may vote to add dissolution provisions to the articles of incorporation or bylaws. This will change the default rule that a corporation has continuity independent of the dissociation of shareholders.

•    Ownership – Corporations are owned by shareholders. Closely-held corporations are held by a small group of shareholders. Non-publicly-traded corporations may be more widely held, but shares are not traded on a public exchange. Public corporation shares are publicly traded on exchanges (or in over-the-counter transactions) and are often very widely held. The shareholders are entitled to receive any profits of the corporation upon sale or liquidation (after all liabilities are paid). Shareholders may be divided into classes, depending upon the type of shares they own. Most commonly, a corporation will issue two types of shares — common and preferred. Common and preferred shareholders often have different levels of entitlement. The ownership structure of a corporation can be very complex. Corporate boards often authorize various types of preferred shares that carry specific rights. These shares are used to seek certain types of investors or to assure control to certain shareholders.

⁃    Note: Corporate ownership is discussed in greater detail in the Corporate Governance chapter. Also, see our Finance and Funding material for more detailed information.

•    Control – Responsibilities within a corporation are divided among three groups — shareholders, directors, and officers.

⁃    Shareholders (owners) – Common shareholders (and sometimes preferred shareholders) have two primary types of authority. First, shareholders vote to elect the board of directors, and second, shareholders must approve any major corporate actions (e.g., amending the articles of incorporation, increasing authorized shares, adding new classes of shares, dissolving the corporation, entering into a merger, and some stock repurchases). Some of these decisions also require director approval (or at least initiation).

⁃    Directors (high-level managers) – Directors make high-level and strategic management decisions for the corporation. Basically, the board makes all material decisions that are outside of the ordinary course of business operations. For example, director approval is required for issuing shares, granting options, entering into very large contracts, opening new lines of credit, appointing new corporate officers, purchasing another business, dissolution of the corporation.

⁃    Officers (daily operations managers) – Officers are in charge of the daily affairs of the corporation. They account for all business activity not reserved for the directors and shareholders.

•    Limited Liability Protection – Shareholders have limited personal liability for the obligations and torts of the corporation. Shareholders are only liable to the extent of their investment in the corporation. Assets of the corporation can be used to satisfy such debts, which may decrease the value of the shareholder’s equity. Directors and officers are generally not liable for actions taken in the course of business; however, both may be subject to shareholder lawsuit for any actions (or approval of actions) that damage the corporation. These suits are known as “derivative shareholder actions”. In this type of action, shareholders sue the directors or officers on behalf of the corporation. Officers and directors are protected from liability from negligent acts in the performance of their duties by a doctrine known as “the business judgment rule”. This rule provides that an officer or director may only be held liable for her bad faith conduct. Bad faith conduct includes intentional misconduct or self-serving conduct.

⁃    Note: One special instance of personal liability in the corporation is that of the “promoter”. A promoter of a corporation is the individual undertaking the task necessary to bring the corporation into existence. She will often enter into forward-looking agreements on behalf of the non-existent corporation. Once formed, the corporation will generally adopt this agreement and enter into a novation with the other party. This novation relieves the promoter of liability. If, however, the corporation never materializes or it never enters into a novation with the contracting party, the promoter remains personally liable on those contracts executed when organizing the corporation.

•    Compensation – Shareholders who are not employees of a corporation receive compensation in the form of dividends. Corporations distribute dividends from either annual profits or retained earnings. Distributing dividends is optional and usually done pursuant to a vote of the directors. In some cases, the articles or bylaws may provide dividend rights to certain shareholders. As previously discussed, dividends are taxed at a more favorable rate than ordinary income. Further, dividends (as long as not part of the shareholder’s business practices) are not subject to payroll or self-employment taxes. Employees of the corporation, including officers and directors, receive a salary for their services. If a shareholder is also an employee, she will receive a salary for her services and dividends pursuant to her status as shareholder.

⁃    Note: It is a common practice for shareholder employees to receive a low salary and receive more of their compensation as dividends. This practice avoids paying payroll taxes. As such, the IRS requires shareholder employees to receive a reasonable salary for her services to the corporation. If a salary is unreasonably low, some of the dividends received by the employee may be reclassified and taxed as wages (rather than dividends).

•    Taxation – Corporations may be taxed either: 1) as a pass-through entity or 2) subject to double taxation.

⁃    C Corporation – A corporations taxed pursuant to Subchapter C of the Internal Revenue known as C-corporations. C corporations pay taxes on its profits. Paying taxes as a business entity is known as entity-level taxation. If the profits are distributed to shareholders as dividends, the shareholders must pay taxes on those distributions. This scenario is known as double taxation. Corporate tax rates are discussed above.

⁃    Example: Larry, Moe, and Curly form a corporation and own an equal number of shares. They are all shareholders and directors of the corporation. They elect to be taxed under Subchapter C of the IRC. The corporation has a profit of $15,000 at the end of the tax year. The corporation will have to pay income taxes on these profits at the corporate tax rate. As directors, Larry, Moe, and Curly decide to distribute the remaining profits (after taxes) to themselves as dividends. They will report and pay taxes on these dividends on their personal income tax returns.

⁃    S Corporation – Pass-through taxation is achieved pursuant to Subchapter S of the IRC. If the corporation meets the necessary qualifications, it can elect to be taxed under subchapter S on a pass-through basis. The corporation is commonly referred to as an S corporation. This method of taxation is somewhat similar to partnership taxation, but there are some notable differences that are discussed in detailed in higher-level tax courses.

⁃    Note: If the corporation fails to qualify under subchapter S, or it does not make an “S election”, it will be subject to double taxation under Subchapter C of the IRC.

⁃    Example: Larry, Moe, and Curly form a corporation and own an equal number of shares. They are all shareholders and directors of the corporation. They elect to be taxed under Subchapter S of the IRC. The corporation has a profit of $15,000 at the end of the tax year. The corporation does not pay taxes at the entity level. As directors, Larry, Moe, and Curly can decide whether to distribute the remaining profits to themselves as dividends. Regardless of whether the profits are distributed or no, the $15,000 of profits will pass through to Larry, Moe, and Curly in the amount of $5,000 each. They will report and pay taxes on these dividends on their personal income tax returns.

Regardless of whether taxed under Subchapter S or C, salaries paid to employees (directors and officers) and payments to contractors are expenses to the corporation that are deducted from income. After-tax distributions of profits to shareholders (dividends) are taxed again to the shareholder. In a C-corporation, shareholders pay income taxes on the dividends received as owners of corporate stock. In an S-corporation, shareholders pay taxes on their share of annual corporate profits whether distributed or retained in the corporation.

•    Discussion: Why are most (nearly all) publicly traded companies organized as corporations?

•    Practice Question: In a short paragraph, can you describe the primary attributes of a corporation?

 

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