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Overview of Corporations

What is 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).

• Note: The rights of a corporation have consistently expanded in recent years. For example, the US Supreme Court has determined that corporations are legal persons and have rights similar to those of individuals.

How is the corporation created?

The state issues a charter upon the application of individuals known as incorporators. The application for a corporate charter is known as filing the articles of incorporation. 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).

Incorporators are charged with assembling the support and resources necessary to form a corporation. The incorporate often acts as a promoter of the soon-to-be corporation. This may include soliciting capital for the corporation and entering into forward-looking contracts on behalf of the organization. The incorporator is generally responsible for any obligations are actions in forming or promoting the corporation. She is only relieved of potential liability when the new corporate board ratifies the incorporator’s actions and agrees to hold the incorporator harmless for all promoter activity. This decision to hold the incorporator harmless does not fully insulate the incorporator from being named as a defendant in a lawsuit.

The articles of incorporation is the document filed with the state (Secretary of State’s office) to form the corporate entity. The state reviews these documents and issues a Charter or Certificate of incorporation signifying the existence of the business entity. The Articles include important information about the structure and governance of the corporation.

The incorporator will call the first meeting of the corporation. She will appoint a corporate secretary to record the meeting. During this meeting, she will appoint the initial board of directors. The directors then undertake the formal procedure of setting up the corporation.

This includes a host of other procedural undertakings, including:
• Authorizing the principal office or place of business;
• Preparing and filing of qualification to do business as a foreign corporation in any other states;
• Designating the corporate fiscal year;
• Ratifying the corporate Employer Identification Number;
• Designating the size of the board of directors (which is generally included in the bylaws);
• Undertaking the election of officers;
• Designating of management powers as appropriate;
• Authorization of corporate stock (number of shares and classes of shares if there are multiple classes);
• Approving the issuance of founder’s stock (common stock) to the business founders;
• Approving any stock option grants to founders (if applicable);
• Approving the minutes,
• Authorizing the corporate seal and stock certificates;
• Approving the subchapter “S” tax election for the corporation (if applicable);
• Authorizing the management to open bank accounts;
• Approving any proprietary information and inventions agreements;
• Approving any indemnification agreements with officers and directors;
• Approving any stock option or issuance plans or option agreements’
• Note: Many of the actions of the board are authorized in the Articles of Incorporation and Bylaws. The board can only act within the bounds of these governing documents.

What is included in the articles of incorporation?

The articles of incorporation serve as the charter for the business. As such, it must contain the primary information about the business, including:

• The name of the business,
• The name and address of the incorporators,
• The corporate purpose (nature of business),
• The duration of the business (generally perpetual),
• The name and address of a registered agent, and
• The information about the stock being issued (number of shares, the classes of shares, and the value of each share).

• Note: Many states require that the filing be advertised in the local newspaper for a stated period of time to make the public aware of the filing.

What are the corporate bylaws and why do they matter?

The bylaws is a single document containing the governance provisions controlling the business operations and the relationships between those involved in the business. The incorporators generally write or construct the bylaws prior to forming the business. As such, the initial directors can adopt the bylaws at the first meeting. The primary issues addressed in the bylaws include:

• Demographic information about the corporation,
• The number of directors,
• The method for electing directors,
• The number of classes of equity shares authorized,
• The requirements for director and shareholder meetings,
• The requirements for corporate record-keeping, and
• The procedures for amending the charter or bylaws.

• Note: Most states do not require that the bylaws be publicly filed, but they must be maintained at the business’s place of record. This is important as shareholders are generally entitled to access to and review of the corporate records.

How are corporations maintained?

The amount of formality associated with corporate maintenance increases with the size of the business. For example, large C corporations have extensive requirements for maintaining the business (meetings, voting requirements, etc.), while closely-held corporations have special exemptions from the extensive maintenance requirements. Most of the reporting requirements for a corporation are to the shareholders under state law or to the general public under the federal laws.

• Note: State’s vary in their updated filing requirements for the corporation. The requirements generally include information about the current corporate officials, the principal place of business, the registered agent, etc.

Like other business entities, management must maintain formalities to avoid challenges to the corporate entity status. The most important of these formalities is keeping corporate assets separate from individual assets. Another maintenance formality includes keeping detailed records of all actions taken. This is normally done through director and shareholder meetings or through consents. Both directors and shareholders must hold annual meetings. 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: A corporation must generally have at least one officer – the corporate secretary. She is responsible for documenting the formal transaction of the board or shareholders during meetings. Often a small corporation will have few officers and one individual may hold several positions.

How do these requirements change for small and closely-held corporations (such as startup ventures)?

Closely-held corporations can avoid much of the formality associated with larger and publicly held corporations. Many states have statutes specifically allowing for lesser formalities. Often these businesses will have only a few shareholders who also serve as directors and officers. A corporation can have as few as one owner. The one shareholder can serve as director and officer of the corporation. In fact, the shareholder can appoint herself to fulfill all roles for the company. Absent a statutory exemption, however, small corporations must still comply with many of the corporate formalities to avoid attacks on the corporate entity status.

• Example: Rachel and Keith form a corporation pursuant to a state statute allowing for closely-held corporations. Rachel and Keith act as shareholders, directors, and officers of the business. The state statute allows for Keith and Rachel to hold all of these positions. It also requires far less formalities than a typical corporation. For example, the statute could allow Rachel and Keith to not hold regular meetings or to not keep strict meeting minutes.

• Note: The important point is that a shareholder who holds positions as officer and director must closely observe the formalities in decision-making pursuant to each responsibility and document her actions accordingly.

Why do many businesses incorporate in Delaware?

Many corporations choose Delaware as the state of incorporation for a number of reasons, including: ease of formation, an established body of corporate law, chancery courts to adjudicate disputes, no state income tax on corporations that do not carry on business within the state, and a generally corporate friendly legal system and legislators. The chancery court and the thoroughly established body of corporate law are the primary reasons for incorporating in Delaware. This provides a level of comfort or certainty in carrying on business.

Who owns the corporation?

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 receipt of 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.

• Example: Lawrence purchase shares of common stock of Apple, Inc. He is now an owner of the company. He has the right to vote those shares for the election of corporate directors and for the decision to undertake major corporate actions (such as a merger or dissolution).

• Note: 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. For example, a single preferred share may have 100 votes for directors, where a common share has only one vote.

Who has authority or controls the corporation?

Responsibilities within a corporation are divided among three groups:

• Shareholders (owners)
• Directors (high level managers)
• Officers (daily operations managers).

What is the authority of shareholders?

Common shareholders (and sometimes preferred shareholders) have two primary types of authority. First, shareholders vote to elect the board of directors. 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).

What is the authority of the board of directors?

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.

• Note: Some director responsibilities are must be proposed by directors and approved by shareholder vote.

What is the authority of officers?

Officers are in charge of the daily affairs of the corporation. They account for all business activity not reserved for the directors and shareholders.

• Example: Terry is appointed by the board of directors as Chief Executive Officer (CEO) of the GoodBiz, Inc. She is now in charge of all business operations. All subordinate managers and employees will report to her and she will report to the board of directors. In many corporations Terry will also serve on the board.

• Note: Many of the requirements for shareholder and board approval are outlined in the bylaws. In some cases, the shareholders or directors will vote to add governance requirements to the articles of incorporation.

What is the continuity of the corporation?

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. If desired, shareholders may vote to add dissolution provisions to the articles of incorporation or bylaws.

• Example: Amy, Jean, and Violet form a corporation. Each is a shareholder, serves as a director, and holds a position as corporate officer. If any one of them decides to leave the business, then the corporation does not dissolve. At this point it is important to have bylaws that address the issue of a shareholder leaving a closely held corporation. The bylaws will determine the rules for dissolution and the procedures by which a shareholder may dissociate. Further, it will determine the mechanism by which the dissociating individual resigns their positions as officer and/or director.

• Note: Closely-held corporations or corporations that issue restricted shares should have detailed buy-sell agreements. Corporate buy-sell agreements will contain the same provisions as LLC buy-sell agreement. They generally provide investors with liquidity through redemption rights and allow the corporation to control the distribution of shares through rights of first refusal. Buy-Sell agreements generally address: who can buy shareholder stock; under what conditions the company must repurchase shareholder stock; how to value the stock; payment terms in the event of buyout; events that give rise to a duty to buy or sell stock; etc. Examples of events possibly giving rise to dissolution include: death, incapacity, personal bankruptcy, divorce, termination of employment in the business, etc.

What is the extent of limited liability protection in a corporation?

All parties have limited personal liability for the debts 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 suits 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.

• Example: Mary is the CEO and a director of ABC, Inc. She decides to purchase a corporate jet with business funds to make it easier for her to travel to business meetings. The shareholders are angered by her purchase and bring a shareholder’s derivative action against her for waste of corporate funds. Mary will be protected by what is called “the business judgment rule” if her decision to purchase the jet with business funds was a reasonable decision. If, however, her decision was reckless or grossly negligent, then she could be held personally liable for the expenditure.

• Note: The business judgment rule provides that an officer or director may only be held liable for their bad faith conduct. Bad faith conduct includes intentional misconduct or self-serving conduct.

How can a shareholder lose limited liability protection?

Shareholders risk losing limited liability protection by court order. As previously mentioned, a plaintiff may sue the corporate shareholder(s) alleging that the court should “pierce the corporate veil” and hold shareholders liable for corporate debt (or civil liability). This claim involves the “alter ego theory”. Under the alter ego theory, shareholders who fail to maintain established corporate formalities risk losing their limited liability protections. Such a failure demonstrates that the purpose of the business entity is not to carry on business as a separate entity; rather, the corporate entity is simply a shell used for limited liability purposes. The court will ask the following questions in evaluating whether to pierce the corporate veil:

• Did the business maintain business formalities, such as organizational filings, meeting minutes, etc.?
• Did the business owners intermingle personal and business funds or other assets?
• Is the business adequately capitalized or does it have adequate liability protection in place?
• Does the history of distribution of funds to owners show an intent to drain entity funds?
• Did business members comply with or routinely deviate from their roles and responsibilities?

• Note: If the court is convinced that the shareholders have misused the corporate form, it will be disregarded for liability purposes.

• Example: Bill, Joye, and Thomas form a corporation. The corporation remains closely held by the three founders. They fail to hold regular meetings. They do not document many of their corporate actions. Further, they often pay corporate debts from their personal bank accounts and their personal debts from business bank accounts. If a plaintiff sues the corporation, it is possible that a court would disregard the corporate entity status and subject Bill, Joye, and Thomas to personal liability for any tortious activity or debts of the business.

How are corporations taxed?

Corporations pay income taxes on their net profits. This is known as entity-level taxation. Salaries to employees or 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. This is known as double taxation. Certain corporations may avoid paying taxes at the entity level and pass the tax obligation through to its shareholders.

As stated above, corporations may choose to be either: 1) taxed as a pass-through entity or 2) to be subject to double taxation. 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. 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. The type of corporation is referred to as a C corporation.

• Note: Review Chapter 4 for additional information on double taxation and pass-through taxation.

What are the requirements to qualify as an S corporation?

To qualify for S corporation status, the business must be a corporation organized in the United States. All shareholders must be U.S. Citizens or resident aliens. It cannot have more than 100 shareholders. All members of a family are considered to be one investor for purposes of this rule. All shareholders must be individuals, trusts, or certain other exempt organizations. The company may only authorize one class of stock (common stock). The company must follow an accepted tax year. Finally, all shareholders must consent to the S-election.

• Note: It is fairly easy to run afoul of the S corporation requirements and lose the status. A business may exceed the number of eligible shareholders, accidentally transfer an interest in the business to a business entity, or authorize what is deemed a second class of shares. Certain banking and insurance companies are not eligible for S corporation status.

Are there any ways to be a C corporation and avoid double taxation?

Corporations often avoid double taxation by not paying a dividend. Profits will still be subject to a corporate tax rate, but not taxed as income to the individual. The problem with this approach is that the shareholder does not receive any of the profits; rather, she enjoys capital appreciation of her stock. Another method for avoiding double taxation is paying higher salaries to shareholder employees. This means that the shareholder will pay ordinary income tax on the income. Further, the corporation will have to pay payroll taxes on the salary. The corporation will deduct any salaries paid as corporate expenses. Depending on the tax rate of the corporation and individual, this arrangement may still save money above paying a corporate income tax and individual dividend tax.

• Example: Mike invests money in XYZ, Inc., a C corporation. The corporation is profitable at the end of the year, producing $50,000 in profits. The corporation will have to pay taxes on the $50,000 at its corporate tax rate. If the corporation distributes any funds to Mike, it will be treated as a dividend. Mike will have to pay taxes at the dividend rate. If XYZ, Inc., does not distribute any funds to Mike, then he will not have to pay any taxes on the profits. The value of Mike’s interest in the business (i.e., his share price) may rise with the retention of the earnings.

• Note: The IRS may challenge corporate accumulated earnings or “reasonable” salaries.

• Note: Corporations commonly use schemes to convert shareholder equity into secured or variable-rate debt arrangements. Shareholders will receive interest payments rather than dividends. The corporation can reduce profits by deducting the interest payments, but shareholder generally must include payments as income.

What are professional corporations?

A professional corporation is a type of entity recognized in a limited number of states. It is reserved for service professionals, such as accountants, architects, attorneys, physicians, etc. A professional corporation is afforded limited liability protection, similar to that of a corporation, but is subject to far fewer maintenance requirements and formalities. Shareholders generally hold positions as the only directors and officers in the business. Due to the nature of these entities, eliminating many of these formalities greatly eases the burdens on the shareholders.

• Note: Few businesses choose professional corporation status as they are currently taxed at a flat 35% tax rate.

What is a statutory-close corporation?

A statutory-close corporation, as the name implies, is formed pursuant to a special state statute. The business must meet a statutory purpose and other state requirements. Common restrictions include the number of shareholders, classes of stock, and stock restrictions. The primary benefit behind statutory close-corporations is the reduction in corporate formalities.

• Note: Many state statutes eliminate the requirement to have a board of directors. Shareholders are allowed to take part in the management and decision making. The shareholders do not have to hold meetings. In general, the governance requirements are similar to those of an LLC.

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