What is a Corporation: Everything You Need to Know
A corporation is a company that is owned by its shareholders who are comprised mainly of those who formed the corporation as well as individual investors. 9 min read
What is a Corporation?
A corporation is a company that is owned by its shareholders. The shareholders, who are comprised mainly of those who formed the corporation as well as individual investors, elect a board of directors to oversee the company’s activities. One instance where the shareholders do not participate is when the company is being held liable for its debts and any actions it takes that affect the business in an adverse manner. These situations are the responsibility of the corporation.
A corporate structure may well be the best way to open a business because the corporation exists separately from its shareholders.
Corporations are owned by their stockholders, who share in the gains and losses generated by the company, and have three distinct characteristics:
- Legal Existence,
- Limited Liability, and
- Continuity of Existence.
A corporation can operate as a for-profit entity, as virtually all companies are. A corporation also can also exist as a not-for-profit entity. This would fall under the category of charitable organizations. They have the right to loan money, borrow it, enter into contract agreements, sue other companies, hire employees, and to purchase assets.
A corporation is different from other types of businesses in that it is a legal entity, individual and separate from those who own and manage it, who are otherwise known as its shareholders.
A corporation is considered, by corporation law and various tax laws, to be a "legal person" who can fall into debt and owe taxes, separately from its owners. In general, a corporation has all the legal rights of an individual, except for the right to vote and some other restrictions.
As a result of this type of structure, a corporation does not dissolve when its owners (shareholders) change or die. All of the owners also enjoy a limited liability, in that they will never be held personally responsible for a corporation's debt.
If a corporation is held liable for damages in a lawsuit, the most a shareholder can lose is his or her investment in the stock. A shareholder's personal assets cannot be used for corporate liabilities.
There is usually a fee that a corporation must pay in order to do business in a particular state. When incorporating in one state to take advantage of its liberal corporate laws, and then doing business in another, will require that the corporation file for "qualification" in the state where the corporation wants to do the business.
After incorporating, the company's shareholders receive stock in the company in exchange for cash or other personal investments. The board of directors elects officers to conduct the day-to-day business of the corporation. They file company paperwork, such as the articles of incorporation, and adopt company bylaws that govern how the business will be run, including granting certain powers and authority to themselves, the officers and the shareholders.
When a large corporation sells its shares to many individuals, it almost always has to register with the Securities and Exchange Commission, or SEC, as well as various other state regulatory agencies.
If the corporation is small, the shareholders should prepare and sign a shareholders buy-sell agreement. This states that if any shareholder dies, or wants to sell their stock, the right of first refusal must be offered to the remaining shareholders.
The buy-sell agreement also will determine a method to decide the fair price that should be paid for those shares. With a small corporation, the responsibilities of its shareholders can be summed up in corporate minutes; a shareholder wanting to leave usually can do so without running into any problems, legal or otherwise.
What is a Professional Corporation?
A professional corporation is a unique type of business that only members of certain professions, such as attorneys, physicians, and other workers in the health care industry, are able to establish. In forming such a corporation, these professionals are able to limit their personal liability claims of malpractice on their own part or of their associates.’
Creating a Corporation
A corporation can have a single stockholder or many. When it comes to publicly-traded corporations, there are usually many thousands of shareholders.
Corporations are created and regulated under corporate laws in their jurisdictions of residence. They often are formed in the state where the business intends to operate, but they don’t have to be.
When creating a corporation, a document called "articles of incorporation" must be filed with state government’s corporations’ department. There is a filing fee ranging from roughly $100 to $800, depending on the rules of the state where the corporationis formed.
The articles of incorporation contain basic information such as:
- The corporation's name,
- The physical address of the corporation,
- The name and address of the person who is designated to be the liaison between members of the public and the corporation, and
- In some states, the names of the corporation's directors.
When forming a corporation, there also are corporate bylaws that must be created. Corporate bylaws make up a document that lays down the rules that will govern a specific corporation.
Before a corporation can begin doing business, the board of directors must hold an initial meeting to handle some formalities and to issue stock to the initial shareholders.
Day-to-Day Operations of a Corporation
Shareholders usually get one vote per share owned. Annually, they will elect a board of directors who will oversee the day-to-day operations of the corporation. The directors are responsible for fulfilling a corporation's business plan and must do whatever is necessary to achieve that.
Board members are not responsible for the debts of a corporation, but they do owe a duty of care to take the proper steps in managing a corporation, and personal liabilities can be exacted if they neglect to do so.
Liquidation of a Corporation
The legal life of a corporation can be wrapped up through the process of liquidation. Basically, thecorporation appoints a liquidator to sell its assets. Afterward, the liquidator will pay the corporation’s debts and whatever is remaining will be paid to the stockholders.
Types of Corporations
Considering corporations, there are two primary types. One is a Subchapter C corporation and the other is a Subchapter S corporation. Subchapter C corporations are larger and owned by many different shareholders, which can also be other businesses. Subchapter S corporations are often smaller businesses that are owned by an individual shareholder.
Prior to forming a corporation, determine what kinds of benefits to expect to get from establishing this type of business. The biggest advantages of having a corporation are that:
- Corporations provide limited liability protection for its shareholders.
- Companies looking to raise money, usually from new investors, will find it easier to operate as a corporation because it can sell ownership shares.
- Corporate profits are taxed at a lower rate than personal income tax rates.
- Employees may find the prospect of ownership benefits that come with working for a corporation to be a better benefit than what a privately-held company can offer.
Even though corporations can protect owners from liability, there are also sizable, and costly, downsides:
- C Corporations are complicated to set up and can be very expensive.
- A corporation can spend a lot of money just keeping up with current business regulations and filing paperwork in a timely manner, which is crucial for big organizations with a lot of employees.
- Unlike limited liability companies, corporations have to pay taxes on their profits at the federal, state, and often even local levels.
How Corporations Differ from Partnerships, Sole Proprietorships, and LLCs
Partnerships and sole proprietorships do not provide limited liability for its owners the way a corporation does. This means that the creditors of those types of businesses can pursue any debts owed to them by the business by making claim to the owners' personal assets.
Organizing and operating a partnership or sole proprietorship is much easier than forming a corporation, however, because no formal paperwork is required. An LLC, or limited liability company, offers the protection of limited personal liability, just as a corporation does. While formal paperwork is required to form a limited liability company, running such a business is much less complex than running a corporation. For instance, owners of a limited liability company don’t need to have regular ownership and management meetings, nor do they have to submit to other formalities associated with running a corporation.
The above-named business structures also are different from corporations in how various levels of government levy taxes against them. A corporation pays taxes on its profits, or, what remains after it has paid all deductible expenses, such as salaries and bonuses.
Business profits are not taxed for partnerships, sole proprietorships, and limited liability companies. Instead, their profits trickle down from the business to the owners, who then report the company’s income or losses on their own personal tax returns.
Who Should Form a Corporation?
Due to the formalities and expenses required to set up a corporation and issuing stock, you should only form a corporation only if there is a valid reason, such as:
- You should form a corporation only if your business needs to be able to issue stock or stock options to attract certain desired employees or additional outside investment capital.
- You should form a corporation if your business earns enough in profits that a large amount of income tax can be saved by keeping some of those profits in the corporation every year. This is known as "income splitting." It helps a corporation take advantage of lower tax rates on income of up to $75,000.
- You should form a corporation only if you own a family business and want to start making ownership gifts family members when making an estate plan, or in planning for the generation of owners to come.
Do I Need to Worry About Securities Laws When I Issue Stock in My Corporation?
Securities laws are in place to help protect financial investors from unsavory company owners. They often require corporations to meet comply with some stringent regulations in order to accept financial investments in exchange for stock in the company.
The Securities and Exchange Commission, or SEC, requires a corporation to register their sale of stock with it and its state agencies before being able to issue any stock to initial shareholders. Registering company shares is time-consuming, usually involving additional accounting and legal fees.
Luckily for small corporations, many can forego the registration process due to exemptions provided under state and federal laws. Many states have their own versions of the small business federal exemption from registration.
If you are creating a corporation with just a few associates, one where you will be the one who is actively managing operations, you will definitely qualify for a small business exemption, and there will be no registration paperwork to file.
What is Limited Liability" and Why is it Important?
If a business owner has "limited liability," it means that he or she is not personally responsible for business debts and obligations of the corporation.
Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating.
Limited liability, traditionally associated with corporations, is the main reason most people consider incorporating while sole proprietorships and general partnerships do not.
Does Running a Corporation Involve More Paperwork Than Running Other Types of Businesses?
Corporations must comply with statutory rules that unincorporated businesses, such as limited liability companies (LLCs), partnerships, and sole proprietorships, do not.
Corporations must file and pay taxes on a separate corporate tax return and must set up a double-entry bookkeeping system to record business transactions, complete with daily journals and a general ledger.
How is Corporate Income Taxed?
Unlike sole proprietors and owners of partnerships and limited liability companies, a corporation's owners do not pay individual taxes on all business profits.
The owners pay taxes only on profits paid out to them in the form of salaries, bonuses, and dividends.
Dividends are portions of profits that large corporations sometimes pay out to shareholders in return for their investment in the company.
The corporation pays taxes, at special corporate tax rates, on any profits that are left in the company from year to year (called "retained earnings").
If your corporation elects to be taxed as an S corporation, all of the corporation's profits and losses will "pass through" to the owners, who will report them on their individual income tax returns.
What is Double Taxation? Does it Mean That Corporate Income is Taxed Twice?
Corporations are only taxed twice in the instance of earnings, or dividends, that are paid out to shareholders. This is only true, however, for shareholders who work for the corporation and also pay themselves a salary and bonus.
A corporation can declare, as ordinary and necessary business expenses, salaries and bonuses, meaning that they are not required to pay any corporate taxes on them. An employee can avoid being taxed twice by taking profits in the form of their annual pay and related bonuses, rather than through dividends.
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