Corporations
A corporation is
legal entity wholly separate and apart from its owners (the shareholders
or "stockholders"). Corporations are formed by filing a
"Certificate of Incorporation" or "Articles of
Incorporation" with the Secretary of State. The "Articles of
Incorporation" contains information specified by the state
corporation statute. The document may also include:
- Provisions regarding corporate management
- Provisions indemnifying the corporation’s
directors and officers, and limiting their personal liability to the
corporation and its shareholders
Once the certificate or articles are filed, the information
is part of the public record and can be obtained by anyone for a small
search fee.
The rights and obligations of the corporate shareholders are
set forth in great detail in state corporation statutes. These lengthy
and complex statutes set out basic rules such as:
- How a corporation must be formed
- Officers that it must have
- Annual reports that must be filed
- The types of shares which can be issued by the
corporation
Some of these rules must be followed exactly while others, at
the option of the shareholders, may be varied in the certificate or
articles of incorporation, or in the bylaws of the corporation.
Bylaws are a separate set of rules governing how a
corporation is run. Bylaws are adopted by the shareholders who formed
the corporation. They can later be changed by a vote of the shareholders
or the directors, depending upon the particular state corporation law
and the provisions of the certificate of incorporation.
Corporations are governed at three levels:
- Shareholders elect directors. Shareholders do
not, other than through the election of directors, typically
exercise any control over the overall plans, goals, or day-to-day
operations of the corporation. However, corporate statutes give
shareholders rights to approve or dissent from major corporate
actions not in the normal course of its business, such as mergers
and sales of all (or substantially all) of a corporation’s assets.
- Directors are responsible for the management and
exercise the rights and power of the corporation. More specifically,
directors, either acting as a board or through one or more
committees of the board, set corporate policy, establish short and
long term plans and strategies, and determine the overall direction
of the corporation’s business.
- Directors elect officers such as president, vice
president, treasurer and secretary to carry out the policies of the
board and to run the corporation on a day-to-day basis.
Corporations enjoy many advantages as a business form.
Perhaps the most important advantage is that a corporation’s
stockholders, directors, and officers are not liable for the debts or
other obligations of the corporation. Usually they are liable only for
any debts or other obligations which they have personally guaranteed or
result from their own negligence or misconduct.
Because it is a separate entity, a corporation is not
terminated or dissolved upon the death or departure of a shareholder. As
a result, the shares of corporations are usually freely transferable. If
the corporation’s shares are "publicly-traded", the shares
can be purchased on a national stock exchange such as the New York Stock
Exchange, NASDAQ National Market System, or the American Stock Exchange.
Smaller corporations are often "closely-held"; that
is, the shares are owned by a small group of shareholders. It is common
for the shareholders of smaller corporations to have
"buy-sell" agreements limiting when shares may be sold and to
whom they may be sold.
Tax Treatment of Corporations
The federal tax treatment of corporations is governed by the
Internal Revenue Code. Attorneys, accountants, and other professionals
usually refer to the types of corporations and their tax treatment
according to the provision of the tax code that applies to that type of
corporation. For tax purposes, there are two main types of corporations:
- "C" corporations
- "S" corporations
A corporation taxed at the entity level is known as a
"C" corporation. Income that has been taxed at the entity
level will again be taxed if, and when, it is distributed as dividends
to shareholders. This double taxation is, perhaps, the single greatest
disadvantage to operating a business as a corporation. However,
"S" corporations may avoid much of this double taxation.
Despite double taxation, corporations do enjoy some
tax-related advantages as compared to other business forms. Because of
disparities in the top federal tax rates applicable to individuals
(39.6% as of 1998) and corporations (35% as of 1998), corporations may
enjoy a tax advantage in those circumstances where capital must be
retained to fund purchases of equipment, machinery, or other assets on a
regular basis. For example, if a capital-intensive business was
conducted as a partnership, the partners would be individually taxed
(possibly at the 39.6% top rate) on these earnings, even if they had to
leave all or part of these earnings in the company to fund the
acquisition of machinery and equipment. However, a corporation is not
required to distribute earnings to its shareholders and may use them for
corporate purposes. The corporation’s top tax rate on these earnings
would be 35%. Corporations that are not performing certain professional
services are entitled to rates as low as 15% if their income is below a
certain threshold.
There are, however, limitations to the amount of earnings a
corporation may accumulate before it must distribute them to
shareholders or face an additional tax on these accumulated earnings.
"S" Corporations
Certain small companies with no more than 75 shareholders and
meeting certain requirements (only one class of common stock, only
certain types of shareholders) can be taxed as an "S"
corporation. An S corporation is also limited in the shares it may own
in another S corporation unless the other corporation meets the
requirements of a qualified subchapter S subsidiary (QSSS).
If a corporation elects to be taxed as an S corporation and
qualifies, it will be taxed at the federal level very similarly to
partnerships and limited liability companies. That is, the income,
losses, and gains will be passed through directly to the shareholders
and there will be no tax "at the entity level."
Notwithstanding an S election, certain transactions by S corporations
that were previously C corporations may result in an entity level tax.
This includes:
- A tax on appreciation that occurred prior to the
election to be taxed as an S corporation
- A tax on passive investment income
- A tax on LIFO recapture
Some states do not recognize "S" corporations for
tax purposes and tax them as they would a "C" corporation;
that is, at the entity level. Some states recognizing "S"
corporations tax them, but at a reduced rate.
Professional Corporations
Professional corporations are corporations formed by doctors,
lawyers, accountants, engineers, architects, and other professionals to
do business in their respective professions. Under most state laws, only
licensed professionals can be shareholders and directors of professional
corporations. The same rule usually applies to partnerships, limited
liability companies, and other entities formed by professionals to
practice their professions. In most states, a professional will not be
liable for the negligence or misconduct of other professionals working
for the corporation, except those directly supervised by such
professional. Of course, professionals will be liable for their own
negligence or misconduct.
A professional corporation can be either a "C" corporation or an "S" corporation under the federal Internal Revenue Code.