There are different types of corporations, but the one nearly every entrepreneur is interested in is the general business corporation. Corporations are creations of state laws (or a foreign nation if you want to be exotic). The basic structure and attributes of a corporation do not change much regardless of the state, although there can be a great deal of variety concerning the more particular characteristics and duties of a corporation in any particular state.
This guide to corporations is a rough sketch. Your state’s laws may differ in ways that will affect your decision, so be sure to talk to an attorney familiar with corporate law. You do not have to incorporate in the state where you live. And just because you live in Utah, Michigan, New York, or wherever does not necessarily mean you want to incorporate there! Talk to an expert in corporate law who can explain (i) how your home state will treat a business incorporating there, and (ii) discuss the benefits of some of the other states commonly chosen by corporations as the state of incorporation. All states are not alike in their corporate laws. That being said, the differences among the states are hardly so stark that you will ruin yourself by choosing one state over another.
Laws governing incorporation must be strictly followed, otherwise the attempt at incorporation may fail and a partnership may result. The necessary actions to incorporate are fairly standard:
- prepare and execute a pre organization subscription agreement for the stock that the corporation will issue;
- prepare and file the corporate charter with the appropriate secretary of state;
- prepare the by-laws;
- hold an organizational meeting of the board of directors;
- establish the books, records, home office, etc. of the corporation;
- file any reports required by the state.
Mistakes in these documents can cause problems ranging from minor annoyance to business-killing litigation.
Please, if you have any hope of building a sophisticated business, do not try to create a corporation on your own or use an attorney who is inexperienced in this area. The author of this web page knows of a very successful businessman who tried to incorporate on the cheap with an attorney who did not know what he was doing, and then a few years later, when his business was booming and he was ready to leap up to the next level, that businessman had to spend hundreds of thousands in attorneys’ fees and pay millions in settlement amounts to someone who deserved nothing, simply because the corporation had not been set up properly. His business lost the investors who were interested and he has yet to recover from the whole incident. Do you think it could not happen to you? That’s is the kind of thinking that really makes lawyers rich! Avoid the courtroom solution, pay an experienced attorney to set up your corporation.
Characteristics of a Corporation
A corporation is an autonomous legal entity, existing apart from its shareholders, officers and directors, whereas neither the sole proprietorship nor the partnership can truly be considered distinct from the persons creating it. Corporations usually possess most of the economic powers that any person would: they can own property, sue in court, sell or transfer property, etc. For a startup, the most important characteristics of a corporation are the continuity of existence, lack of pass-through tax treatment, limited liability for investors, and the ease of adding investors and selling interests.
Continuity of Existence
Corporations have a kind of legal immortality. With proper care and maintenance, the Corporation should exist for as long as the shareholders desire. A corporation continues on regardless of the circumstances surrounding the owners. Deaths and transfers of interests in the corporation have no impact, and unless the state law has put a limitation on the existence of a corporation, it can continue indefinitely.
The shareholders can dissolve a corporation by a vote, and legal proceedings can also end a corporation’s existence. Often, one of these two methods will be employed by shareholders when the corporation’s outlook is bleak. Judicial dissolution is the commonly used method when there is infighting among the shareholders.
Minority shareholders should think about their relative lack of power and the inability to control the corporation’s destiny before accepting this diminutive role. With proper lawyering, many of the pitfalls of a minority position can be avoided, but in the end it is still a minority position.
Unlike partnerships and sole proprietorships, corporate shareholders are not liable for any of the corporation’s debts. This means that what you pay for the stock or what you pay to incorporate is the total sum that you are risking, and nothing more. This is true regardless of how much a shareholder participates in management. A shareholder who owns 100% of a business and makes every decision cannot be held liable for the debts of the corporation, unless of course he runs afoul of a certain area of law known as “piercing the corporate veil”. Also, the corporation will be liable for the acts of its employees and agents who commit tortious acts, but the owner will not.
This protection against liability for corporate debt is deceptive to the uninitiated. You must understand that most lenders (banks, investors, etc.) who offer money to small corporations make the principal owners sign personal guarantees for the loans made to the corporations (we are talking about money, after all), so the limited liability of this structure (and all other structures) is somewhat misleading. You are likely to take on some of the liabilities of the corporation. The benefit to incorporating still exists, however, because you usually only take on those liabilities to which you consciously agree.
Limited liability will not protect you against lawsuits alleging fraudulent or criminal actions by you in the course of corporate business, but that is just common sense. After all, you cannot expect corporate laws to protect crooks from suffering the consequences of breaking the law.
Ease of Adding Investors and Selling an Interest
To add new investors or sell an interest, the transacting parties simply exchange shares. Absent a shareholders’ agreement to the contrary, there is no requirement that the other shareholders agree to the transfer, and there is no way that the other shareholders can withhold any of the benefits of stock ownership from the new shareholders. The new shareholders step into the place of the old ones without any diminution of rights or interest. In a small business, this kind of transferability is not a good thing for the other, non-selling shareholders. after all, who wants strangers coming into the business through a stock sale? That is why a shareholders’ agreement restricting such actions is commonly signed among the shareholders.
Formation and Maintenance
Corporations require a greater investment than most other business entities, except for perhaps a partnership or a limited liability company. In addition to the state filing fees, there is the initial organizational documents, where the shareholders, if there are more than one, agree about things like the number of directors, corporate officers, voting arrangements, sale of shares, etc. But note that attorney’s fees to craft these agreements should be smaller than those charged for a partnership agreement due to the greater standardization of the corporation. This rule of thumb changes, however, if there are securities issues or complicated capital arrangements.
Maintenance of a corporation, on the other hand, is usually more expensive than other forms. States often require corporations to pay franchise fees or other taxes as part of their yearly re-licensing. Added to this is the expense of minute preparation, registered agent fees, board of directors proceedings and legal fees stemming from an increased need for attorney’s advice about how to perform corporate actions “properly.” Moreover, more owner and employee time is spent on caretaking of the entity than is generally performed for other entities.
Piercing the Corporate Veil
This is a dramatic name for a simple act. When a smaller corporation has financial trouble, and creditors are not going to get back all of their money, courts are often asked to issue a judicial order stating that the corporate owners are liable for the corporation’s unpaid debts. If the courts agree to issue the order, this act is known as “piercing the corporate veil.” Before issuing such an order, courts look at certain actions by the owners and management of the business to determine if the order is warranted.
Generally, the court looks at three factors:
- Did the owners fail to observe corporate formalities such as keeping minute books, passing resolutions, and holding board meetings?
- Did the shareholders treat the corporation as a separate entity or as a simple artifice?
- Did the corporation have any money to start with or in its infancy or was it merely a shell?
To avoid such judicial action, shareholders and directors of smaller corporations should follow a few basic rules:
- Treat all corporate money as just that, corporate money. Do not commingle personal funds with corporate funds.
- Deal with third parties as an officer of the corporation, not as a person making a business deal on his or her own.
- Start the corporation with enough money to make it legitimate (how much is enough? Talk to a competent business attorney! At least if he gets it wrong you will be able to sue him if the corporate veil gets pierced because of undercapitalization.)
- Treat the corporation like it is a separate entity. Take care of the minute books, save all documents, make sure the small stuff is taken care of and observe all formalities. A little time spent this way can save a lot of money later.
Where to Incorporate
As you may know, each state has its own version of incorporation statutes. Any one of the fifty states can be chosen by a small startup deciding to incorporate, regardless of what state in which the owners reside or conduct their business. Some states, however, are generally preferred due to their more sophisticated body of law concerning corporate law. Delaware, New York, and (happily, for all you Left Coasters) California are all considered to be among the “top-level” states when incorporating a new business.
People often choose Delaware as the state of incorporation due to the flexibility and the management-friendly body of legal rulings handed down by the state’s court system. With an expeditious incorporation process, no minimum capitalization requirements and broad rules concerning a corporation’s indemnification of its directors, Delaware is in some ways very attractive to small startups. Nevada and Maryland are among the other corporation-friendly states.
Please note, however, that where you incorporate is not the only place where you will have to worry about state laws affecting your business. Whatever states (or countries!) in which your business (be it a partnership, corporation or anything else) actually does business, your business will be subject to that state or country’s laws, and you could be hauled into court in that jurisdiction as well. As ever, sound legal advice is a good thing when entering a new state or country for the first time. California, for instance, requires “foreign” (this term includes corporations from other states) corporations to comply with some terms of the California state corporate laws when those foreign corporations start to do business in California.
Management and Control
According to law, day-to-day management of a corporation rests with the officers appointed by the board of directors, who are ultimately responsible for the management of the corporation. The board of directors is elected by the votes of the shareholders.
The exact duties of the board and the officers are usually spelled out in the by-laws or, less frequently, the articles of incorporation.
Oftentimes, there are agreements between the shareholders of smaller corporations dictating who the shareholders will put on the corporate board of directors. Other voting arrangements include creating different classes of stock entitled to different numbers of votes.
In addition to voting for the board, shareholders typically have the right to inspect the corporate records and official documents.
Death of a shareholder has no impact on the corporate structure, unlike a partnership.
Fiduciary Obligations of Officers and Directors
Remember those fiduciary duties partners owed one another in a general partnership? Well, they apply to officers and directors of a corporation too. In essence, the fiduciary duties of a director or officer require them to act in good faith, in the best interests of the corporation, and use reasonable care when performing their duties. Essentially, this means that you have to do what is best for the corporation, even if that is not what is best for you. These duties exist whether the corporation is public or private. Although these duties sound easy enough, in the tangled spaghetti relationships that usually exist in small corporations, where directors are often shareholders, officers and sometimes creditors, discerning the proper course of action under these duties is often difficult. Failure to perform the duties creates liability for the officer or director who does not perform up to the Law’s demands. In sum, it is best to have a lawyer involved in corporate affairs; he or she can help the officers and directors perform their proper duties. And again, if the lawyer screws up and the officer or director gets sued, that person can turn around and sue the lawyer if the lawyer’s advice was very bad. Lawyers are good for some things!
Recently, courts have begun imposing the fiduciary duties on the majority shareholders of small corporations who are dealing with the minority shareholders. For instance, if the corporation is very profitable and the minority shareholders want a dividend to be paid out, but the majority shareholders are refusing to do so (and probably hoping that this forces the minority shareholders to sell their shares to the majority shareholders at a lower price), a court is likely to step in and treat the majority harshly. The court may impose a monetary award to the minority shareholders or otherwise involve itself in the management of the business until things get worked out.
Transferability of Interests
As said earlier, unless there are specific agreements to the contrary, owners of shares may freely transfer them to potential purchasers (subject to securities laws).
Parties may contract to impose reasonable restrictions on the sale of shares in a corporation. This type of agreement, called a shareholder’s agreement, is often done to prevent a shareholder from selling to a new party which the other shareholders find unacceptable. Also, majority shareholders usually have a duty not to knowingly (including those instances where they should have known) sell their shares to a purchaser who intends on “looting” the corporation’s assets.
But just because you can transfer shares does not mean someone will be eager to buy them. Shares in a small corporation are often difficult to sell, unless the shares are listed on a recognized exchange, and even then large blocks may be difficult to sell. Small businesses are often dependent on the personal relationships of the people running them; continuation of sales, supplies, and personnel may all depend heavily on the few people running the corporation. A person buying such a business cannot be sure that when he buys the business, he will get everything that he sees in the business before the purchase. Moreover, if it is less than a majority stake, the purchaser is stepping into position of weakness relative to the other shareholders. So exit from the corporate form is usually just as difficult as it is for a partnership.
Tax Aspects of a Corporation: This is the downside to corporations, at least as far as small businesses are concerned. With a corporation, you do not get the “flow-through” tax benefits that all of the other small business entities enjoy. What this means is that the profits and losses of the company are the company’s profits and losses, not yours. The corporation will have to file a tax return and pay taxes on the income it receives. Then, if there are any dividends to be paid to the owners (you!), those owners will have to pay taxes again on the money received as dividends. This is the double taxation of corporations that so many shareholders grumble about.
There are ways, however, for small corporations to avoid the double taxation of income. Often, a small corporation will pay its owners salaries rather than pay dividends, so the corporation gets a deduction for the amount paid to shareholders. But the IRS watches such salary payments very closely, and if you push it too far, they may be treated as dividends. Not surprisingly, startup businesses rarely adopt the traditional corporate format (unless it is going to “go public” almost immediately after creation, something that occurs about as often as Immaculate Conception). Instead, small businesses opt for one of the other corporate forms we discuss in the other sections of the Choice of Entity Chapter.