Corporations are not just limited to Fortune 500 companies and other large businesses. The size of the business has little bearing on whether it should be a corporation or not. Corporations also come in several varieties. The most common is the C-Corporation, but there are also other variations, including S-Corps (which can have the tax characteristics of partnerships), and the increasingly popular Benefit Corporations (which are companies chartered to serve a public good as well as the profit of the shareholders).
Formal creation is required to create a corporation. This creation requires filing a certificate (or articles) of incorporation with the state, sometimes referred to as the “charter.” The commencement of corporate existence is the date the certificate is filed, meaning the corporate body begins its existence. We will get into more detail regarding the incorporation process in the next section. Another key characteristic is the separation of ownership and control. In a corporation, there is separation and the corporation is its own legal entity. Because of this separation, interests are easily transferrable (such as buying and selling shares). The corporation has perpetual duration until it is formally dissolved. A major reason for incorporating is because outside investors usually only want to invest in corporations!
Incorporation occurs when the certificate is filed with the state. This is a fairly simple process if you are happy operating under the state’s default rules and can usually be accomplished online in just a few minutes. The requirements are fairly standard, but there is still some variation from state to state. Under Delaware law for instance, if the certificate does not name initial directors those listed as incorporators will serve as the directors until others have been elected; other states require the directors to be listed. After the certificate is filed, there must be an organizational meeting of the incorporators or initial directors (if they had been named) to adopt bylaws, elect directors, etc.
The certificate of incorporation must include the following: number of authorized shares of stock, name and address of a registered agent in the state, purpose of the corporation, initial directors, management provisions, bylaw provisions, and indemnification. The initial power to enact the bylaws either belongs to the incorporators or the directors, but only if they do so before filing the certificate or before the corporation distributes any stock. Once the corporation issues stock the power to amend is in the hands of the shareholders unless amended in the certificate.
It can be more difficult to amend the bylaws of a corporation than it is to change the structure of other types of entities because it requires the shareholders to act. There must be a shareholder meeting and vote; a vote in lieu of a meeting may also be permissible. The bylaws are a private document and do not have to be filed with the state. To amend the certificate of incorporation, a majority of the board must propose a change, they must put the proposal on an agenda for shareholder meeting, the shareholders must approve the change and lastly the amended certificate must be filed with the state. You must be strategic in what is written in the bylaws or the certificate due to the differences in the amendment process.
Running any business means following certain procedural steps. Running a corporation has the most extensive list of required steps, also known as corporate formalities. A corporation is required to keep track of shareholder meetings, record corporate minutes, maintain records of its stock issuances and ownership, and to obtain the necessary approvals of the officers, directors, or shareholders for certain actions. Corporations are also required to file annual reports with the State Corporation Commission (or Secretary of State’s Office, depending on the state). Perhaps most importantly, you need to ensure that your personal and corporate finances are kept separate. These requirements can be quite burdensome if you are already busy running your business and you don’t have the resources to share the load.
While these may just seem like internal, bookkeeping requirements, they are actually much more than that. Failing to maintain the required corporate formalities can jeopardize your personal liability protection. If you don’t treat your corporation like a separate business, but rather as an alter ego, you may not be able to rely on the corporate entity to protect you from being personally liable for debts, obligations, or claims made against the corporation. And since part of the reason you formed a corporation rather than operate a sole proprietorship or general partnership is to keep your personal assets safe losing that protection because you didn’t take the necessary steps could undo all your hard work.
A corporation’s capital structure is a made either debt, equity, or a combination of the two.
Equity in a corporation is represented by shares of stock. Stock provides the buyer the power to indirectly control the corporation (usually by voting) and the right to receive profits from the corporation. There are different types and classes of equity. With a class of stock there can also be a series. The shares are considered issued when they are sold and are considered outstanding if the shareholder holds them. The two most important distinctions between shares are common shares and preferred shares. Common shares have unlimited voting rights and the right to residual assets after the payment of all liabilities. A corporation must have at least one share of common stock outstanding at all time. Preferred shares have some preference or priority over common shares. Some advantages of using equity include having no required repayment and no personal guarantees. However, some downsides to equity are that owners of the corporation must surrender some of their ownership stake and there is uncertain future value. You also need to ensure that if you are granting stock to employees, or selling stock to an investor, that you make sure you are following all of the potentially complex rules from the state and federal agencies that regulate securities.
Now let’s consider debt. Debt is a fixed obligation of repayment that is independent of the success or failure of the business (unlike equity). Debt is not something that is included in the charter, rather it is laid out in contracts. Some advantages of debt include: tax deductible interest payments on debt, repayment is a nontaxable return to an investor, any bad debt would be an ordinary loss (as compared to a loss to the investor), debt does not give the debt-holders control (voting power) and you know upfront how much the loan will cost. The primary risk to financing through debt is that it requires repayment regardless of the success of the company, whereas equity only requires repayment when the company is doing well.
Now we’ll examine the roles of the directors and shareholders of a corporation.
© 2016 John V. Robinson, P.C.