Corporations are an extremely popular form of business organization, mostly because the liability of its owners (the shareholders) does not normally exceed the amount they invested. Corporations also provide a relatively easy way to transfer ownership interest. Thousands of new corporations are formed each year. The law makes a corporation a legal “person” separate from the people who own it and manage it. Corporations exist only by the authority granted by the state. Therefore, it’s important to follow the operation rules of a corporation to ensure that the benefits will continue to exist. A corporation can own property of any kind, borrow money, and pay taxes in its own name. It can last forever, even if its owners die or transfer their shares to someone else. Corporations can exist with one shareholder or, in the case of publicly-traded corporations, with many shareholders, numbering in the hundreds of thousands. The process of forming a corporation is relatively easy and straightforward.
Kiplinger’s Small Business Attorney provides a basic package of documents and instructions that you can use to form a corporation in many states. Also, many books and forms are available, and public libraries can provide assistance.
Important Tip: For assistance, you can contact the office of the Secretary of State in your state. Many will mail you the appropriate fill-in-the-blank corporation forms. For further understanding and analysis, go to the link for “Advantages of Small Business Corporations (S-Corp.).”
When forming a corporation, you must first choose a state of incorporation. Most often, the people forming the corporation (the incorporators) pick the state where they live, or the state where the business will primarily operate. If two or more states are appropriate for incorporation, the state selected often depends on the fees and taxes charged to a corporation, and the ongoing franchise fees and income taxes that will be collected over the years. While the mechanics of forming a corporation differ somewhat from state to state, they are all essentially the same. First, one or more individuals must file a document with a certain state office, usually the Secretary of State. This document, called a “Certificate of Incorporation” or “Articles of Incorporation,” sets forth certain key facts, such as the name of the corporation, its registered office, certain facts about the company’s capital stock, and the names and addresses of the incorporators. Some states require a detailed statement of the business in which the corporation will engage. For example, you might be required to specify whether the corporation will sell donuts, distribute software, manufacture furniture, or whatever else it will do. Others require only a general statement about operating a business “permitted by law.” When the Articles or Certificate are filed and the filing fee paid, the corporation then comes into existence. The incorporators then elect the first Board of Directors, who in turn meet or act by unanimous consent to carry out the corporation’s first activities. Those activities usually involve approving the corporation’s bylaws, electing officers, issuing stock and other matters, such as formally opening bank accounts. Because a corporation is an entity of the state, each state establishes its own rules with respect to the operation of the corporation. Most important, officers and directors must take steps to ensure that actions they take on behalf of the corporation are specifically identified as such.
For example, all business contracts and documents you sign should identify you as signing as a corporate officer. Otherwise, a third party may try to impose personal liability on the officers and directors, or a court may “pierce the corporate veil,” meaning a creditor can ignore the corporation and collect corporate obligations directly from the shareholders. A court may permit a plaintiff to pierce the corporate veil if individual shareholders have ignored the corporate form. In other words, a court can remove the benefit of limited liability, if the shareholders have blurred the distinction between their individual activities and the actions of the corporation. To avoid the risk of losing corporate benefits, such as limited liability, shareholders must continually make a clear distinction between the corporation and themselves. For example, money should be transferred from the corporation to the individuals only through reasonable salaries, dividends, reimbursement of expenses, and the like. Also, all of the requirements of the state must be met (i.e., income tax returns must be filed and taxes paid; franchise reports must be filed and fees paid, if applicable; meetings must be regularly held and resolutions properly adopted.) As previously mentioned, a corporation is owned by shareholders who, in turn, elect a Board of Directors to oversee the corporation’s management. The Board of Directors then elect corporate officers to manage the day-to-day functions of the corporation. (Normally, the Directors are not involved in carrying out day-to-day functions.) Because a corporation is a separate legal entity, it is required to file income tax returns and pay taxes on its corporate income. Individual shareholders are also taxed on the money distributed out of the corporation in forms of salary or dividends. To some, this “double taxation” makes the corporation unattractive. The IRS provides some relief in this area. Subchapter S of the Internal Revenue Code permits shareholders of qualifying small businesses to be taxed like partners. In other words, profits and losses are charged directly to such shareholders for tax purposes.
Important Tip: The rules for “S-Corporations” are detailed. Consult your attorney or tax advisor before electing S-Corporation status. Also consider other vehicles, such as a limited partnership or limited liability company.
Once a corporation is established, and the business begins to grow, it will often do business outside of the state in which it was incorporated. Foreign corporations (corporations formed outside of the state), must comply with the laws in each state where they do business. “Doing business” in another state is more than an isolated transaction. It generally means operating some business on an ongoing basis or having an employee regularly within that state. Foreign corporations are required to become qualified in those states where they do business. This usually involves:
Providing the state office with a copy of your Articles or Certificate of Incorporation.
Designating a registered agent within the state.
Paying the local fees for qualification.
Filing annual reports for as long as you do business in the state.
Income tax returns and business licenses might also be necessary.
Ownership in the corporation is reflected by shares of stock. A corporation cannot issue more stock than is authorized in its Articles or Certificate of Incorporation (which can be amended to provide for more stock.
The rights of a shareholder often depend on the kind of stock issued. These are the basic types of stock:
Common Stock. Normally, common stock entitles the shareholder to one vote for each share of stock owned. It also allows the shareholder to receive dividends if declared by the Board of Directors.
Preferred Stock. Shareholders who own preferred stock get paid before common shareholders when the Board of Directors declares a dividend. They also receive preference in the distribution of corporate assets upon liquidation. The Directors are not required to pay dividends to shareholders, although “cumulative preferred stock” allows the preferred shareholder to collect unpaid dividends when distributions are finally made. Normally, preferred shareholders cannot vote for Directors or on other corporate matters.
Convertible Stock or Convertible Debt. These securities can be exchanged for common stock using a predetermined formula. Other classes of stock exist, and each class can be further divided into subclasses. Shares of different classes of stock usually carry different voting rights.