What is a Corporation?
- A corporation is a legal business entity formed by filing documents with the state.
- Corporations can choose C corporation or S corporation status for federal tax purposes.
- Shareholders are generally protected from corporate liability.
- Creditors of a shareholder may acquire the shareholder’s shares in the corporation.
A corporation is a traditional legal structure designed to provide liability protection for the business owners (shareholders or stockholders). Founders form a corporation by filing appropriate documents with the state in which the corporation will be formed.
A corporation is recognized as a legal entity separate from its ownership. To form a corporation, the founders must file documents with the state in which the entity will be incorporated. The documents usually include, at a minimum, articles of incorporation. The founders should also adopt bylaws to govern the affairs of the corporation and reflect the formation of the corporation in the organizational minutes.
For tax purposes, a corporation may be treated as either a C corporation or an S corporation.
C corporation status is the default classification. The Federal tax rules governing C corporations ensure that all income is taxed twice: once at the corporate level and again when distributions are made to shareholders.
Unlike C corporations, S corporations do not pay income taxes. Instead, an S corporation’s income, losses, deductions, and credit are passed through to the shareholders for Federal tax purposes and taxed directly to them. As a result, S corporations are taxed only once, at the shareholder level.
Capitalization and Contributions
Corporations are initially capitalized by transferring property to the corporation in exchange for shares of stock in the corporation. As a matter of corporate law, there is no limit on the number of shareholders that the corporation may have. The corporation’s stock may be divided into different classes of shares (such as preferred stock and common stock), each with their own right to voting and distributions.
Shareholder Liability for Entity Obligations
Under state law, corporate shareholders are generally protected from liability for corporate obligations. The corporation is treated a separate entity and is solely responsible for its own debts and obligations. This veil of protection may be pierced, however, if the shareholders fail to follow corporate formalities, commingle personal and corporate funds, engage in fraudulent behavior, or inadequately capitalize the corporation to the detriment of creditors. Shareholders are also personally liable for any loans or other obligations that they personally guarantee.
Entity Assets Not Protected from Shareholder’s Personal Creditors
Creditors of a shareholder may acquire the shareholder’s shares in the corporation, in which case the creditor will succeed to the shareholder’s rights to distributions and management of the corporation. If the shareholder had enough shares to liquidate or dissolve the corporation or force distributions of assets from the corporation to the shareholder, then the creditor will acquire those same rights. If, on the other hand, the shareholder had nonvoting shares that conferred few rights or benefits, the creditor will only acquire the limited rights that the shareholder had.
Control of a corporation is determined primarily by the corporation’s articles of incorporation and bylaws, within the limits established by state law. State law also fills in the gaps for situations where the articles of incorporation and bylaws are silent. While most state laws have similar provisions regarding control of the corporation, there are some state-by-state variations to consider, such as the amount of control required to liquate, dissolve, or sell substantially all the corporation’s assets.
Continuity, Transferability, and Dissolution
Corporations exist until they are dissolved. Dissolution can occur by the shareholders, by creditors, or by the state for failure to file periodic reports. The shareholders are generally free to transfer their stock unless restricted by the articles of incorporation or bylaws or by agreement between the shareholders. State law may prohibit an absolute restriction on transferability.
A corporation files its articles of incorporation and annual reports with the state. The documents are not private and can generally be viewed by third parties. The corporation’s bylaws, minutes, resolutions, and other books and records are not publicly accessible, but the shareholders may obtain and review them in some circumstances.
Transition to Other Entity Form
In some circumstances, a corporation may be converted to another form of entity through a cross-entity merger or reorganization. Generally, though, it is easier to convert to a corporation from an LLC or other non-corporate entity (such as an LLC or partnership) than from a corporation to a non-corporate entity.