Corporations: An Overview

Corporations are the most commonly used business entity. Corporations are, generally, a more complex form of business operation than either a sole proprietorship or partnership, and are subject to more state regulations regarding both their formation and operation.

In California, a corporation is created by filing Articles of Incorporation with the Secretary of State. The Articles of Incorporation serve as a public record of certain formalities of corporate existence. Adoption of corporate bylaws, or internal rules of operation, is often the first business of the corporation. The bylaws of the corporation outline the actual mechanics of the operation and management of the corporation.

There are two basic types of corporations: C-corporations and S-corporations. These prefixes refer to the particular chapter in the U.S. Tax Code that specifies the tax consequences of either type of corporate organization. There are significant differences in the tax treatment of these two types of corporations, however, they are both generally organized and operated in a similar manner.

In its simplest form, the corporate organizational structure consists of the following levels:

• Shareholders: who own shares of the business but do not contribute to the direct management of the corporation, other than by electing the directors of the corporation and voting on major corporate issues.


• Directors: who may be shareholders, but as directors do not own any of the business. They are responsible, jointly as members of the board of directors of the corporation, for making the major business decisions of the corporation, including appointing the officers of the corporation.


• Officers: who may be shareholders and/or directors, but, as officers, do not own any of the business. Officers (generally the president, vice president, secretary, and treasurer) are responsible for day-to-day operation of the corporate business.

Disadvantages

Due to the nature of the organizational structure in a corporation, a certain degree of individual control is necessarily lost by incorporation. The officers, as appointees of the board of directors, are answerable to the board of management decisions. The board of directors, on the other hand, is not entirely free from restraint, since it is responsible to the shareholders for the prudent business management of the corporation.

However, in most small, family-owned incorporated businesses, only one or two people may occupy all roles, from shareholder to director to officer to employee. In this type of situation, the shareholder/directors continue to exercise full control over the operation of the business.

The technical formalities of corporation formation and operation must be strictly observed in order for a business to reap the benefits of corporate existence. For this reason, there is an additional burden of detailed recordkeeping. Corporate decisions must be reflected in the corporate records. Corporate meetings, both at the shareholder and director levels, must be formally documented.

Advantages

One of the most important advantages to the corporate form of business structure is that it limits the liability of the founders of and investors in the corporation. Liability for corporate debts is generally limited, to the amount of money each owner has contributed to the corporation. Certain requirements must be met, however, to assure that the limitation on liability remains in effect. Courts may be able to pierce the corporate veil, that is, hold shareholders personally liable, for the following reasons:

• Failure to observe corporate formalities. The corporation must hold the required shareholders’ and directors’ meetings (or sign consents), keep a corporate minute book, comply with all state filing requirements, etc. Even a corporation with just one shareholder/director must still comply with these formalities. In addition, corporate officers must always sign all documents with the corporate title (e.g. John Doe, President).


• Commingling of assets. Shareholders must take care to avoid mixing their personal assets with those of the corporation. Corporate assets should not be used to pay personal debts. Corporate and personal funds should be kept in separate accounts. Transfers between the corporation and the shareholder, whether a loan, reimbursement, paycheck, etc., must be appropriate and clearly documented.


• Inadequate capitalization. If corporate founders fail to raise or contribute enough operating capital, the courts may require the shareholders to pay the corporate obligations. If the shareholders do not have sufficient capital to fund the corporation, they should purchase adequate liability insurance.


• Fraud. A corporation may not be used to shelter fraud. Even if the fraud is committed in the name of the corporation, the shareholders may be held personally liable.

Depending on your personal situation, there may be significant tax advantages to incorporating.

Every corporation should have an experienced accountant or tax attorney on its team, to help determine whether tax treatment C-Corporation or an S-Corporation provides the most benefit, and to help with tax planning strategies before the close of each fiscal year.

In many cases, it is possible to reduce taxable profit to the point that the corporation pays only the corporate minimum tax. If the corporation stands to show a substantial profit at the end of the year, that tax is paid at the corporate tax rate (often much lower than individual tax rates), and that income can be reinvested in the corporation to further grow the business. Hiring a qualified tax advisor will pay for itself many times over.