A corporation is a legal entity wholly separate and apart from its owners (the shareholders or "stockholders"). You form a corporation by filing a "certificate of incorporation" or "articles of incorporation" with the Secretary of State in the state where your business will operate. The certificate or articles of incorporation contains such information as:
- Provisions describing corporate management
- Provisions protecting the corporation's directors and officers, and limiting their personal liability to the corporation and its shareholders
Once the certificate or articles are filed, the information is public record and can be obtained by anyone for a small search fee.
The rights and obligations of the corporate shareholders are set forth in great detail in your state corporation statutes. These lengthy and complex statutes set out basic rules such as:
- How a corporation must be formed
- Necessary officers
- Annual reports you must filed
- The types of corporate shares you can issue
Some of these rules must be followed exactly while others, at the option of the shareholders, can be varied in the certificate or articles of incorporation, or in the bylaws of the corporation.
Bylaws are a separate set of rules governing how a corporation is run. .Shareholders who form the corporation adopt bylaws. They can later be changed by a vote of the shareholders or the directors, depending upon your particular state's corporation law and the provisions of the certificate of incorporation.
Corporations are governed at three levels:
1. Shareholders elect directors. Shareholders do not, other than through the election of directors, typically exercise any control over the overall plans, goals, or day-to-day operations of the corporation. However, corporate statutes give shareholders rights to approve or dissent from major corporate actions not in the normal course of its business, such as mergers and sales of all (or substantially all) of a corporation's assets.
2. Directors are responsible for the management and exercise the rights and power of the corporation. More specifically, directors, either acting as a board or through one or more committees of the board, set corporate policy, establish short and long term plans and strategies, and determine the overall direction of the corporation's business.
3. Directors elect officers such as president, vice president, treasurer and secretary to carry out the policies of the board and to run the corporation on a day-to-day basis.
One of the most important advantages of a corporation is that stockholders, directors, and officers aren't liable for the debts or other obligations of the corporation. Usually, they're liable only for any debts or other obligations they have personally guaranteed or result from their own negligence or misconduct.
Because it's a separate entity, a corporation isn't terminated or dissolved upon the death or departure of a shareholder. As a result, the shares of corporations are usually freely transferable. If the corporation's shares are "publicly-traded," the shares can be purchased on a national stock exchange such as the New York Stock Exchange, NASDAQ National Market System, or the American Stock Exchange.
Smaller corporations are often "closely-held," meaning that the shares are owned by a small group of shareholders. It's common for the shareholders of smaller corporations to have "buy-sell" agreements limiting when shares may be sold and to whom they may be sold.
Tax Treatment of Corporations
The Internal Revenue Code rules the federal tax treatment of corporations. Attorneys, accountants, and other professionals usually refer to the types of corporations and their tax treatment according to the provision of the tax code that applies to that type of corporation. For tax purposes, there are two main types of corporations, "C" corporations and "S" corporations.
A corporation taxed as an entity is known as a "C" corporation. Income that has been taxed at the entity level will again be taxed if, and when, it is distributed as dividends to shareholders. This double taxation is the single greatest disadvantage to operating a business as a corporation. However, "S" corporations may avoid much of this double taxation.
Despite double taxation, corporations do enjoy some tax-related advantages as compared to other business forms. Because of disparities in the top federal tax rates that apply to individuals (39.6% as of 1998) and corporations (35% as of 1998), corporations may enjoy a tax advantage in those circumstances where capital must be kept to buy equipment, machinery, or other assets on a regular basis. A corporation isn't required to distribute earnings to its shareholders and may use them for corporate purposes. The corporation's top tax rate on these earnings would be 35%. Corporations that are not performing certain professional services are treated to tax rates as low as 15% if their corporate income is below a certain amount.
There are, however, limitations to the amount of earnings a corporation may accumulate before distributing them to shareholders or facing an additional tax on these accumulated earnings.
Certain small companies with no more than 75 shareholders and meeting certain requirements (only one class of common stock, only certain types of shareholders) can be taxed as an "S" corporation. An S corporation is also limited in the shares it may own in another S corporation unless the other corporation meets the requirements of a qualified subchapter S subsidiary( called a "QSSS").
An "S" corporation will be taxed at the federal level very similarly to partnerships and limited liability companies, with income, losses, and gains passed through directly to the shareholders and no tax at the corporate level.
Some states do not recognize "S" corporations for tax purposes and tax them as they would a "C" corporation. And some states recognizing "S" corporations tax them, but at a reduced rate.
Professional corporations are formed by doctors, lawyers, accountants, engineers, architects, and other professionals to do business in their respective professions. Under most state laws, only licensed professionals can be shareholders and directors of professional corporations. The same rule usually applies to partnerships, limited liability companies, and other entities formed by professionals to practice their professions. In most states, a professional will not be liable for the negligence or misconduct of other professionals working for the corporation, except those directly supervised by such professional. Of course, professionals will be liable for their own negligence or misconduct.
A professional corporation can be either a "C" corporation or an "S" corporation under the federal Internal Revenue Code.