What is a Corporation?

Everyone seems to have a loose understanding of what is a corporation. But, when you drill down to the nitty-gritty, most people won’t be able to tell you the details. For example, most people don’t know what a board of directors is or how they interact with the rest of the corporation. But that’s not really anyone’s fault. The corporation can be a very complicated critter indeed.

This article is the first of a series of three on the corporation. We aim to introduce you to the basics of the corporate business format. This way, if you ever need to talk to a lawyer or accountant about forming one, you’ll already have a solid understanding of the basics. Then, you can quickly get down to the details.

So, let’s start with a very general definition of a corporation.

The Definition of a Corporation

The corporation is a type of legal entity used to run businesses. It is recognized all over the world, and it is suitable for running both large and small businesses.

The corporate business format allows the owner(s) to transfer ownership easily by selling and buying shares/stock. The corporation also protects its owners from legal and financial liabilities. But the corporation is somewhat expensive to set up and maintain.

The law treats a corporation as a person, with many of the legal rights of a person. But, unlike natural persons, sole proprietorships, and many partnerships, a corporation can live forever. This is a short explanation of what is a corporation. Now, let’s go into more detail by exploring what a corporation can do and how it is controlled and run.

What a Typical Corporation Can Do

 In general, a corporation has the power to:

• Make internal rules to govern itself
• Sue or be sued (and to settle such lawsuits)
• Own and sell property
• Enter into contracts
• Borrow or lend money

Ownership of a Corporation is Divided into Shares

The ownership of a corporation is divided into little bits called shares. There can be different types of shares, with different types of rights.

By default, a share is a common share. It carries the right to, among other things, receive dividends and vote on corporate decisions.

Sometimes, a corporation will issue preferred shares. Typically, preferred shares have the right to receive dividends before common shares (sometimes there are only enough profits to pay out to preferred shares). Usually, owners of preferred shares do not have the right to vote.

A corporation can issue as many shares as it wants, be it 100; 1,000,000; or even 1,234,567. Those who own shares are called shareholders. Shareholders can be real people, other corporations, partnerships, LLCs, and some other less well-known legal entities (e.g. trusts).

What are the Board of Directors and Corporate Officers?

Even though shareholders own corporations, they don’t have to run its day-to-day operations.

Instead, shareholders elect a Board of Directors. The Board hires corporate officers like the CEO, the CFO, the Corporate Secretary, etc. Together, they run the corporation.

The corporate officers oversee the day-to-day operations of the corporation. The Board meets at least several times a year to vote on and make the most important decisions for the corporation.

The Primary Documents of a Corporation are the Articles of Incorporation and Bylaws

If you’re in the US, a corporation is formed by filing the Articles of Incorporation (sometimes called Certificate of Incorporation or Corporate Charter) with a state and then by drafting up the company’s bylaws.

The Articles is a document accessible by the public. It discloses various information such as the corporation’s principal place of business and agent for service of process. The bylaws set out the rules on how the corporation runs itself (e.g. when to hold the annual shareholder meeting). It is an internal document that strangers usually do not see.

Most small businesses incorporate in the same state the shareholder(s) live. But this is not mandatory. For various legal and tax reasons, very large businesses typically incorporate in Delaware but have their corporate headquarters in another state.

S Corporation vs. C Corporation: a Tax Distinction

Corporations have to pay income taxes and, in the US, you can pick to be taxed as an S corporation or a C corporation. Note that the S and C designations are for tax law only. They have nothing to do with the essence of what is a corporation.

In all other areas of the law and internationally, a corporation is a corporation. The S and C designations are meaningless.

C Corporations

By default, the IRS treats all corporations as C corporations. This means that the C corporation will pay income taxes on its profits. After paying taxes, it can then pay the profits (called dividends) out to its shareholders.

The C corporation’s shareholders then have to pay income taxes on the dividends again. This is called double taxation.

S Corporations

Under some circumstances, you can ask the IRS to tax you once instead of twice. The corporation doesn’t pay income taxes. Instead, the shareholders pay income taxes on the dividends on their personal tax returns. This is called pass-through taxation. All you have to do is to file a form with the IRS and elect to be an S corporation.

To qualify as an S corporation, the corporation has to:

• Be a US corporation
• Shareholders may not be partnerships, corporations, or non-resident aliens (individuals, some trusts, estates, resident aliens OK)
• Have no more than 100 shareholders
• Have only one class of stock
• Cannot be financial institutions, insurance companies, or domestic international sales corporations.

Most small businesses elect to be S corporations. Remember, though, that the S corporation designation is only a tax distinction. S corporations must observe the same corporate formalities as C corporations.

Shareholders or Board Members are Employees when They Work for the Corporation

Shareholders and members of the Board can work as employees of the corporation. In fact, in a small business, there usually is just one shareholder who owns all the shares and who is the Chairperson of the Board as well as the CEO. However, unlike sole proprietorships, partnerships, and some LLCs, the process of employing a shareholder is a little different.

With sole proprietorships, partnerships, and some LLCs, the owners pay themselves through an owner’s draw. Then, they pay self-employment taxes to the IRS every quarter. With shareholder-employees, the corporation pays them a salary and withholds Medicare and Social Security taxes, just like it does for every other employee.

Publicly Traded vs. Privately Held Corporations

Corporations can be very big or very small, and they can be publicly traded or privately held. Publicly traded corporations have to disclose a lot of financial information publicly. This is because any random person can go to the open market and buy a share of the corporation. The random person is entitled to know the financial status of what they’re buying.

Privately held corporations (also known as close or closed corporations) can keep their financial information private under most circumstances. Shares of a privately held corporation can still be bought and sold, but the potential buyer’s identity is always known. The potential buyer has a right to look at the company’s financial records, but these records can remain just between the buyer and the seller.

Corporations Operate under a Set of Corporate Formalities

Corporations are persons only under the law. They have no real physical form like a natural person. So, the way to keep a corporation as a separate, independent entity from its shareholders is if everyone treats the corporation as a separate entity. The way to do this is to follow some standard corporate formalities.

One formality is to keep corporate funds in a corporate bank account instead of a personal bank account. Another formality is to keep corporate assets only for corporate (as opposed to personal) use. One of the most important formalities is to hold shareholder meetings at least once a year (and keep meeting minutes to show that the meeting happened).

If you follow these formalities and if you’re ever dragged into court for some sort of liability issue, the courts typically will treat your corporation as a separate person. This means you normally won’t be personally liable for any corporate debts or liabilities.

This concept of shielding corporate liabilities from its shareholders is called the corporate veil.

The Corporate Veil Protects Shareholders’ Liabilities, but Can Sometimes Fail

Owners of small businesses are typically very busy because they have to handle many aspects of their business. So, many small corporations–and especially small corporations with one shareholder–often forget to keep up with the corporate formalities.

If the owner(s) use the corporate bank account to pay personal bills, use the corporate warehouse as storage for personal items, or fail to hold shareholder meetings at least once a year, then the corporate veil can be pierced. More specifically, under US law, a corporate veil can be pierced when:

• You fail to keep up with corporate formalities such as the ones described above
• The corporation commits fraud (usually at the direction of the shareholder(s))
• The corporation was never adequately funded with the capital it needs to run the business

Once the corporate veil is pierced, you can be held personally liable for corporate debts and liabilities.

The Pros and Cons of the Corporate Business Format

As you can see from above, it can be pretty complicated to do business as a corporation. So, if you’re trying to decide whether or not to run your business as a corporation, here are some of the pros and cons to think through:

Pros

The main advantages of a corporation are that it limits the business liability of its owners. Another advantage is that ownership of the business is easy to transfer. In addition, laws governing what a corporation can and cannot do are very robust, all around the world. So, you can do business as a corporation with a lot of certainty.

Cons

The main disadvantage of a corporation is that it requires keeping to corporate formalities in order to maintain the corporate veil. Very small businesses with typically one owner tend to not have the time or resources to keep up with the paperwork. This unintended neglect can cause the corporate veil to fail.

Corporate taxes tend to be more complicated when compared with other business formats. Unless you can qualify as an S corporation, you’ll be paying taxes twice. The corporation also has more tax requirements at the state level. You’ll often have to pay a franchise tax or another form of tax based on income.

Defining What is a Corporation Is Describing Its Major Attributes

As you can see from above, a corporation isn’t a physical thing. To define what is a corporation, you’d have to describe its major attributes. It’s almost like the parable of The Blind Men and the Elephant, where each blind man learns what an elephant is by feeling some parts of it, instead of seeing it as a whole.

With this article, we hope we’re at least a little bit successful in describing the corporate elephant as a whole to you. We also hope to have brought out some of the advantages and disadvantages of running a small business as a corporation.

In our next article and the second in our series on corporations, we’ll look at how to form a corporation and set it up to the point for you to be ready to do business.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

DISCLAIMER: This article does not constitute legal advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer. Only lawyers properly licensed in your state/country are qualified to give you legal advice.