Introduction to Corporations

In kicking off my series on different business entity structures, I’ll start with corporations.

What is a corporation?

A corporation is a limited liability entity that exists separately from its legal owners. One or more owners hold shares of stock in the corporation that grants them certain economic rights to the profits and residual assets of any business operated by the corporation, as well as certain voting rights as to the management of the corporation. The corporation is able to enter into its own contracts and legal relationships with other parties, which is part of what protects the shareholders from liability. Except as described below in regards to an “S” corporation, a corporation is taxed separately and in addition to its owners, meaning that when a corporation earns a profit that amount is taxed by certain states and by the federal government. In addition, once the corporation takes those profits and distributes them to shareholders as dividends, the shareholders will also be taxed on that income (which is often colloquially referred to as “double taxation”).

Corporations are governed in accordance with state law. All states provide for a board of directors that oversees the management of the corporation as well as the appointment of officers to execute such management. However, each state varies in the particulars as to how the relationships between stockholders, board directors and officers will be governed and how disputes will be resolved. Additionally, each state taxes corporations differently. To add a further layer of complexity, some states (such as California) impose certain “long-arm” state law regulation on the governance of  foreign corporations when such corporations are resident in California or have a certain amount of shareholders in the state. Therefore, the choice of jurisdiction in which to incorporate is a complex matter that plays an important role in establishing a new business. In some cases it will make sense to incorporate in the state where a business will be located and operate, and in others it makes sense to incorporate in particular states that offer governance or tax benefits (Delaware is a very popular choice, and to a lesser extent Nevada is, too). Today, many professional investors require their portfolio companies to be incorporated in Delaware, thus if you are seeking angel, seed or venture capital investment, it is best to incorporate in Delaware from the start rather than try and convert your business at a later time.

“C” corporations and “S” corporations

“C” corporations and “S” corporations are not different types of corporations. Rather, the designation reflects whether the corporation makes a particular election under the tax code. Corporations that have less than 100 shareholders and no non-resident aliens or non-natural persons as  shareholders (except estates and certain trusts and exempt organizations) may elect to become an “S” corporation if they meet certain requirements. If so qualified, the corporation itself does not pay taxes on profits but instead “passes through” the tax liability to shareholders, thus avoiding the “double taxation” issue.  Corporations that do not make this election and are taxed at both the corporation level and the shareholder level are called “C” corporations.

How is a corporation formed?

Incorporating is fairly easy: you file a document called Articles of Incorporation (in California) or Certificate of Incorporation (in Delaware) with the Secretary of State where you wish to incorporate. What is more complex and has potential for problems is taking it from there: appointing a board, capitalizing the corporation and issuing stock, assigning ownership to the corporation of intellectual and tangible property required to run the business, and governance and approval of the initial set of transactions.

In my next post I’ll write a little bit about the differences in for-profit, non-profit and California’s new entities, “flexible purpose” and “benefit” corporations.