Corporations: What Are They and Should I Form One?

Last month, we discussed limited liability companies. Today we follow last month’s discussion with another popular business structure, the corporation. The corporation grabs the attention of many, but comparatively few understand the meaning of the corporate form. In this analysis, we review common misconceptions of the corporation, discuss the advantages and weaknesses of the corporation, and compare the different types of corporations.

Do Corporations Have to be Large?

Although the corporation often comes to mind when one hears the term “big business” and although many use the word “corporation” interchangeably and synonymously with the term “big business,” not all corporations are large; the law does not impose a size requirement upon corporations; and many small and medium businesses also choose the corporate form.

Who Owns Corporations and How do Corporations Raise Money?

Corporations may generate spendable money by issuing shares. The holders of these shares are the company’s shareholders. Whether a shareholder owns one percent or ninety-nine percent of the corporation’s shares, the shareholder is an owner of the company. Although S-corporations may have only up to one hundred shareholders, a C-corporation may have an unlimited number of shareholders. C-corporation shares may be publicly traded and registered with the Securities and Exchange Commission, but S-corporation shares may not be publicly traded. An S-corporation’s shareholders must also all be United States citizens or residents. In exchange for these ownership restrictions, the S-corporation enjoys substantial tax advantages as a “pass-through” entity, a status coveted by many business owners and prospective business owners.

What Are Corporate Directors’ Duties and Liabilities?

The corporation protects its shareholders and its directors well. Generally, a shareholder bears liability only up to the amount of capital contributed. In addition, a corporation’s certificate of formation may limit or entirely eliminate directors’ personal liability to the corporation or to its shareholders. Corporate shareholders and directors should take reasonable precautions despite this protection because failure to separate assets and other blunders may render shareholders personally vulnerable to claims and disputes. Shareholders’ co-mingling of personal and business funds, egregious use of business equipment for personal pleasure, payment of personal expenses using business funds, and other risky behavior could support a claimant’s attempt to “pierce the corporate veil.” Like the managers of an LLC and other entities, however, a corporate director will be liable for breaches of his or her duty of loyalty and for intentional misconduct notwithstanding the company’s certificate of formation or other governance documents.

How Are Corporations Managed?

Corporations may elect management via a board of directors or management directly by its shareholders. In the case of the former, the shareholders select directors, and the directors may in turn employ others, including other management positions and lower-level employees. In the case of the latter, the shareholders themselves manage the company without intermediary directors. This structure allows corporations the option of informal management similar to that of a partnership.

How Are Corporations Internally Governed?

Corporations’ management and affairs are governed by shareholder agreements and bylaws. These are often more complex than the governance documents of other business entity types. These instruments may set forth the company’s management, operations, voting procedures and standards, employment practices, share classes, ownership rights, and more. Thorough shareholder agreements may anticipate and address potential future problems via procedures like rights of first refusal, conveyance restrictions, gridlock resolution procedures, and more.

Corporations enjoy unique visibility. The structure deserves some of this visibility because it is often, though not always, the only choice for businesses targeting public trading. The corporate form need not always be cumbersome, as is the case for publicly traded companies, as the corporation may avail itself of several tools easing management, governance, tax, and ownership requirements. It behooves even small businesses to consider a corporation with S-corporation status and informal management without a board of directors. If a business exerts the effort to establish a corporation, it will enjoy the protection of the corporate form while allowing room to grow.

Samy Diab

Attorney

Diab Law Firm, PLLC