A corporation is a legal business entity in which the owners are protected from liability for the company’s actions and financial status. Completely separate from the owners or shareholders, a corporation may exercise most of the rights and responsibilities that an individual business owner would possess, which means that a corporation may enter into contracts, borrow money, sue and be sued, own assets, pay taxes, and hire employees. To explore this concept, consider the following corporation definition.
Definition of Corporation
- An organization, created under authority of law, which exists independent of its members, and holds powers, authority, and liability distinct and separate from its members.
1400-1450 Late Middle English
What is a Corporation
A corporation is a type of business entity that is authorized, by the state in which it is registered, to operate. A corporation functions almost like an artificial person in carrying on its business, or other activities. In fact, a properly formed corporation is a legal entity endowed with the characteristic of “personhood.” A corporation can own property, buy and sell assets, and enter into contracts, just like a person. It must pay taxes on its earnings, and it can be sued. If a corporation takes actions that are against the law, it can be punished, though punishment is generally in the form of fines and monetary damages, as a corporation cannot be sent to prison.
One advantage of forming a corporation is that the company can continue to exist for an indefinite period, beyond the tenure or lifetime of any founder, member, or shareholder. In addition, the members of a corporation are exposed to only limited personal liability. This means that they cannot be held personally liable for actions of the corporation, unless they have personally committed fraud in relation to those actions.
A disadvantage of forming a corporation is the potential for double taxation. This is more likely to be a problem for a small business owner, such as the owner of a local boutique, a dentist, or a dog washer, who forms a corporation. This occurs because, as an entity wholly separate from its owners, a corporation must pay taxes on its profits. The owner, or shareholder, is paid by this entity, often in wages, as well as dividends. In this example of corporation and individual taxation, the business owners (shareholders) must then claim this personal income to the IRS, and pay taxes on it.
Limited Liability of Corporate Shareholders
The primary purpose for most business owners to register their companies as corporations is to ensure they will not be held personally responsible for the company’s debts. In the event the business fails, or goes into bankruptcy, the company’s assets may be taken and sold to pay off its debts. While this may result in shareholders losing the amount of their financial investment, they cannot lose their personal assets, such as their homes, their cars, or their savings, to pay the company’s debts.
Exception to the Limited Liability Issue
In order to help prevent people from hiding behind a corporate “veil” while perpetrating fraud, or engaging in other unsavory, or illegal, activities, there are circumstances in which shareholders may be held personally liable for the acts and debts of the corporation. This is known as “piercing the corporate veil.” Convincing a court to hold corporate shareholders liable for the company’s debts or acts is more likely to be successful if the affairs of the business are so entangled with its individual shareholders that there is no discernible difference.
Another exception to the limited liability issue occurs if the corporation fails to comply with the legal requirements of maintaining a corporation, which includes keeping proper records, and making the required reports to the state. The owner of any business entity, regardless of type, is held personally liable if the company fails to pay to the government the payroll taxes it withheld from employees’ paychecks.
Example of Corporation Liability in Payroll Taxes
Maximillian Diehard incorporates his automobile sales company, hires four employees, and proceeds to do business. Max is not making the amount of money he had envisioned, and things come up. It is learned a couple of years after opening of the car lot that, while he did make the proper payroll tax deductions from his employees’ paychecks, Max never passed those tax monies on to the government.
When Max is accused of tax fraud, he attempts to hide behind the protections of his corporation, believing it will protect his personal assets if he is found to have perpetrated this type of tax fraud. In this example of corporation protections, Max clearly does not understand that, regardless of the company structure, whether a corporation, limited liability company, partnership, or sole proprietorship, the owner will be held personally liable for committing this type of payroll tax fraud.
What is a C Corporation
A C corporation is any corporation that is taxed separately from its owners or shareholders. This is the most common type of corporation registered in the United States, and unless a corporation is registered as a different type of corporation, it is automatically treated as a C corporation for tax purposes. A C corporation may offer reduced tax liability for the company, which in turn attracts investment by venture capitalists.
Additional benefits of forming a C corporation include:
- Perpetual existence in the event an owner, director, or shareholder leaves the company
- Limited Liability for shareholders, directors, officers, and employees
- Tax advantages include tax-deductible business expenses
- Greater credibility when dealing with lenders and suppliers
- Unlimited potential for growth
- No limitation on number of shareholders, but once the company reaches 500 shareholders, and $10 million in assets, it must register with the SEC.
There are certain disadvantages to registering a business as a C corporation. These come in the form of financial liabilities, and red tape. Disadvantages to operating a C corporation include:
- Expensive start-up, as there are fees for filing the documents with the Secretary of State, and often additional fees that must be paid to the state in which the corporation operates.
- Double taxation, as the company is taxed on its income, then the shareholders are personally taxed on the dividends they receive on their investment.
- Deductions for corporate losses not allowed on the shareholders’ personal tax returns.
- Regulations and government oversight tend to be more heavy-handed with a C corporation, than with other types of business entity. This is due to the protection granted the shareholders from corporation liabilities, and complex tax rules.
- Quarterly tax filing requirement.
- Filing and maintaining corporate documents and records may require the assistance of professionals, including an attorney and an accountant.
What is an S Corporation
An S corporation is created when an eligible corporation chooses an IRS tax election under Subchapter S of the IRS code. The primary advantage of an S corporation comes from this IRS election, as the company’s profits may pass through the business, without being taxed, to the shareholders’ individual tax returns. This is known as “pass-through taxation,” and it eliminates double taxation.
If any shareholder is employed by the corporation, he must be paid “reasonable compensation,” which means, in addition to his dividends, he must earn a salary that is in line with fair market value of the services he provides. If this is not done, the IRS may assign any additional corporation earnings as wages for tax purposes.
Advantages of forming an S corporation include:
- Limited liability for company shareholders, directors, officers, and employees.
- Pass-through taxation, and elimination of double taxation.
- Stock offerings create investment opportunities for investors.
- Once-a-year tax filing.
Disadvantages of an S corporation include:
- Must be a U.S. citizen or legal resident of the U.S. to make this election.
- Number of shareholders limited to 100.
- Expenses for formation and maintenance. The company must first be incorporated, then a S corporation can be claimed. Also, there may be ongoing fees charged by the state.
- Mandatory upkeep of tax qualification status. Making mistakes on these filings may result in termination of the S corporation status.
- Closer IRS scrutiny, monitoring payments to shareholders and employees, as each is taxed differently.
How to Form a Corporation
To form a corporation, it is necessary to register the business and obtain a state charter. The first step is determining in which state the corporation will be registered. The next steps are as follows:
- Choose a Business Name – the name must end with “corporation,” “incorporated,” or “limited,” and cannot be the same as any other corporation registered in the state. Each state provides an online portal from which names can be searched.
- Appoint the Directors – it is common for the business owners to appoint themselves as the initial directors, but directors do not necessarily need to be owners.
- File the Articles of Incorporation – this requires the payment of a filing fee. These documents may have a slightly different name, depending on the state.
- Create the Corporation’s Bylaws – this document specifies the corporation’s operating rules, including such information as when directors’ and shareholders’ meetings are to be held, voting information, and other corporate operational information.
- Hold a First Meeting of the Board of Directors – this is necessary, even if the owners are the only directors.
- Obtain Required Licenses and Permits – this varies by state and city in which the business is to operate, as well as the type of business.
Corporation Example of Director Liability
In 1985, two energy companies were merged to form the Enron Corporation, based in Houston, Texas. A few years after its inception, high-powered executives of the company engaged in a systematic effort to use accounting loopholes and other methods to maintain the company’s lofty financial position as a publicly traded entity, hiding billions of dollars in debt. The Chief Financial Officer and other executives intentionally misled Enron’s board of directors, as well as its audit committee, as they led the company down the road to the biggest corporate bankruptcy in U.S. history at the time.
Enron shareholders, whose stock had reached a high of over $90 per share in mid-2000, filed a $40 billion class action lawsuit when those same shares hit bottom at less than $1.00 per share by the end of 2001. As a result of an investigation by the U.S. Securities and Exchange Commission (the “SEC”), many of Enron’s corporate officers and executives were criminally charged, and several went to prison.
Although the corporate structure would normally protect officers and executives from personal financial liability from lawsuits regarding the company’s failure, the Enron case involved many, ongoing acts of fraud perpetrated by the company’s executives. As a result, those executives faced the potential of being ordered to pay huge sums to the shareholders who had filed the civil lawsuit against them. When the court made it clear that the board of directors had a duty to check up on the information given them by the executives, ten Enron directors agreed to pay out $13 million from their personal coffers, and the liability insurance company paid out a much greater sum to settle the suit.
The Enron case illustrates the fact that simply structuring a company as a corporation does not protect its owners, officers, and executives from liability in any event. The law takes a close look at the actions of those individuals, considering whether they took any intentional actions that led to the harm caused, especially if such actions can be classified as fraud.
Related Legal Terms and Issues
- Corporate Charter – A grant by a state creating a corporation.
- Liability – Responsibility for payment of damages, or for other court-imposed penalties in a civil lawsuit.