Corporations
We here begin a general discussion of the corporation, with an emphasis on the closely held corporation. A corporation is an artificial legal entity recognized by government as an officially sanction form of doing business. The corporation is characterized by the following attributes:
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Responsibility for carrying out decision making is vested in officers (e.g. president, secretary, treasurer) and management (e.g., CEO, CFO).
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The corporation is a separate legal entity, with many (but not all) of the rights of legal person hood, is subject to state and federal taxation, can contract, sue and be sued in its own name, and own and convey property in its own name.
Incorporation carries with it some additional burdens not present in the partnership or proprietorship form. There are startup costs associated with creating and filing Articles and ByLaws. There may be filing and annual registration fees. The traditional C-Corporation is subject to state and local federal taxation, with the accompanying responsibility to keep careful financial records and file complex returns. If a corporation honors formalities, as it should, it holds board meetings, keeps minutes of official board decisions, conducts an annual meeting, and complies with other similar formalities. In most states, a corporation cannot conduct litigation except through a lawyer, whereas a proprietor can represent himself. Conduct of business is regulated by state corporation codes, which govern the manner of formation, impose fiduciary limitations, and regulate termination of business. Corporations with freely transferable stock may be subject to state and federal securities laws.
On the other hand, the corporation provides a number of advantages. Limited liability encourages risk taking, because it protects the non enterprise property of shareholders from the consequences of catastrophic losses. In larger corporations, the free transferability of shares of stock encourages investment in the corporate enterprise. The ability to separate ownership from management provides significant benefits in many circumstances. It encourages persons with no interest in daily management to invest in the enterprise. Properly managed and planned, the corporation can provide an enduring business form, independent of the life or health of any particular individual.
Throughout the 1960's corporate lawyers could recite a regular set of well understood rules regarding the way in which corporations conducted their internal business. Shareholders expressed their will at duly noted shareholder meetings, primarily by electing a board of directors and by giving consent for certain major changes where consent was required by state law or the corporate articles. They had a right to certain basic information about the operation of the company, upon reasonable request. Directors exercised their fiduciary responsibilities based upon information supplied by management, approving major actions such as business expansions, major loans, and selecting corporate management. The traditional corporation law looked askance at shareholders agreements establishing who serves as the chief executive officer, or guaranteeing certain owners a job, or maintaining equal salaries. All of these were regarded as possible invasions of the traditional fiduciary responsibility of the board of directors.
But the traditional rules regarding corporate affairs unduly constrain smaller corporations. There is a class of corporations which operate more like partnerships than corporations. We call these corporations "close corporations" or closely held corporations. A shareholder invests in the shares of publicly traded corporations for two reasons--to receive dividends and to be able to sell those shares at a higher price at some time in the future. As the value of the publicly traded corporation increases, the price of shares increase on the market: this means that the shareholder can reap profit from corporate success at any time. Federal securities laws, and the marketplace, afford some measure of supervision protecting the shareholder's investment. But the ability to collect dividends, and to "buy low and sell high", does not meet the needs or expectations of shareholders of many smaller businesses. Most corporations are owned by active entrepreneurs. Collecting dividends stands low on their list of priorities, and indeed typically represents the least advantageous method of collecting wealth from the enterprise, because dividends are not a tax deductible expense to the corporation. Many shareholders of closely held corporations expect to profit from the corporation by receiving a meaningful job and a salary reflecting the success of the corporation. In addition, they want to be able to receive fair value for their interest in the corporation upon disability or retirement, or to pass those shares on to children.
But traditional corporate law provided no guarantees protecting these expectations. If, for example, three siblings incorporate a family partnership, they may expect that all three will retain equal rights in the profits and management of the corporation, just as they did in the partnership phase. But as shareholders, any two can exclude the third from the board of directors. The directors can then control the management of the company, and can then fire the third. Or they can change the job description and relative salaries of the owners. As a result, the excluded third shareholder would be completely cut off from participation in the wealth of the company. For example, it is not uncommon for a closely held company to avoid corporate profits by paying out salaries to the working owners. The excluded owner cannot sell his shares for a price reflecting the fair value of the company, because his buyer will not receive dividends. Perhaps the company may not be sold during his lifetime. Obviously, the ownership of shares in a close corporation needs additional protection. This protection comes primarily from a well crafted shareholder agreement and in many states from special statutory provisions governing close corporations.
S Corporation election. Some owners make an S Corporation election for their corporation to receive partnership-like tax treatment. State law does not create a special S Corporation designation. It is a special tax designation granted by the IRS to corporations which meet IRS requirements. Ordinarily a corporation pays a federal corporate income tax on its profit. If the company declares a dividend, the shareholders must report the dividend as personal income and pay more taxes.
An S Corporation may have no more than 75 shareholders. Shares of an S-Corporation may be held only by individuals, estates, and certain trusts. The shareholders must be citizens or residents of the United States. S Corporations may only issue one class of stock. There are a number of other restrictions.
We discuss issues regarding close corporations in the next panels.
Harvard Business Services (Delaware Incorporation information)
O'Neal & Hodge Leading treatise on Close Corporations
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