what is a corporation how does it work

How do Corporations Work? The Basics Regular People Need to Know

If you’re going to invest in corporations through stocks, mutual funds, a 401(k) plan, exchange traded funds (ETFs) or some other means, it’s important to understand the basics of how they work.  In keeping with that theme, the purpose of this article isn’t to provide an exhaustive, technical explanation of what a corporation is and how one works, but to focus on fundamental principles related to corporations that you need to understand so that you can be a more informed, knowledgeable investor (or even a potential business owner!).

A corporation is a separate legal entity

A corporation is a legal entity that is recognized in the eyes of the law.  That is extremely significant, because as a legally recognized entity a corporation has certain rights, such as the right to own property, to open and maintain bank accounts, to hire employees, to protect its rights in court, and so on. With these rights corporations also have responsibilities, such as the responsibility to pay taxes and to otherwise operate within the law.  Finally, a corporation’s ongoing status as a separate legal entity is not automatic.  The owners of corporations must make annual filings, pay fees, and follow certain legal formalities.

The owners of a corporation have limited liability

One of the greatest benefits and protections of investing through a corporation is that it provides limited liability to its shareholders.  In other words, when it comes to the debts or legal liability of a corporation, shareholders are only at risk to the extent of the value of the stock they own.  Said another way, individual shareholders are shielded from the debts and liabilities of the corporation they own.

The fact that shareholders have limited liability does not mean that they (or corporate employees) are exempt from prosecution if they engage in criminal activities.  In other words, people who own and operate a corporation cannot evade taxes, intentionally dump chemical waste in the town water supply, or engage in fraud and the avoid criminal prosecution simply by hiding behind “the company.”  In all such cases the authorities can criminally prosecute those responsible for breaking the law because it’s recognized that you can only put people in prison, not corporations.[1]  Following are some practical examples to illustrate how these principles work.

  1. You sell bananas out of your home as an individual.  If a customer comes over and slips on a banana peel and is injured then you could personally be sued for damages.  In other words, if there was a $200,000 judgment against you then you could stand to lose your savings, home, cars, and other assets.
  2. Assume the same facts as Example #1, except you are the owner of the corporation Deadly Bananas Inc. (“DBI” for short).  In that case the clumsy customer could only name the corporation in the lawsuit, not you personally.  In the unfortunate event that DBI lost the lawsuit and could not pay the full amount, the clumsy customer could not come after your personal assets such as your home, car, savings, investments, etc.
  3. You sell bananas out of your home as an individual.  You place a large order on your personal credit card.  If your business were to fail then you would be personally liable for the credit card balance.
  4. Assume the same facts as Example #3, except this time, as the owner of Deadly Bananas Inc., you get a loan from a bank to purchase a large shipment of bananas.  If the corporation is later unable to pay back the loan then the bank can seek to recover corporate assets to pay it off, but they cannot lay claim to any of your personal assets (assuming you didn’t sign something personally guaranteeing the loan!).
  5. You steal a massive crate of bananas and purposefully set banana peel traps all over town in an intentional attempt to cause chaos, injury and mayhem.  You could be criminally prosecuted for your actions, whether you were acting in your capacity as an individual or as the CEO of DBI.

Corporations have continuity of life

If you run your banana business as an individual, which is technically known as operating a “sole proprietorship,” then the business will die when you do.  Granted someone else could step into your shoes and continue to run the same business, but they would be doing business, signing contracts, and developing customer relationships in their name, not yours.  On the other hand, if you do business as Deadly Bananas Inc. (you really need to do something about that name) then the corporation will live on as a separate, distinct legal entity as long as it makes the necessary legal filings, pays the appropriate fees, etc.  In summary, there are many, many corporations in business today that have long outlived their original owners.

Corporations allow for the easy transfer of ownership

You can easily transfer ownership in a corporation by selling (or giving) the stock in the company to someone else.  Because all of the company’s property, contracts and business relationships are already in the name of the corporation, the business can continue to roll on just as it did before; all that’s happened is that the company has a new owner.  On the other hand, if someone wanted to by your unincorporated, home-based business, then they would have to do so one asset at a time.  And what would you do about liabilities?  For example, what if you had a shipment of 10,000 bananas on order?  Unless you made special arrangements, that order would still be in your name and you would have to pay for it.  But again, if you were incorporated and sold the stock of your company then not only would ownership of the assets transfer with the stock, but responsibility for the debts and other liabilities of the company would transfer as well.

Ownership in corporations can easily be divided

Generally speaking, ownership in a corporation is determined by how many shares you have in the company.  The owners of a corporation have the ability to divide their shares, something that provides them with a substantial amount of flexibility in managing the overall structure of the company.  Following are some examples to illustrate these principles.

  1. A company has 10 shares outstanding, and you own 7 of them.  That means that you own 70% of the company (your 7 shares divided by 10 total shares).
  2. Assuming the same facts in Example #1, you want to sell 1% of the company to 3 different investors.  The problem is that each share of the company has an ownership percentage of 10%.  The solution?  You could increase the total shares outstanding by doing a 10 for 1 (or 10-1) stock split.  That would increase the number of shares you own to 70 (7 shares x 10) and the total number of company shares outstanding to 100 (10 shares outstanding x 10).  Now you could sell one share (each equal to 1% of the company) to 3 different investors, leaving you with 67 shares.
  3. True or false – By increasing the number of your shares you increase the overall value of the company?  The answer is false; stock splits only increase the number of shares outstanding, not the value of the company itself.  For example, if a company is worth $100,000 and there are 1,000 shares outstanding then each share is worth $100 ($100,000 divided by 1,000 shares).  If the company did a 100 for 1 (or 100-1) stock split then the total shares outstanding would increase to 100,000 (1,000 shares outstanding x 100), but then each share would be worth $1 rather than $100.

Stock can be divided into classes

If all a corporation has is “stock” then it is generally considered to be “Class A common stock.”  Each share of Class A common stock has equal voting and economic rights with respect to the company.  But other classes of stock can be created which have different voting and economic rights.  These principles can be illustrated as follows.

  1. A couple wants to give shares in their company to their children, but they want to maintain control of the management of the company.  They create Class B shares and give these to their children.  These shares have equal economic rights to the Class A shares held by the parents, so the children can share in the profits of the company just as if they had Class A shares, but the Class B shares do not have voting rights.  As a result, the children do not have a say on who will be officers in the company, or in other major decisions such as whether the company will merge, acquire, or be acquired by another company, etc.
  2. The owners of a company want to raise additional funds for expansion, but they don’t want to give away a significant amount profit potential in the process.  The owners find a group of investors who want a higher potential investment return than what is offered by interest bearing investments, but they don’t want to take on an excessive amount of risk.  In this case the owners of the company could issue “preferred stock” to the investors.  Generally speaking, preferred shareholders are first in line when corporate distributions are made and are promised a certain rate, but once they receive an agreed upon amount then the rest of the distributions belong to the Class A shareholders.[2]

Corporations can be “publicly held”

One huge advantage of corporations is that they can “go public,” or be “publicly held.”  In other words, corporations can be listed on a public stock exchange such as the NASDAQ or the New York Stock Exchange, which enables the shares of the corporation to be sold to the general public.  And what is the significance of a company being publicly traded?  It means with a little bit of money and a few clicks of a mouse (or a phone call) that you and I can become part owners of any company listed on a stock exchange: Exxon, Walmart, Google, Bank of America, GE, IBM, just to name a few.

While the process going (and remaining) public is long, complicated, expensive, and involves a tremendous amount of work on the part of a company, it also provides extraordinary opportunities.  It gives the owners of the company an opportunity to “cash out,” or to sell some of their stock to the public.  And for the company as a whole, it provides a means to raise capital (which means raising money) from a huge pool of investors in order to fund projects that will (hopefully) further drive the growth of the company.

Corporate governance

The corporate organization provides a framework to govern the affairs of a company so that it acts in the best interests of the shareholders while also being a responsible corporate citizen.  This is primarily done through the board of directors.  The shareholders use their voting rights in the company to elect members to the board who then select a chairman.  One of the main responsibilities of the board is to select a chief executive officer (“CEO”) to run the day-to-day operations of the company as well as to monitor that person’s performance.  Boards of directors generally grant a degree of latitude to CEOs to run a company according to their best business judgment.  However, if the company under-performs for an extended period of time and/or engages in questionable business practices then the board has the power to replace the CEO.

As a practical matter, corporate governance is of greater importance in companies whose stock is widely held by many owners as opposed to a company where stock ownership is concentrated.  For example, if a shareholder owns 75% of a company then they can effectively make all of the decisions: they can elect all members of the board, appoint themselves as chairman of the board, and even appoint themselves CEO.  In addition, no matter how poorly such a “closely held” company performs, the only way a majority owner can lose their job as CEO is if they fire themselves!  On the other hand, at a very large company the CEO may own less than 1% of the outstanding stock.  In such cases the CEO’s performance and the relationship they have with the board of directors is more important and takes on a greater degree of formality.

As a shareholder you generally want a board of directors to take a balanced approach in overseeing the affairs of the company.  On the one hand, you don’t want them so involved that they interfere with the CEO’s running of the day-to-day operations of the company.  On the other hand, you don’t want them to be overly passive either, effectively rubber stamping everything the CEO does and asks for.  Such an approach creates an environment where there is a sense of complacency and a lack of accountability, which is a recipe disaster.  In summary, an effective board is informed and involved, mostly using its position to influence rather than interfere, but also acting decisively when needed to protect the overall interests of the shareholders.

Corporations do NOT have a life of their own

Following on the concept of corporate governance, one final thing I want to point out is that corporations themselves are not inherently good or evil; they don’t make smart or dumb decisions; they don’t hire or fire people; they are neither charitable nor ruthlessly capitalistic.  In fact, corporations don’t make any decisions at all.  Only the people who are part of corporations can do that.

Applying this concept to one of the examples above, was it really “Deadly Bananas Inc.” or, more generally, “The Corporation,” that deviously spread banana peels all over town in an attempt to wreak havoc on the general public?  Of course not, the corporation itself is simply a set of documents locked away in some filing cabinet.  No, the real culprit was the individual(s) at the company who was orchestrating all of the mayhem.  While it may sound obvious that, for good or bad, people are always behind the acts of corporations, I point it out because it’s a frequently overlooked concept.

Summary: Corporations provide a powerful means to do business and to raise capital

In reviewing all of the above characteristics of a corporation it becomes much easier to see why they’re a very attractive means to do business.

  • Separate legal entity – Assets and liabilities can be in the name of the company.
  • Limited liability – Shareholders are not personally liable for the actions and debts of the company.
  • Continuity of life – A corporation can exist indefinitely.
  • Transferability of ownership – Shares of a corporation can be transferred, bought and sold.
  • Division of shares – Ownership in a corporation can be divided in an infinite number of ways.
  • Corporate governance – Corporations have formal processes to appoint officers and to oversee the business.

For all of the above reasons, a business organized as a corporation has intrinsic value.  In other words, even if a corporation had no assets or liabilities, meaning that it was just a shell company, it would still have value in and of itself because it’s organized in a manner that’s extremely effective for doing business…it just needs someone to pull the switch to get the business going.  And it’s for all of these reasons that in terms of assets owned, goods and services produced, and people employed, the corporation is the most dominate form of business in the United States (and the world!).

[1] While this is true, it’s also important to note that a corporation as a separate “person” can get hit with legal, administrative and operating sanctions that can hamper its ability to do business.  For example, if an oil company has a major industrial accident then the corporation can be hit with fines and/or lose the right to drill in certain areas.  In extreme cases a company can even get shut down altogether.

[2] I will write about preferred stock in more detail at a later time.  The point I am trying to illustrate for now is that a corporation’s stock can be divided into classes.

Types of Businesses Entities

Types of Businesses – Business Entities

Are You Currently Without Limited Liability Protection? It May Be Time to Consider Incorporation.

Different Types of Businesses – Suppose you are giving basketball lessons in your driveway for $5 an hour. You don’t file paperwork with the state and don’t share business with anyone else. If a student breaks his leg while attending a lesson, your personal assets are not protected if the student were to take legal action. The same goes for a general partnership. If you and your best friend jointly operate a corner candy store without signing any agreement between you and without filing any documents with the state, your business would be considered a general partnership.

If you default on loans for the business, you would be personally responsible for paying the debts. Whether you are set up as a sole proprietorship or a general partnership, you are personally and fully liable for all business debts. Thus, personal property could be taken to pay those debts. So what can you do to protect yourself financially? We’ll cover the different types of businesses and help you decide, which is right for you.

Limited Liability Protection – Types of Businesses

Brief descriptions of ways to incorporate your business are featured below. These descriptions also include limited liability protection parameters essential to protecting your personal assets.

C Corporations and S Corporations.

Both C corporations and S corporations are legal entities that exist separately from their owners. They are sometimes called for-profit or business corporations. A C corporation is simply a standard business corporation. It is called a C corporation because it is taxed under subsection “C” of the IRS code. An S corporation is a C corporation that has made an optional election to be taxed under subsection “S” of the IRS code. Corporations offer business owners (called shareholders or stockholders) limited liability protection. This means that the owners are not held personally liable for the debts and obligations of the company unless they are proven to be personally negligent. The liability of the owners is typically limited to the amount of money they have invested in the corporation. To find out more about S Corp vs C Corp.

Limited Liability Company.

Commonly referred to as “LLCs,” limited liability companies are for-profit legal entities that exist separately from their owners. The first LLC was introduced in 1977 so it is a newer entity, blending key features of a corporation with key features of a sole proprietorship or general partnership. LLCs offer limited liability protection to the owners and pass-through taxation. Read more about Corporation vs LLC

Professional Corporations and LLCs.

A special type of corporation or LLC is reserved for those companies that will engage in a learned profession such as law, medicine, architecture, engineering, etc. They are usually referred to as a Professional Corporation (PC), Professional Association (PA) or Professional Limited Liability Company (PLLC). In many states, only one profession can be offered in a professional entity. The liability is the same as standard corporations and LLCs.

Limited Partnership.

A limited partnership (LP) is a partnership owned by two classes of partners: general partners and limited partners. General partners manage the enterprise and are personally liable for its debts. Limited partners contribute capital and share in the profits but typically do not participate in the management of the enterprise. Another noteworthy distinction between the two classes of partners is that limited partners sustain no personal liability for partnership debts beyond their capital contributions. In an LP, at least one partner must be a general partner with unlimited liability, and at least one partner must be a limited partner whose liability is limited to the amount of his or her investment. Limited partners enjoy liability protection much like the shareholders of a corporation or the members of an LLC.

Limited Liability Partnership.

A limited liability partnership is an existing general partnership or limited partnership that elects to have all partners receive limited liability for business debts. It is commonly referred to as an “LLP.” All partners receive limited liability protection. In many states, this liability protection is less than what LLCs or corporations receive.

Non-profit Corporation.

A non-profit corporation is one that is organized for a charitable, civil, religious, social, etc. purpose. It is organized for the “greater good” and not for the purpose of making a profit. These corporations are also referenced as “not-for-profit corporations.” As far as liability is concerned, non-profit corporations offer limited liability protection.

You may also want to seek the legal advice of your attorney in making your determining which different types of companies (business entities) is right for you.

Corporation vs LLC

Corporation vs LLC: Some Corporation Benefits to Consider

For many business owners, the decision between incorporating your business as a corporation vs LLC (limited liability corporation) may be a difficult one. Developing a laundry list of pros and cons may be helpful in clarifying which incorporation type will best benefit you. Remember that the decision you make may have different ramifications in the future.

Is forming a corporation the smart choice for you?

For some business owners forming a corporation vs LLC can be the better decision. Corporations are a separate legal entity owned by shareholders. For this reason, shareholders cannot be held personally responsible for the debts of the corporation. Your personal liability is typically limited to the amount you invested in the company. The worst fears of an investor is to risk losing more than he or she invests in the company. This can be a wise choice when trying to minimize your exposure.

Another reason you may wish to form a corporation vs LLC, is that your business can have many investors. This will allow you the ability to raise money from the public. Having an LLC can beneficial if you are not going to have many investors. In some cases, the investors are the ones who can get a company up and running and keep it going. If you form an LLC, this is not a viable option.

Lastly, if you form a corporation vs LLC your business might be able to bring in new employees by offering stock options. If you form an LLC you would not be able to do this, as they do not have stocks. With an LLC, employees can be offered membership interests. This is not the same as being offered stock in the company and can also be an awkward process to complete.

Corporation vs LLC which is right for you?

So, if you are thinking about forming your business as a corporation vs LLC, therefore you may want to consider using an incorporation services provider. Using a company that specializes in incorporation services can provide you with peace of mind. Since you know that they are experts in the ins and outs of incorporation. To find out more about the benefits of using an incorporation service provider read How to Incorporate.

How To Incorporate Your Business

How To Incorporate Your Business? Factors To Consider

There are many pros and cons that factor into forming a corporation or limited liability company (LLC). That’s why its important to investigate and research the laws and policies relative to your specific business goals and business type to fully maximize the benefits of incorporating. Here are some criteria to keep in mind when learning more about incorporating your business. We’ll also cover how to incorporate your business.

Incorporating Your Business

“How to incorporate your business?” The protocol of incorporation is usually the same incorporation process across the states.

These basics include:

  • Selecting your business name
  • Recruiting and/or appointing members/managers (LLCs) or director(s) (corporations)
  • Selecting your incorporation type
  • Filing incorporation paperwork
  • Opening a bank account for your business

Additionally, these other factors are helpful in determining which incorporation type is best suited for your business:

  • Businesses providing professional services. If providing a licensed, professional service, consider forming a professional corporation or a limited liability partnership. It is advisable to contact your licensing board to determine your requirements. Professional corporations (PCs) are allowed to be formed as are professional limited liability companies (PLLCs).
  • Initial report and business license requirement. Requires corporations and LLCs to file an Initial List of Officers/Directors and Business License on or before the last day of the month following incorporation.
  • Federal tax identification number (EIN). Corporations and LLCs that have employees are required to have a Federal tax identification number (EIN). Additionally, an EIN may be required to open a business bank account.
  • State tax identification number. To do business in the states, a state tax identification number is necessary.
  • State S corporation election. Recognize the federal S corporation election.
  • Business purpose. Allows corporations and LLCs to be formed for any lawful business activity. There is no need to state the corporate purpose in the Articles of Organization or the Articles of Incorporation.
  • Stock. Corporations can purchase, sell, hold and even transfer shares of their own company stock. However, corporations are required to list authorized shares and par value in the Articles of Incorporation. An increase in the number of shares or par value can affect initial filing fees.
  • Registered agent. Corporations and LLCs must list the name and address of a registered agent with a physical address (no post office boxes). The registered agent must be available during regularly scheduled business hours to accept important legal and tax documents for the business.

Many entrepreneurs and small business owners enjoy the benefits of having their companies incorporated. Just keep in mind that consulting with an attorney or accountant helps clarify if these benefits will work for your business type and goals. Learn more about the Different Types of Businesses.

S Corp vs C Corp

S Corp vs C Corp

S Corporation vs
C Corporation ?

Both C corporations and S corporations are legal entities that exist separately from their owners. They are sometimes called for-profit or business corporations. A C corporation is simply a standard business corporation. The reason it’s named “C Corporation” is because it is taxed under subsection “C” of the IRS code. An S corporation is a C corporation that has made an optimal election to be taxed under subsection “S” of the IRS Code. This article will help you better understand a S Corp vs C Corp. Read on to learn more about the advantages and disadvantages of both types of corporations.

Defining C Corporations

The C corporation is the most common business structure. A corporation is a separate legal entity owned by its shareholders. As a result, it protects its owners from personal liability and corporate debts and obligations. A corporation’s directors, officers and shareholders must witness particular formalities in a corporation’s administration and operation. For example, decisions regarding a corporation’s management must often be made by formal vote and must be recorded in the corporate minutes. Meetings of directors and its shareholders must be properly noticed and must meet quorum requirements. Finally, corporations must meet annual reporting requirements in their state of incorporation and in states where they do significant business.

Taxation is a significant consideration when choosing a business structure. Unlike a partnership that allows “pass-through” taxation, a C corporation is taxed as a separate legal entity. If the corporation distributes profits to the shareholders in the form of dividends, shareholders pay income tax on those distributions; thus, commentators criticize C corporations as imposing “double taxation.”

As with any business entity that offers liability protection to its owners, a corporation must be created at the state level. A corporation begins its life by filing articles of incorporation (sometimes called a certificate of incorporation) in the appropriate state and paying the necessary filing fee.

Advantages of C corporations

  • Typically shareholders are not personally responsible for the debts and liabilities of the business.
  • C corporations can have an unlimited number of shareholders.
  • Ownership is easily transferable through the sale of stock.
  • Corporations have unlimited life extending beyond the illness or death of the owners.
  • Certain business expenses may be tax-deductible.
  • Additional capital can be raised by selling shares of the corporation’s stock.

Disadvantages of C corporations

  • C corporations may incur double taxation.
  • Corporations are more expensive to form than sole proprietorships and partnerships.
  • C Corporations face ongoing state-imposed filing requirements and fees.
  • All C Corporations face ongoing corporate formalities, such as holding and properly documenting annual meetings of directors and shareholders.

Defining S Corporations

An S corporation is standard corporation after filling for a S corporation status with the Internal Revenue Services. The S corporation’s tax election adopts pass-through taxation – thereby sidestepping the double taxation burden borne by C corporations. Much like a partnership an S corporation files an informational tax return, but the entity pays no tax. The shareholders report their share of the S Corporation’s profit or loss on their individual tax returns.

Advantages of S corporations

  • S corporations are not taxed at the entity level – profits pass through to owners.
  • Shareholders are typically not personally responsible for the debts and liabilities of business.
  • S corporations have unlimited life extending beyond the illness or death of owners.
  • Certain business expenses may be tax-deductible.
  • Additional capital can be raised by selling shares of the corporation’s stock.

Disadvantages of S corporations

  • The IRS imposes restrictions on S corporation shareholders. This requires there to be less than 100 shareholders. The shareholders must be individuals, estates or certain qualified trusts; and cannot be non-resident aliens.
  • S corporations can have only one class of stock (disregarding voting rights).
  • All shareholders must agreement in writing to the S corporation election.
  • S corporations are more expensive to form than sole proprietorships and general partnerships. They also face continuous, state-imposed filing requirements and fees.
  • A few states do require a state-level filing for the entity’s S corporation status to be recognized by the state.
  • S corporations deal with continuous corporate formalities, such as holding and properly documenting annual meetings of shareholders and directors.

You should now have a better understand of a S corp vs C corp. When you compare a C corporation vs S corporation there are lots of things to consider. No matter which direction you take when it comes to incorporating your business in you should fully understand all of the legal entities and decide, which one will work best for your business.