All businesses, particularly startups, should consider organizing as a legal entity form. Many entities will choose to carry on business as a corporation. The corporation is the oldest and most recognized form of business entity. As such, it has very defined characteristics that make it the best option for certain businesses. Below, we discuss the benefits of forming a corporation as a corporate entity form and the types of companies that should organize as a corporation.
Benefits of the Corporate Entity Form
Understanding the number characteristics of the corporate entity form will allow you to make the appropriate decision as to whether to incorporate or to choose an alternative entity form. The primary characteristics of the corporate entity are: formation, maintenance, continuity, ownership and control, and personal liability of owners. Corporate tax status has unique characteristics; however, other forms of business entity can elect to be taxed as a corporation.
Formation – Forming a corporation is fairly easy. You must file with the secretary of state’s office in the state where you wish to organize. You will also be required to register as a foreign business entity in any state where the corporation intends to carry on business. Forming a corporation requires information on incorporators, corporate purpose, number and type of shares issued, par value or the shares, registered agent, location of business or records retention, and a filing fee.
Maintenance – Maintenance of a corporation is the subject of corporate governance. A corporation is primarily governed by state law and the company’s articles of incorporation, bylaws, and shareholder agreements. State law is the default rule. The company will use its corporate governance documents to alter the default governance provisions — though some provisions, such as shareholder meeting rights, may be protected by law and not subject to change. Each of these corporate governance documents performs a separate function. The articles of incorporation provide for the number and nature of ownership interests. The bylaws lays out the rights and obligations of shareholders and directors. This includes voting rights, meeting rights, rights to information, authority limitations, etc. Shareholder agreements are agreement between shareholders and the company. These agreement commit the shareholders to a specific course of action regarding voting or disposition of their shares.
Continuity – The corporate entity continues in existence separately from its owners. So, if a shareholder leaves the corporation or sells her interest to a third party or back to the corporation, the company continues in existence. This is in contrast to some other business entity forms that legally dissolve when an owner dissociates from the business.
Ownership and Control – Shareholders own the corporation. The shareholders have meetings, receive company information, vote and elect company directors. The directors are charged with managing the high-level affairs of the company. Directors orchestrate company meetings, ensure compliance with state and federal disclosures, approve budgets, set corporate strategy, and hire officers. The officers run the daily affairs of the company. This includes hiring the employees that carry on company business and make up the corporate hierarchy. This complex ownership and control structure allows large or diverse companies to appropriately allocate rights and obligations among interested parties.
Personal liability of owners – The corporate entity form provides personal liability protections to shareholders. This means that shareholders, as owners of the corporation, are not personally liable for the debts or obligations of the company. This becomes very important when the company has significant outstanding debt from loans or legal actions. Protecting the personal assets of the shareholder from creditors of the corporation induces individuals to invest in the company without fear of loss beyond the amount of their investment.
Tax status – While many business entities can choose to be taxed as a corporation, it is important to understand the options available. A corporation can be taxed under subsection S, subsection C, or provision 501 of the Internal Revenue Code. Subsection S allows for taxation very similar to that of partnerships. The profits or losses of the company flow through to owners. A C corporation is taxed as a business entity. Any profits distributed to owners are then taxed to the owners as dividends. Provision 501 allows a company to avoid federal taxation as a non-profit or not-for-profit entity.
What Type of Companies Need to be a Corporation?
A startup business that is growing quickly or is highly diverse in its ownership structure should consider organizing as a corporation. As described above, the ownership and control structure allows for the customized dissemination of rights and duties among owners and managers. This becomes very important as the company grows and seeks outside investors. For example, a company may seek to have a large shareholder base that does not take part in the high-level management or daily affairs of the company. Similarly, a startup company seeking investment from venture capitalists will generally offer preferred shares to the investors in exchange for funds. The corporate entity form allows for the authorization of multiples classes of shares, including common stock and preferred shares with unique characteristics. The laws surrounding these types of ownership interest is very developed. While it is possible to create unique classes of ownership for other business entities, the law surrounding these types of interest is less developed. As such, it requires for more detailed contract drafting to establish similar rights as those commonly held by preferred shareholders.
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