Chapter 9
Corporations:
Ownership Without Liability
Introduction
This chapter introduces you to the corporate form. Corporations have traditionally been the favored business organization for limiting the personal liability of business owners. With continuity of life, centralized management, limited liability, and free transferability of interests, corporations offer investors vehicles for their investment dollars while offering them protection from responsibility for debts or obligations of the corporate business.
The advent of limited liability companies and limited liability partnerships has caused a decline in popularity of the corporate form. However, several types of corporations have developed to accommodate the needs of the diverse business interests seeking the liability protections offered by the corporate form. Therefore, even with the emergence of new organizational forms that adopt some corporate characteristics, the corporation will undoubtedly remain an organizational form of choice for many business owners in the future.
Lecture Notes
¨ Corporation Defined
A corporation is a legal entity (a “person”) owned by investors (shareholders) and
managed by a board of directors. A corporation is a legal “person” born or created by statute.
¨ Corporate Characteristics
Corporations are generally characterized by the following:
1. continuity of life
2. centralization of management
3. limited liability
4. free transferability of interests
Not all corporations possess all four characteristics (e.g., a small S corporation may be entirely owner-managed); however, all four of these characteristics can coexist only in a corporation. Because these four corporate attributes also are generally recognized as the advantages of the corporate form, they are individually addressed in the following section.
Advantages of Corporate Form
continuity of life
centralization of management
limited liability
free transferability of interests
Ø Continuity of Life
A corporation’s life does not end on the death or withdrawal of one or more of its members. The corporation is its own “person,” with its own “life.” A corporation is said to have “continuity of life,” because it exists independent of its ownership.
Ø Centralization of Management
Unlike most other business forms, shareholders of a corporation do not have the right to participate directly in the management of the company. A corporation is generally managed by an elected board of directors, while its daily operations are run by corporate officers (president, vice-president, etc.) appointed by the board.
Ø Limited Liability
Corporate owners (shareholders) and managers (board) are protected from personal liability for the contractual obligations and other debts of the corporation. Thus, corporations are said to “shield” their owners from personal liability.
Example: Scott is an attorney licensed to practice law in the state of Nevada. He forms a professional corporation for his law firm to protect his personal assets (family home, personal car, etc.) from being seized by creditors of the firm, particularly in the event of a malpractice lawsuit.
Piercing the Corporate Veil
If a corporation is improperly run (failure to follow corporate formalities), is operated for fraudulent reasons, and so on, the court may pierce the corporate shield and hold managers, shareholders, or both personally liable for obligations of the corporation. This is known as “piercing the corporate veil.”
Example: Scott, from the previous example, devises a scheme to cheat elderly people out of their retirement. He forms a professional corporation for his law firm with the intent that it will shield him from personal liability for his scheme. Undoubtedly, in a suit brought by a defrauded senior citizen, the court will pierce the corporate veil and hold Scott personally liable for his wrongful conduct.
Ø Free Transferability of Interests
In large corporations, shareholders generally are simply investors in a corporation. Because they have no management rights, their ownership interests can usually be sold or transferred without the consent of the managers of the corporation.
However, small corporations that allow shareholders and owners to participate in the management of the corporation may want to restrict who can own an interest in the corporation. These smaller, closely held corporations generally include a transfer restriction on their stock certificates, containing language as set forth on page 94.
Disadvantages of Corporate Form
corporate formalities
double taxation
Ø Corporate Formalities
Corporations are known for the extensive filing requirements imposed by statute, both to form and operate a corporation. Articles of incorporation must be drafted and filed to create a corporation; extensive bylaws establish the corporation’s operating procedures; at a minimum, annual meetings must be held for shareholders and directors to address corporate business; and minutes must be kept of all meetings. In addition, the appropriate annual reports must be filed with the secretary of state. If corporate formalities are not complied with, the state may set aside the corporation, thus exposing its owners to personal liability.
Ø Double Taxation
Business owners like the personal liability protections offered by corporations. However, they don’t like sharing their corporate profits, especially when the IRS taxes them twice on the same business income! Because a corporation is seen as a separate person, the IRS taxes the corporation on its profits. When the corporation distributes the profits to its shareholders in the form of dividends, the IRS holds out its hat to collect from the individual shareholders as well.
To get around the double taxation imposed on corporations, smaller corporations may qualify as an S corporation, discussed later in this section, and elect to be taxed as a partnership, with pass-through (single) taxation.
¨ Corporate Forms
Although corporations are often pictured as the large corporate conglomerates of the New York Stock Exchange, most corporations are small businesses, owned and operated by friends or family. Several corporate forms are available to suit the diverse needs of business interests:
business corporation
statutory close corporation
nonprofit corporation
professional corporation
S corporations (IRS designation)
Ø Business Corporation
This is the traditional corporate form, owned by anonymous shareholders and managed by an elected board of directors.
Ø Statutory Close Corporation
Just as the name suggests, this is a corporation owned and operated by closely affiliated shareholders, such as friends and family. These smaller business organizations generally allow its shareholders to participate in the management of the corporation.
Ø Professional Corporation
States generally limit the professions that may form corporations. It is important to refer to your state’s listing of professions permitted to incorporate.
The key issues for professional corporations are
Ownership Restrictions
Ownership and management of the corporation is limited to qualified professionals. This requirement is intended to prevent investors from attempting to maximize profits without regard for professional standards.
Personal Liability
Professionals remain liable for their own malpractice and that of others under their supervision. This is unlike the traditional corporate form, which shields owners and shareholders from all personal liability.
Ø Nonprofit Corporations
Nonprofit corporations are generally formed for charitable purposes.
Contributors
The corporation is not “owned” by shareholders; rather, memberships are generally granted to those that contribute to the charitable purpose. Members of a nonprofit corporation do not receive traditional corporate dividends (profits).
Taxation
Nonprofit corporations are generally exempt from taxation.
Ø S Corporations
S corporations are an IRS designation, not a separate corporate form. An S corporation can avoid the double taxation that most corporations suffer. A business corporation, a close corporation, or a professional corporation that qualifies can make an S election.
Note: Nonprofit corporations are tax-exempt, so it is unnecessary for them to make an S election.
Answers to Study Questions in Review
1. Who owns a corporation?
Its shareholders and stockholders
2. What document must be filed with the secretary of state before a corporation can begin its existence?
Articles of incorporation
3. What is the purpose of corporate bylaws?
The bylaws establish the corporation’s operating procedures such as dates and places of shareholders’ and board of directors’ meetings, voting mechanisms, election of directors, duties of directors, and stock issuance and ownership.
4. What is “continuity of life” for a corporation?
A corporate exists indefinitely, without regard to its ownership (e.g., the death of a shareholder). Therefore, it is said to have continuous life.
5. Who manages a corporation?
A corporation is managed by its board of directors, with the exception of the statutory close corporation.
6. What are the responsibilities of a corporate shareholder?
None. Shareholders are merely investors in the corporation.
7. What does “free transferability of interests” as it applies to corporations?
Corporate shares (ownership) may be assigned, sold, or otherwise transferred to a third party outside the corporation without the consent of the other shareholders.
8. What are the main disadvantages to incorporating a business?
(1) The formalities required in organization, operation, and annual reporting
(2) Double taxation
9. What is “double taxation” of a corporation?
Corporations are taxed at the corporate level based on their business income. Profits are then distributed to the shareholders, and the profits become taxable personal income of the shareholders.
10. What is the difference between a business corporation and a statutory close corporation?
A business corporation, also known as a C corporation, is the traditional corporation, owned by shareholders with freely transferable stock, managed by a board of directors, and having perpetual life. In contrast, the statutory close corporation is owned by closely affiliated shareholders (e.g., family members) whose shares are not freely transferable, managed by shareholders, and unencumbered by many of the formalities that plague the traditional business corporation.
Answers to Case Studies in Review
1. Toybox, Inc., a California-based toy manufacturer, has been losing money for the last five years. It is now $500,000.00 in debt. It has considered bankruptcy, but its new CEO believes that he can turn the company around within the next two years. However, the corporation’s creditors are getting impatient. Can the creditors sue the shareholders to cover the corporation’s debts?
No. Corporations provide shareholders protection from personal liability for the contractual debts and other obligations of the corporation. Thus the personal assets of the corporation cannot be attached to satisfy the obligations of the corporation.
2. The Davis family owns a large ranch in western Wyoming. All 10 members of the family live and work on the ranch, raising cattle. The family wants to incorporate. Based on your review of the available corporate forms, what corporate form would you recommend and why?
The best corporate form for a small family-run business is generally the statutory close corporation. Most states impose minimal formation and operating requirements on these corporate forms. In addition, the shares of a statutory close corporation are not freely transferable, thus restricting who can own the corporation.
Project Applications
1. Research your state’s statutes applicable to corporate business organizations. Provide the statutory citations for each type of corporate form (business, close, nonprofit, and professional).
2. Refer to the statutory provisions applicable to professional corporations. What types of professions may incorporate in your state?