Over the next couple of weeks, I’ll be going into more detail regarding the most common types of business structures — the corporation, the partnership, and the limited liability company. My intent is to give a very brief overview of the most prominent legal features, pros, and cons of these business organizations, so that when the time comes for you to start organize your own business, you will be a bit more knowledgeable when you sit down to speak with you attorney!
Here in Part 1, I will discuss the basic corporation — of course, there are other flavors of corporations, such as the professional corporation or the non-profit corporation, that I will discuss in more detail in future articles. Indeed, there are sometimes differences between a corporation that is a Fortune 500 company (commonly known as a publicly held corporation), and a corporation that is a small business with a few owners (known as a closely-held corporation or close corporation). Where there might be differences between the two, I will try to point them out in this article.
Corporations are possibly the most formalistic of any business organization, because the law requires that they be structured and run in certain ways. The law requires that a for-profit corporation be managed by a board of directors, and requires a minimum number of people to serve on the board (depending on the number of shareholders), and requires that the corporation have a set of bylaws that dictates the rules by which the board manages the corporation. (Terminology note: I’ve seen entrepreneurs ask attorneys to draw up “bylaws” for their partnership or LLC — partnerships and LLCs have partnership or operating agreements, corporations have bylaws; it’s best always be clear with what you ask your lawyer for, otherwise you may end up with something like an LLC holding company with a corporate subsidiary!) Corporations are required to have, at the very least, annual meetings of the board of directors and annual meetings of the stockholders (if any) where the board makes management decisions and stands for election by the stockholders. This contrasts with other types of business organizations, which are generally not required to have a written operating agreement and can be relatively informally run by some or all of the owners.
Ownership interests are held by stockholders/shareholders. At the most basic level, stock is the most liquid business interest and can technically be freely bought and sold; however, it is possible to restrict the sale of stock in one way or another by adding restrictions to the legend on the stock certificate. Of course, practically speaking, stock in start-up corporations is almost completely illiquid, as one would be hard-pressed to find someone to invest in a new, unproven business.
Ownership interest in a corporation does not automatically grant management interest; although the stockholders of a start-up corporation are often the directors, the law does recognize a distinction between the two. Difficulties may arise with start-ups where owners are also directors — directors sometimes have fiduciary duties to the corporation that may be opposed and superior to duties to the shareholders; director/shareholders acting in their own interest against the interest of the corporation can run into serious trouble with the business’ creditors. While management power can be delegated to corporate officers, it may not be reserved to the stockholders. Stockholders generally are limited to electing directors and ratifying major strategic decisions of the board, such as mergers, acquisitions, or dissolutions.
The ownership and management interests of a corporation can be structured to free up most of the equity to sell to investors, while keeping management in the hands of the founders; for example, a corporation may have stock owned by the founders that only owns a relatively small percentage of the equity while having electoral control of the board of directors, in addition to stock sold to investors that owns a majority of the equity, but does not have majority control of the board — of course, such a structure must be drafted carefully to avoid any fiduciary duties that the founders may have as both directors and stockholders.
Corporations have the option to be taxed under two subchapters of the Internal Revenue Code: Subchapter C and Subchapter S. Under the default classification of Subchapter C, corporate income is taxed both at the corporate level, and then again when profits are paid to shareholders in the form of distributions/dividends. The advantage to this form is that the tax liability remains with the corporation so long as dividends are not paid. Under Subchapter S classification, the profits and losses of the corporation, as well as the tax liability flow directly to the shareholders, thereby avoiding the double-taxation problem of Subchapter C classification; however, Subchapter S classification has several restrictions, including a limit of one class of stock, having no more than 75 shareholders who are either individuals (excluding non-resident aliens or spouses of non-resident aliens who have an interest in the U.S. citizen’s stock) or estates, certain types of trusts, or tax-exempt pension plans or other organizations, and not being an ineligible business such as a financial institution or insurance company.
Choosing Subchapter C taxation may be preferable for start-ups where the owners intend to reinvest all of the profits and not take dividends and have the tax liability remain with the business; Subchapter S allows owners to claim the corporation’s profits and losses and receive dividends without having the income taxed at the corporate level. However, entrepreneurs with corporations should take care in their selection, as a corporation can only make one selection in a 60 month period.
The above is a rather cursory overview of some of the major legal aspects of corporations; if you have any questions or would like a further explanation of an issue covered above, please go to our Contact page to send us your questions, or set up an initial consultation if you are interested in setting up a corporation. Thanks for reading!