What is a Corporation

A corporation is a business entity created under state law, that stands as an independent legal "person" apart from its shareholders and directors. Accordingly, a corporation may enter into contracts, obtain loans, and pay taxes on its own behalf, and it continues to exist even after its founders or shareholders die or transfer their shares to others.

A corporation's owners or shareholders receive the benefit of limited liability for the obligations of the corporation, and are thus ordinarily shielded from the corporation's creditors even in the event that the corporation cannot pay its obligations.

Unless limited by state law or its own articles of incorporation, a corporation continues indefinitely. Ownership can be transferred through sale of stock, and the sale or transfer of a controlling interest in the corporation does not necessarily affect its management structure or operations.

Types of Corporation

Corporations come in a variety of forms, each with its own set of features that may benefit particular types of business, business activity, or other types of operation such as a membership or charitable organization. Those forms include:

  • The Close Corporation - A close corporation, or closely held corporation, is owned by a small group of shareholders, as defined by state law, usually not exceeding thirty to fifty individuals. The stock of a close corporation is not sold either on a stock exchange or "over the counter" (sales that are not made through a listing on an exchange).

  • The Public Corporation - A public corporation is a corporation whose shares are publicly traded, whether on a stock exchange or "over the counter".

  • The C Corporation - A C Corporation is a standard business corporation, which pays tax under Subchapter C of the tax code.

  • The S Corporation - An S Corporation is a corporation which has elected for its profits to be taxed in the manner of an unincorporated entity. Not all corporations can opt to become S Corporations.

  • The Professional Corporation (PC) - A special type of corporation incorporated to perform professional services, such as the practice of law or medicine. (Historically, professionals were not permitted to incorporate. Now, many professional practices incorporate as PC's or LLC's.)

  • The Nonprofit Corporation (PC) - A corporation that is required to reinvest any profits that it generates back into its operations, rather than paying out dividends to shareholders. Nonprofit corporations are often formed by charitable organizations that hope to gain the advantage of property and sales tax exemptions, or to qualify as charitable organizations that may receive contributions that are tax-deductible to donors.

Limited Liability for Corporations

Perhaps the biggest advantage of the corporate form is its extension of limited liability to the corporation's officers, directors and shareholders. That is to say, if a business is sued or is unable to pay its debts, the creditors can ordinarily only reach the corporation's assets and cannot reach the assets of the shareholders. This protection against liability is referred to as the corporate veil.

Certain types of misconduct by a corporation or its officers may enable creditors or state tax authorities to pierce the corporate veil and reach the personal assets of those who engaged in the wrongful conduct. For tax debts, federal tax authorities may be able to bypass the corporate veil to recover distributions made to share holders. Even with the protection offered by incorporation, shareholders may be held responsible for their own negligence and misconduct, for actions intended to damage or defraud the corporation, and for corporate debts that they have personally guaranteed.

In recent decades, additional limited liability entities have been created, such as the limited liability company (LLC), giving business owners a greater range of choices in how to organize a business while enjoying some protection from liability beyond the value of their share of the business.

Articles of Incorporation

When you form a corporation, the first step is to file articles of incorporation with the state in which you desire to incorporate, along with the required filing fee. Most states offer approved forms for completing and submitting articles of incorporation.

States normally require that articles of incorporation include:

  • The name of the corporation;

  • The address of the corporation;

  • The identity of the corporation's registered agent (the person designated by the corporation to receive service of process and certain important documents on its behalf); and possibly

  • The names of the directors of the corporation.

When state law requires that directors be named, some corporations name an initial set of directors and then, after registering the corporation, hold a board meeting to appoint new directors. By using that approach, a business can keep the identity of its directors out of the public record.

Getting Started as a Corporation

In addition to filing articles of incorporation, every new corporation must do the following:

  • Create a set of bylaws that govern its operation;

  • Hold an initial meeting of its board of directors; and

  • Issue stock to its shareholders.

Corporations must also hold regular board meetings, usually no less than once per year, and file an annual report with the state. Corporations are also expected to meet certain bookkeeping standards and to maintain their own bank accounts, and most businesses will benefit from consulting with an accountant in setting up appropriate accounting and record-keeping systems.

As they get started, most corporations will benefit from formulating a buy-sell agreement, to help guide the sale or transfer of shares by the initial set of shareholders, covering such issues as how the share value will be determined if a shareholder wishes to sell his interest, and what will happen if a shareholder dies, becomes disabled, or wishes to sell shares to a third party.

A corporation's failure to follow proper formalities may result in the loss of shareholder protection from liability against creditors, as well as the state's declaring the corporation to have lapsed.

The Roles of Corporate Officers

The management and operation of a corporation involves its shareholders, directors, and officers:

  • Shareholders - A shareholder is the owner of shares in a corporation. Depending upon the nature of the shares, a shareholder may ordinarily participate in votes to select or remove directors, to amend the corporate bylaws or articles of incorporation, to merge or reorganize the corporation, or to dissolve the corporation or liquidate its assets.

  • Directors - A corporation's directors are normally empowered to elect of corporate officers, issue stock, exercise oversight and approval of major financial transactions, and to approve compensation packages for executives and officers of the corporation. In many small corporations, most or all of the shareholders will also serve as directors.

  • Officers - The officers of a corporation oversee its daily operations and activities. Most states require that a corporation have a President (and possibly a Vice President), Secretary, and Treasurer. In simple terms, the President has authority to direct the business, the Secretary has authority over corporate records, and the Treasurer has authority over corporate finances. Most states permit a corporation to appoint one person to all three positions.

The shareholders of a small or close corporation will often serve as its directors and officers.

Annual Meetings and Reports

Among the obligations a corporation must meet on a continuing basis, a corporation is required to hold an annual meeting, keep minutes reflecting what occurred at the meeting, and to file an annual report and fee with the state in which it is incorporated. Failure to follow these steps can cause the corporation to lapse.

While it may be possible to cure the lapse by filing late reports and payments, if it is not possible the shareholders may find themselves liable for the corporation's outstanding debts and obligations.

Taxation of Corporations

A C Corporation pays taxes on its corporate income, whereas the profits of an S Corporation pass through to the shareholders who report their share of the profits on their personal tax returns. Even if corporate income tax has been paid, any dividends paid by a corporation to its shareholders are also subject to taxation as income to the shareholder.

C Corporations must file annual tax returns.

Securities Laws

As the number of shareholders to a corporation grow, the possibility arises that state and federal securities laws will apply to the corporation and its conduct. If shares are to be sold or distributed to more than a limited set of shareholders (usually about thirty-five shareholders), the corporation may have to register the sale with the securities authorities of the state and federal governments before it can issue the shares. Securities laws can also be implicated by issuance of stock options to employees. Corporations should take care to know how securities laws apply to their situation in advance of taking action which might implicate those laws.

Differences Between Corporations and LLCs

Due to the comparative complexity of starting and managing a corporation, businesses should carefully consider whether their needs will be better served by forming as an limited liability company (LLC), or even as a partnership or sole proprietorship.

An LLC has fewer formalities to observe in order to maintain its status, and is generally simpler to create, own and operate than a corporation. For example, an LLC is not required to hold annual meetings.

An LLC may also have greater flexibility in allocating business profits between its members than does a corporation. If a C Corporation has profits, it must pay corporate income taxes on those profits, whereas the profits of an LLC pass through to its members who individually report their share of the profits on their own tax returns. S Corporations also have pass-through profits, so it is possible to gain that advantage if you prefer the corporate form but are not going to be negatively affected by restrictions on S Corporations, such as limits on the number of shareholders and who may own shares.

Corporations have an advantage over LLCs through their ability to issue stock, and possibly stock options, to key employees and investors. A business may also gain a tax advantage by having the corporation retain some of its own profits, even with the payment of corporate income taxes, over having all of its annual profits distributed to the owners and investors.

For people who want to pass their businesses or investments to their children, there are advantages and disadvantages to using the corporation or an LLC for purposes of estate planning and wealth transfer. Those issues should be discussed with a qualified estate planning professional prior to choosing a business form for that purpose.

Copyright © 2004 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on Jul 19, 2016.