The corporation is the most sophisticated form of business entity and the most common among large companies. The corporate business form was well-developed under Roman law. In the second and third centuries, the corporate form was used by the early Christian church to hold and transfer church property, for example, for transferring control of parish assets to the new bishop when the previous bishop died. The corporate form was brought to the American colonies by the British.
When to Incorporate
A venture usually does not need to incorporate in its very early stages. The need for incorporation often arises from a specific event such as:
The business begins to sell a product, opening up potential liability.
The business seeks external financing, necessitating the need for a formal legal structure.
Some other specific reason develops.
From a venture capitalist's point of view, C corporations are the preferred choice of business form because the VC partnership does not want to see the pass-through income. For entrepreneurs without VC funding, limited liability companies are the preferred choice since losses in the first few years can pass-through for personal tax deductions. Delaware now allows easy conversion from a limited liability company to a C corporation.
Forming a Corporation
To form a corporation, an incorporator (anybody can act as one, e.g. the secretary of a lawyer) performs a name check to determine whether the proposed corporate name is available in the state of incorporation. However, the right to use the name is in the domain of trademark law. The incorporator then files the articles of incorporation. Most large corporations are incorporated in Delaware because of its highly developed corporate legal system.
The articles of incorporation include:
The name of the corporation, which must be followed by a corporate indicator such as "Corporation", or "Ltd."
The address (not a post office box) of the corporation's registered office and the name of the registered agent at that office. The registered agent is the person to be served if the corporation is sued. This is an office for legal purposes and does not have to be the corporation's business office.
The length of time that the corporation is to exist. This duration can be perpetual or renewable.
The capital structure such as common stock, preferred stock, the rights and responsibilities of each, and how much of each. One often authorizes about 20 million shares of common stock and 5 million shares of preferred stock. However, many closely-held small corporations that do not require outside investors may have only common stock and may limit the authorized shares to only a few thousand in order to minimize franchise taxes, depending on the state.
The name and address of the incorporator.
Up to this point in the incorporation process, one has spent no more than a few hundred dollars in fees for filing the articles of incorporation. The incorporator then elects a board of directors and goes away as the board of directors takes over. The directors then issue shares and elect the officers.
For a corporation organized under subchapter C of the 1986 IRS code (known as a C-corp), the federal tax rate ranges from a minimum of 15% to a maximum of 35%, depending on the corporation's level of taxable income. All but the smallest corporations are taxed in the 34% - 35% range at the federal level. The state tax rate varies.
Double taxation may be an issue with C corporations since profits paid out as dividends are taxed a second time at the personal level. To reduce the tax burden, the company can include debt in its capital structure, but at a certain level of leverage the IRS will reclassify the debt as equity. A more common way of reducing the tax burden is to pay year-end bonuses so that the corporate income is reduced to near zero. However, there is a limit to what the IRS considers reasonable compensation, at which point further amounts are considered to be non-deductible.
Another way to reduce the tax burden is to form a general partnership or a limited liability company that owns the equipment used in the business. The rental fees for the equipment can be used to channel income.
For a corporation organized under subchapter S of the Internal Revenue Code (S stands for small business corporation), there is pass-through taxation. An S corporation can be formed by making a subchapter S election when forming a C corporation. This distinction is at the federal level, but some states recognize it as well. The subchapter S election affects the corporation only from a taxation viewpoint. The income, gains, losses, and deductions are passed through in proportion to one's share of ownership in the S corporation.
The subchapter S election has some additional requirements:
The S corporation must be a domestic corporation.
The maximum number of shareholders is 75. Before 1997 this limit was 35. There are ways around this limitation, for example, by forming two S corporations that form a joint venture.
The shareholders of an S corporation must be individuals or certain estates and trusts.
The shareholders of an S corporation must not be non-resident aliens.
An S corporation may not have more than one class of stock, for example, common stock. However, there can be two types of common stock - voting and non-voting. In some cases, options and warrants may count as a second class of stock. Debt is not considered a second class of stock unless it is classified as equity. There are three requirements for debt to be acceptable for subchapter S election:
- Its interest is not tied to profits.
- The debt is not convertible.
- The creditor must be an individual.
The corporation must make the S election within 75 days of formation, otherwise it will be a C corporation for the first year, and an S corporation thereafter.
If the exit strategy is to be acquired, for a small non-dot com an S corporation is a better choice than a C corporation. C corporations require a higher selling price to make up for the tax differences to the owners. A corporation can change from a C corporation to an S corporation fairly easily, but it is much more difficult to change from an S to a C corporation.
State of Incorporation
The corporation is an entity created by state law, and laws vary from state-to-state. Selecting the state of incorporation is an important decision for a business. Traditionally, Delaware has been a popular state of choice. Other states such as Nevada also have created corporate-friendly legal environments. In many cases, the corporation's principal state of business may be the best choice.
There are several key documents in a corporation. The articles/certificate of incorporation are analogous to a nation's constitution. The bylaws are analogous to a nation's statutes. The organizational minutes evidence a meeting. After those, the key documents of concern are the shareholders agreement and employment agreement.
The shareholders agreement is related to risk and control issues. It regulates how shares are transferred, for example, if a shareholder dies. It also specifies how a shareholder can get out.
Preserving Limited Liability
An important advantage of the corporation as a business form is that shareholders are not personally liable for the debts incurred by the corporation. However, this protection is not ironclad. Individuals can be held liable when it can be shown that the incorporation process was not performed properly (defective incorporation), when one personally signs a contract without explicitly stating that it is on behalf of the corporation, and when a court decides to pierce the corporate veil and remove the limited liability protection.Reducing Potential Personal Liability Associated with Sitting on the Board of Directors
Have an indemnification - an indemnification agreement creates an exemption from incurred liabilities. One can guard against personal liability by getting the company to agree to pay for legal defense and to reimburse any damages.
Have a contract that specifies the indemnification.
Have director and officer (D&O) insurance.
Corporate Opportunity - for misappropriation to occur, the opportunity must be in the company's direct line of business.
Case: Klinicki v. Lundgren
In 1977, Klinicki and Lundgren incorporated Berlinair, Inc. Lundgren served as president and a director; Klinicki was a vice-president and a director. Lundgren and Klinicki, as representatives of Berlinair, met with a consortium of travel agents about a potentially lucrative business opportunity. Without telling Klinicki, Lundgren incorporated Air Berlin Charter Company as the sole owner in order to take advantage of the opportunity. Air Berlin Charter Company was granted the contract. Lundgren defended himself by arguing that Berlinair did not have sufficient financial resources to pursue the opportunity.
The issues are corporate opportunity and fiduciary duty.
Lundgren misappropriated the lucrative contract.
Lundgren should have presented the opportunity to Berlinair's board of directors and shareholders. Had they voted against pursuing the opportunity, Lundgren would have been free to pursue it.
Stock and Debt
When forming a corporation, there are three things that must be divided: earnings, assets, and management.
The authorized stock is the total number of shares that the articles permit to be issued. For example, a Delaware C corporation might issue 15 million shares of common stock and 5 million shares of preferred. Of this, the founders may own one million shares and the angel investors 300,000 shares. Too many authorized shares may result in higher taxes since some states tax a corporation on the number of shares. (Delaware does not). In this example, 1.3 million shares have been issued. Treasury stock is stock that has been redeemed by the shareholders and bought back by the corporation. Let's assume in this example that 100 thousand shares have been repurchased. The outstanding stock then is the issued stock less the treasury stock, or 1.2 million shares.
Common stock has voting rights and a residual claim on assets and earnings. Preferred stock can vote only under certain circumstances, for example, if its dividends are not paid or if there is to be a change of charter; the voting rights associated with a change of charter depend on the shareholder agreement.
There are three types of debt:
Notes, of duration less than 10 years, non-secured.
Debentures, of duration greater than 10 years, non-secured.
Bonds, of duration greater than 10 years, secured. Secured debt entitles the debt holders to specific assets in case of default.
Equity compensation plans often use stock options (actually called warrants since they are issued by the company). There are two types of stock options:
Incentive Stock Options (ISO) - these options are given to employees and provide them the right to purchase stock at its fair market value on the date the options were granted. Such options are not taxable upon exercise. An employee can lose such options if terminated for cause. An employee may want to consider negotiating a 30 day termination notice and an "opportunity to cure." If leaving voluntarily, options normally can be exercised within 60 days.
Non-qualified options - exercising such options triggers a tax liability.
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