A corporation is a traditional legal structure designed to provide liability protection for owners of the business enterprise. Corporations are formed by filing appropriate documents with the state in which the corporation will be formed. Some states have more favorable corporate laws than others. As discussed below, for tax purposes, a corporation is classified as either a C corporation or an S corporation.
A corporation is recognized as a legal entity separate from its owner. To form a corporation, the owner(s) must file documents with the state in which the entity will be incorporated. The documents usually include, at a minimum, Articles of Incorporation. The owner(s) should also adopt Bylaws to govern the affairs of the corporation and reflect the formation of the corporation in the organizational minutes.
For tax purposes, a corporation may be treated as either an C corporation or an S corporation, with C corporation being the default classification . The Federal tax rules governing C corporations are designed to ensure that all income is taxed twice: once at the corporate level and again when distributions are made to shareholders. For more information on taxation of C corporations, see What is a C Corporation?, Tax Consequences of Contributions to C Corporations, and Tax Consequences of Distributions from C Corporations.
Unlike C corporations, S corporations do not pay income taxes. Instead, an S corporation’s income, losses, deductions and credit are passed through to the shareholders for Federal tax purposes and taxed directly to them. As a result, S corporations are taxed only once, at the shareholder level. For more information on taxation of S corporations, see What is an S Corporation?, Tax Consequences of Contributions to S Corporations, and Tax Consequences of Distributions from S Corporations.
Capitalization and Contributions
Corporations are initially capitalized by transferring property to the corporation in exchange for shares of stock in the corporation. As a matter of corporate law, there is no limit on the number of shareholders that the corporation may have. The corporation’s stock may be divided into different classes of shares (such as preferred stock and common stock), each with their own right to voting and distributions.
Owner Liability for Entity Obligations
Under state law, shareholders of a corporation are generally protected from liability for obligations of the corporation. The corporation is treated a separate entity and is solely responsible for its own debts and obligations. This veil of protection may be pierced, however, if the shareholders fail to follow corporate formalities, commingle personal and corporate funds, engage in fraudulent behavior, or inadequately capitalize the corporation to the detriment of creditors. Shareholders are also personally liable for any loans or other obligations that they personally guarantee.
Protection of Entity Assets from Owner’s Personal Creditors
Creditors of a shareholder may acquire the shareholder’s shares in the corporation, in which case the creditor will succeed to the shareholder’s rights to distributions and management of the corporation. If the shareholder had a sufficient quantity of shares to liquidate or dissolve the corporation or force distributions of assets from the corporation to the shareholder, then the creditor will acquire those same rights. If, on the other hand, the shareholder had nonvoting shares that conferred few rights or benefits, the creditor will only acquire the limited rights that the shareholder had.
Important Note: If protection of entity assets from the owner’s personal creditors is important, a charging-order protected entity (such as a limited liability company or limited partnership) should be considered.
Control of a corporation is determined primarily by the corporation’s Articles of Incorporation and Bylaws, within the limits established by state law. State law also fills in the gaps for situations where the Articles of Incorporation and Bylaws are silent. While the laws of most states have similar provisions regarding control of the corporation, there are some state-by-state variations that should be considered, such as the amount of control required to liquate, dissolve, or sell substantially all of the corporation’s assets.
Continuity, Transferability, and Dissolution
Corporations exist until they are dissolved. Dissolution can occur by the shareholders, by creditors, or by the state for failure to file periodic reports. The shareholders are generally free to transfer their stock unless restricted by the Articles of Incorporation or Bylaws or by agreement between the shareholders. State law may prohibit an absolute restriction on transferability.
A corporation’s Articles of Incorporation and annual reports are filed with the state and can generally be viewed by third parties. The corporation’s Bylaws, minutes, resolutions, and other books and records are not publicly accessible, but may be obtained and reviewed by shareholders of the corporation in some circumstances.
Transition to Other Entity Form
In some circumstances, corporation may be converted to another form of entity through a cross-entity merger or reorganization. As a general rule, though, it is easier to convert to a corporation from a non-corporate entity (such as an LLC or partnership) than from a corporation to a non-corporate entity.