Skyscrapers imageA corporation is a legal entity having existence separate and distinct from its owners (i.e., stockholders). Corporations are artificial beings existing only in contemplation of law. A corporation is typically created when one or more individuals file “articles of incorporation” with a Secretary of State in a particular jurisdiction. The articles of incorporation generally specify a number of important features about the purpose of the entity and how governance will be structured.

After reviewing the articles of incorporation, the Secretary of State will issue a charter (or certificate of incorporation) authorizing the corporate entity. The persons who initiated the filing (the “incorporators”) will then collect the shareholders’ initial investment in exchange for the “stock” of the corporation (the stock is the financial instrument evidencing a person’s ownership interest). Once the initial stock is issued, a shareholders’ meeting will be convened to adopt bylaws and elect a board of directors. These directors appoint the corporate officers who are responsible for commencing the operations of the business. In a small start-up venture, the initial incorporators may become the shareholders, then elect themselves to the board, and finally appoint themselves to become the officers. This leads one to wonder why go to all the trouble of incorporating?


 

Advantages

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The reasons for incorporating can vary, but there are certain unique advantages to this form of organization that have led to its popularity. One advantage of the corporate form of organization is that it permits otherwise unaffiliated persons to join together in mutual ownership of a business entity. This objective can be accomplished in other ways (like a partnership), but the corporate form of organization is arguably one of the better vehicles. Large amounts of venture capital can be drawn together from many individuals and concentrated into one entity under shared ownership. The stock of the corporation provides a clear and unambiguous point of reference to identify who owns the business and in what proportion. Further, the democratic process associated with shareholder voting rights (typically one vote per share of stock) permits shareholder “say so” in selecting the board of directors. In addition to electing the board, shareholders may vote on other matters such as selection of an independent auditor, stock option plans, and corporate mergers. The voting “ballot” is usually referred to as a “proxy.”

Corporate stock has the benefit of transferability of ownership. It is easily transferable from one person to another. Transferability provides liquidity to stockholders as it enables them to quickly enter or exit an ownership position in a corporate entity. As a corporation grows, it may bring in additional shareholders by issuing even more stock. At some point, the entity may become sufficiently large that its shares will become “listed” on a stock exchange.

An “IPO” is the initial public offering of the stock of a corporation. Rules require that such IPOs be accompanied by regulatory registrations and filings, and that potential shareholders be furnished with a prospectus detailing corporate information. Publicly traded corporate entities are subject to a number of continuing regulatory registration and reporting requirements that are aimed at ensuring full and fair disclosure.

Another benefit of a corporation is perpetual existence. A corporate entity is typically of unlimited duration enabling it to effectively outlive its shareholders. Changes in stock ownership do not cause operations to cease. What would cause a corporation to cease to exist? At some point, a corporation may be acquired by another and merged in with the successor. Or, a corporation may fail and cease operations. Finally, some businesses may find that liquidating operating assets and distributing residual monies to the creditors and shareholders is a preferable strategy to continued operation.

Not to be overlooked in considering why a corporation is desirable is the feature of limited liability for stockholders, who normally understand that their investment can be lost if the business fails. However, stockholders are not liable for debts and losses of the company beyond the amount of their investment. There are exceptions to this rule. In some cases, shareholders may be called upon to sign a separate guarantee for corporate debt. And, shareholders in closely held companies can inadvertently be drawn into having to satisfy corporate debts when they commingle their personal finances with those of the company or fail to satisfy the necessary legal procedures to maintain a valid corporate existence. A Limited Liability Corporation (LLC) is a unique business structure allowed by state statute which may be treated as either a corporation, partnership, or individual for tax purposes and which may protect its owners (members) from some debts or actions.

 

Disadvantages

Corporations are not without certain disadvantages. Most corporations are taxable entities, and their income is subject to taxation. This “income tax” is problematic as it oftentimes produces double taxation. This effect occurs when shareholders receive cash dividends that they must include in their own calculation of taxable income. Thus, a dollar earned at the corporate level is reduced by corporate income taxes (at a rate that is likely about 35%); to the extent the remaining after-tax profit is distributed to shareholders as dividends, it is again subject to taxes at the shareholder level (at a rate that will vary in the 15% to 35% range). So, as much as half or more of the profits of a dividend-paying corporation are apt to be shared with governmental entities.

Tax Bill imageGovernments are aware that this double-taxation outcome can limit corporate investment and be potentially damaging to an economy. Various measures of relief are sometimes available, depending on the prevailing political climate (including “dividends received deductions” for dividends paid between affiliated companies, lower shareholder tax rates on dividends, and S-Corporation provisions that permit closely held corporations to attribute their income to the shareholders thereby avoiding one level of tax). Some countries adopt “tax holidays” that permit newer companies to be exempt from income taxes, or utilize different approaches to taxing the value additive components of production by an entity.

Another burden on the corporate form of organization is costly regulation. In the U.S., larger (usually public) companies are under scrutiny of federal (The Securities and Exchange Commission (SEC) and other public oversight groups) and state regulatory bodies. History shows that the absence or failure of these regulators will quickly foster an environment where rogue business persons will launch all manner of stock fraud schemes. These frauds can quickly corrupt public confidence without which investors become unwilling to join together to invest in new ideas and products. It seems almost unavoidable that governmental regulation must be a part of the corporate scene. However, the cost of compliance with such regulation is high. Public companies must prepare and file quarterly and annual reports with the SEC, along with a myriad of other documents. Many of these documents must be certified or subjected to independent audit. Further, requirements are in place that require companies to have strong internal controls and even ethical training.

 

Did you learn?
Define the essence of the corporate form of entity.
Describe the process by which a corporation is formed, and how business operations commence.
Cite and explain the advantages of the corporate form of organization.
What is a prospectus?
Cite and explain the disadvantages of the corporate form of organization.
Generally describe the regulatory environment for issuing stock to the public.