NFIB

Selecting the Best Legal Structure for Growth: Part III - Corporation
10/ 01/ 2002

by Andrew Sherman

This series of workshops will give you an overview and comparison of the basic business formats to consider (proprietorship, partnership, corporation or limited-liability company), both at the outset of a new venture and periodically throughout your company's growth.

Corporation

In a corporation, a legal entity (as opposed to individuals) owns the business assets and is liable for the business debts. A corporation offers the greatest flexibility in raising money from venture investors and is the structure that investors find most comfortable. For federal income tax purposes, the distinguishing characteristics of a corporation include:

Continuity of life. All state corporation laws provide that a corporation will continue to exist until articles of dissolution are filed, even if the owners (shareholders) die, go bankrupt, retire or give up their interest in the company.

Limited liability. A shareholder isn't personally liable for corporate debt or claims against the corporation, except in special circumstances, such as the misuse of the corporation to perpetrate a fraud.

Free transferability of interest. Shareholders may generally sell all or part of their interest to any buyer without the consent of the other shareholders.

Centralized management. The board of directors (elected by the shareholders) has authority to make independent business decisions on behalf of the corporation.

The details of forming a corporation vary from state to state; however, virtually every state requires that you file articles (or certificate) of incorporation. Once you choose the state in which you'd like to incorporate, you'll have to meet a number of registration requirements in order to obtain (and maintain) corporate status and to enjoy the protections the state affords corporations. Observing all the legal formalities will help protect shareholders from personal liability.

General Characteristics of a Corporation

A corporation is owned by its shareholders, who may be individuals, partnerships, trusts or even other corporations. There is no limit to the number of shareholders a corporation may have. The corporate entity is separate and distinct from its shareholders, and the shareholders' personal assets aren't available to satisfy corporate obligations. The corporation's creditors may look only to the corporation's assets for payment, a protection commonly referred to as the corporate veil. If a corporation is involved in a number of lines of business, separate corporate subsidiaries (corporations owned by another corporation) may be created to protect the assets of one business activity from the liabilities of the other(s).

Management responsibility is vested in the company's board of directors, which is responsible for overall policy decisions as well as the general direction and the business plan of the company. The board appoints officers to manage the day-to-day operations.

Unlike partnerships, the corporation is a tax-paying entity; federal and state tax returns are filed, and taxes paid are based on the profit of the corporation (unless the corporation elects an "S" status, as discussed below). Losses are not passed through to the shareholders but may be carried forward as an offset against the corporation's future income. The board may elect to distribute after-tax profits as dividends to the shareholders, who are then taxed at their individual rates (known as "double taxation"). The document that determines the mechanical aspects of the corporation's governance is known as the bylaws. The bylaws may not exceed the scope of the articles of incorporation or the authority set forth in the state's statute.

Subchapter S Corporations

If your corporation meets certain IRS requirements, you can choose the "S" status, which affects how the corporation is taxed on the federal level. An S corporation must have no more than 75 shareholders who (with very few exceptions) must be both individuals and U.S. residents; and the corporation can't have two classes of stock with different financial interests. The management responsibility is the same as in a regular corporation (which is otherwise taxed under Chapter C of the Internal Revenue Code), but the S corporation doesn't pay federal tax on its income. Rather, the profits and losses are passed through to the shareholders and are declared on the individual's tax return. The main reason to elect S corporation status is that you avoid the double taxation inherent in a Chapter C corporation.

Managing the Corporation: Duties and Responsibilities

The acts and decisions of the board of directors for all types of corporations must be performed in good faith and for the corporation's benefit. The directors' legal obligations fall into three broad categories:

Duty of care. The directors must carry out their duties in good faith with diligence, care and skill in the best interests of the corporation. Each director must actively gather information to make informed decisions regarding company affairs. In doing so, the board member is entitled to rely primarily on the data provided by officers and professional advisers, provided that he or she has no knowledge of any irregularity or inaccuracy in the information. Board members can be held personally responsible for misinformed or dishonest decisions made "in bad faith," such as failing to properly direct the corporation or knowingly authorizing a wrongful act.

Duty of loyalty. Each director must exercise his or her powers in the interest of the corporation and not in his or her own interest or that of another person or organization. The duty of loyalty has a number of specific applications: The director must avoid any conflicts of interest in dealings with the corporation and must not personally usurp what is more appropriately an opportunity or business transaction to be offered to the corporation. For example, say an officer or director of the company was in a meeting on the company's behalf and a great opportunity to obtain the distribution rights for an exciting new technology was offered. It would be a breach of this duty to try to obtain those rights for himself and not first offer them to the corporation.

Duty of fairness. The last duty a director has to the corporation is that of fairness. For example, questions may come up if a director of the company owns the building leased by the corporate headquarters and is seeking a significant rent increase. It would certainly be a breach of this duty to allow that director to vote on this proposal. The central legal concern here is that the director may be treating the corporation unfairly in the transaction because his self-interest could cloud his duty of loyalty to the company.

When a transaction between an officer or director and the company is challenged by a shareholder, the officer or director has the burden of demonstrating the propriety and fairness of the transaction. If any component of the transaction involves a substantive conflict of interest or conduct that may amount to fraud, then the courts might rescind the transaction in question. In order for the director's dealings with the corporation to be upheld, the interested director will have to demonstrate that the transaction had been approved or ratified by a disinterested majority of the company's board of directors.

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Andrew Sherman is internationally recognized as an authority on the legal and strategic aspects of entrepreneurship and business growth. As a senior partner with McDermott, Will & Emery, he manages a multi-million dollar corporate and transactional practice, representing Fortune 1000 corporations as well as hundreds of technology-driven, netcentric and rapidly growing businesses.

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