Corporations: The Basics

Corporations are distinct legal entities owned by their stockholders.  Unlike a partnership, a corporation may be owned by a single person who may (but need not) be the corporation’s sole director and serve as any required officer.  The stockholders elect the corporation’s board of directors but are not otherwise active as such in the management of the corporation.  The board of directors is responsible for the major corporate decisions.  Day to day management is carried on by the corporation’s officers who are appointed by, and serve at the pleasure of the board of directors.

A corporation’s organizational documents (i.e. the certificate of incorporation, bylaws and organizational minutes) are largely boilerplate and “canned” organizational documents are readily available for entrepreneurs who desire to incorporate without hiring a lawyer (see examples of these documents and generate your own in the GO Docs Incorporation Package). For a general overview of the different types of business entities, see my other article Choosing the Correct Business Entity: The Basics. For a quick reference, see also the chart in our article Comparison of C corp, S corp and LLC Entity Types.

Considering a Public Benefit Corporation? Check out What is a Benefit Corporation? for a comparison to traditional corporations and Delaware Public Benefit Corporation — Is It Right For You? A Five-Part Test.

If you can generate incorporation documents for free, why should you hire an attorney?

While this suggestion is admittedly self-serving, engaging an experienced attorney can help avoid tax and fundraising pitfalls. An experienced attorney’s real value is less in preparing the basic documentation and more in the advice he or she can provide on choosing an appropriate capital structure, transferring assets to the corporation in the most tax efficient manner, recommending appropriate equity incentive programs, and generally avoiding pitfalls.

What is a Certificate of Incorporation?

A corporation becomes a legal entity upon the filing of its certificate of incorporation (which in some states is known as the articles of incorporation):

• Usually required to be filed with the secretary of state’s office.
• Items typically included in the certificate of incorporation are:
  • a brief description of the purpose of the business,
  • the name and address of the agent for service of process (the person to whom the state and the courts will direct papers and summonses),
  • the capital (a.k.a. equity or ownership) structure of the corporation, and
  • indemnification of directors, officers, employees and other agents and limiting the liability of directors with respect to certain matters.

What are Bylaws?

A corporation also has bylaws which usually set forth the rules and procedures governing the management of the corporation’s business and the conduct of its corporate affairs, most of which are controlled by the law of the state of incorporation.

First actions of the Incorporator and Board of Directors

The corporation’s first “organizational meeting” is often not held in person but instead documented through unanimous written actions and director consents, which can occur as soon as the certificate of incorporation has been filed. The Initial Action by the Sole Incorporator has the incorporator appoint the first directors. Then the board of directors elects officers, authorizes the issuance of stock to founders, establishes a bank account, and authorizes the payment of incorporation expenses.  In addition, at this first “meeting”, again usually in the form of a unanimous written consent of all members of the board, the board may adopt a standard form of confidential information and inventions assignment agreement (see one for yourself by generating a Cooley GO Docs Form of Employee CIIA) for use by employees and consultants, a form of restricted stock purchase agreement (which typically imposes “vesting” and rights of first refusal on employee stock), and an employee stock purchase and/or stock option plan (see our article Establishing the Ownership Culture: Stock vs Options for more info), selects the fiscal year of the corporation and determines whether to elect to be taxed as an S Corporation.

Corporate tax rates

Unless a corporation elects to be taxed as an S Corporation, it is taxed as a separate legal entity.  (A corporation that does not elect S Corporation treatment is sometimes referred to as a “C Corporation” because it is taxed under Subchapter C of the Internal Revenue Code.) Under current federal income tax law, a corporation is taxed on its net income (gross income less allowable deductions) at rates ranging from 15% to 35%.  Property (other than money) contributed to a corporation will generally be subject to federal income tax unless the person (or group of persons) contributing the property owns stock representing at least eighty percent (80%) of the voting power of the corporation and at least 80% of any class of nonvoting stock.  Money (or other property) distributed as dividends by a corporation to its stockholders is subject to federal income tax again (in addition to the corporate income taxes that were imposed on the income giving rise to the distributions) when distributed to the stockholders, with the stockholders paying that tax.

How to preserve the limited liability provided by your corporate entity

The proper operation of a corporation limits the liability of the stockholders because the creditors of the corporation cannot usually reach the stockholders to satisfy the corporation’s obligations.  However, under the “alter ego” doctrine a court may disregard the corporate entity and hold the stockholders personally liable for the corporation’s obligations, if the stockholders use the corporation to perpetuate a fraud or promote injustice.  In determining whether to “pierce the corporate veil” and make the stockholders directly liable for the corporation’s obligations, a court will examine many factors, such as: was the corporation undercapitalized, were corporate assets used for personal reasons, were corporate assets commingled with personal assets, were the corporate and personal books kept separately, and were corporate actions properly authorized by the board of directors or the stockholders.

To preserve limited liability for its stockholders, the corporation should observe at least the following procedures:

• Obtain and record stockholder and board authorization for corporate actions (an annual stockholders’ meeting and regular board meetings should be conducted and accurate minutes should be prepared and maintained in the corporate records).
• Keep corporate funds separate from personal funds.
• Maintain complete and proper records for the corporation separate from personal records.
• Maintain an arms-length relationship between the corporation and any principal stockholder; for transactions with any of the directors or principal stockholders, or entities they have an interest in, have the board, without the vote of the interested directors, approve the transaction after all the facts material to the transaction are disclosed.
• Start the business with an amount of equity sufficient in light of the future capital needs of the business.
• Make it clear in all contracts with others that they are dealing with the corporation, and sign all contracts in the following manner:

[CORPORATE NAME]

By:

[Name and Title]

Why is Delaware so popular?

Delaware is chosen by many larger companies that are not based in that state because of its well-developed body of corporate law which can, in certain instances, increase the power of management or the majority stockholders with respect to the minority.

The choice of a state of incorporation other than the state of the principal place of business usually results in somewhat greater taxes and other costs because of the need to comply with certain tax and regulatory requirements in both states.  In addition, the selection of another state of incorporation may not provide the expected governance benefits, because some states (notably California) subject a corporation located in the state to most of the significant limitations of the local corporations law, regardless of the state in which the corporation is formed. See our article Where Should You Incorporate? for more information.