A corporation is a form of business organization formed under state law with the following three, mandatory characteristics: (1) an entity considered to be distinct from its owners; (2) an entity whose property is distinct from the property of its owners; and (3) the property of its owners cannot be seized and sold to satisfy any debt of the entity, and vice versa. (See footnote i.)
The “C” Corporation moniker simply means that a business organization has been formed pursuant to state law to carry on a business “for profit.” Corporations are owned by Shareholders, defined as persons that have purchased an ownership interest in the corporation. The Shareholders elect the Board of Directors who has central decision-making authority. The Directors make policy and other major decisions for the Corporation but do not individually represent the Corporation in its dealings with third parties. Rather, the Directors hire Officers to run the day-to-day operations of the business. Corporate officers typically include a Chief Executive Officer, the President, and the Chief Financial Officer. Today, large corporations typically employ a Chief Technology Officer and, in the wake of accounting scandals at Enron and WorldCom, a Chief Accounting Officer, as well. Officers hire Employees to “run” the company under their careful guidance.
A Corporation that is formed properly and operated in compliance with state law assumes a separate legal and tax identity from that of its Shareholders. As a separate legal entity, the Corporation operates with limited powers for specific purposes. A Corporation can continue indefinitely, and its existence is neither affected by the death, disability or withdrawal of any Director, Officer or Shareholder nor by the transfer of its stock from one person to another. In this latter sense, the stock of the Corporation is freely alienable. While the Corporation is not considered a “citizen” under the U.S. Constitution, a Corporation “may sue and be sued” and enjoys some of the same constitutional protections as that of individuals. (See footnote ii.)
This form of business organization “incorporates” its business by filing Articles of Incorporation with the Office of the Secretary of State. The Articles of Incorporation will designate the name of the business in a manner that complies with the state’s corporation laws and identify both the Organizer(s) and the initial Directors. Moreover, the Articles will identify the name and address of the person to serve as the Registered Agent of the Corporation for the purpose of receiving important federal and state notices, and the like. The Registered Agent must also be “of record” to receive the service of process in a lawsuit against the Corporation.
The Organizer(s) and Directors will then create Corporate “Bylaws” that set forth the operating rules of the corporation. As required by state statute, the Board of Directors must hold their “First Meeting.” There, the Directors will adopt a “corporate seal,” make decisions regarding banking relationships, direct certain actions to acquire licenses or permits necessary for the business to legally operate, make other administrative decisions, and issue stock certificates to the initial owners of the corporation. The Corporation must meet certain “corporate formalities” by holding annual meetings of Shareholders and Directors, and all meeting “minutes” must be recorded, acknowledged and maintained with the corporate records.
The “C” Corporation must apply for a Federal Employer Identification Number and state tax identification number. A “C” Corporation is required to file a federal corporation return (Form 1120) and a state corporation franchise tax return, depending on the laws of the state in which it incorporates. The “C” Corporation is also required to file a domestic corporation annual registration with the Office of the Secretary of State once each calendar year.
One of the most attractive features of the corporate form of business organization is the absolute immunity from liability for its Shareholders in most cases and, in limited cases, the cap on liability exposure equal to the amount of their investment. The Corporation alone is responsible for its debts and obligations. This cap on Shareholder liability allows investors to pursue high risk ventures without the worry of losing personal assets in the event of business decisions gone awry.
As a corollary, the Corporation has the unique ability to raise significant capital by selling ownership shares of corporate stock to investors. Potential investors can evaluate the financial strength of the Corporation based on its cash reserves, work-in-process, inventory, fixtures and equipment versus its commercial debt in determining the investment’s potential “upside.” Since the Corporation has a “life of its own,” investors can be more concerned with its asset strength than its key investors or chief officers. The Corporation continues in existence in the event any such person dies, becomes disabled or sells her ownership stake, allowing corporate assets to remain with the Corporation. Furthermore, chief officers are responsible to an independent Board of Directors, thereby restricting various individuals like a President or a major financial investor, from commandeering the company for their own personal benefit.(See footnote iii.) By delegating ultimate control to an elected body (i.e., the Board of Directors), investors will more readily commit resources to the Corporation knowing that individual team members (i.e., Officers) must report to a “higher authority.” (See footnote iv.)
Finally, investors are more likely to invest in any enterprise that by design permits them an “exit strategy.” Many corporations have issued significant shares of stock to outsiders, allowing for new investors to find a ready-made source for the ‘buy back” of their stock in the event they wish to “cash out” of the investment. LPs and LLCs are generally limited in their scope and size and do not offer a ready-made pool of investors to which the partners or members can sell their interests, resulting in an investment that is “locked-in.” The Corporation eliminates the “lock-in” nature of the investment by providing a market for the sale of shares of stock to a larger audience. (See footnote v.)
The main disadvantage of the corporate form of business organization lies in its tax treatment. (See footnote vi.) First, the Corporation is subject to two levels of taxation, making corporate profits taxable twice. The Corporation pays income tax on profits at the federal corporate rate, and Shareholders pay tax on that same income at the individual level when it is distributed to them in the form of dividends. Conversely, cash distributions to the owners of partnerships, LLCs and “S” Corporations are generally tax-free to them, up to the amount of the owners’ capital contributions minus any income previously paid to them. Since the double-taxation of profits does not apply to the other forms of business organization, this difference alone may make a “pass-through” entity far more attractive than the “C” Corporation as the chosen form of business organization.
Second, as a corollary, losses incurred by the Corporation are recognized only at the corporate level, eliminating any tax benefits to the individual Shareholders. In pass-through entities, operating losses flow through to their owners, allowing them in some circumstances to use operating losses as offsets to their other income. While the offset is limited to active investors (i.e., only owners that actively participate in the management of the business), it permits owners to take losses as deductions against other ordinary income. Passive investors may take their share of losses only against other “passive” income. Nonetheless, the opportunity to use losses in one venture to offset profits in another is extremely attractive to many business owners.
To compound matters, the Corporation receives no benefit until or unless it shows an operating profit! The tax regulations prohibit a Corporation from deducting losses in excess of the amount of its gains. Instead, it must carry the loss to future tax years and deduct it from gains that occur in those years. (See footnote vii). While the Corporation can take its prior losses as deductions against future profits, the losses can remain very much “paper losses” for an important period of time.
While the formality and tax treatment of the Corporation may be burdensome and expensive to its owners, “pass-through” entities are rarely used for any business enterprise intent on raising money from venture capitalists. Venture capitalists will want to raise money from large institutional investors, such as non-profit pension funds. Non-profit entities can only invest in companies that are not “pass-through” entities for federal income tax purposes. Moreover, venture capitalists want the right to issue stock to “outsiders” at a much higher price than that issued to “organizers” (or, founders). Hence, venture capitalists want the ability to issue two classes of stock: common stock to those responsible for founding the business and “preferred” stock to the outside investors. The C Corporation is the only vehicle for this investment goal, as S Corporations can only issue one class of stock.
[i] See generally, Matheson and Eby, supra, at 153; Mann, supra, at 391-92.
[ii] Rev. Rul. 88-76, 1988-2 C.B. 360. Under this Ruling, an entity will be taxed as a corporation if it has three of the four following characteristics: (1) continuity of life; (2) centralized management; (3) limited personal liability for entity debts; or (4) free transferability of assets.
[iii] Blair, supra, at 432-34.
[v] See generally, Blair, supra, at 388; Hansmann, et al., supra, at 7-9.
[vi] My comments regarding Advantages, Disadvantages and Opportunities of the corporate entity were improved by my reading of and reliance upon two law review articles: Victor Fleischer, The Rational Exuberance of Structuring Venture Capital Start-ups, 57 Tax L. Rev. 137 (2003), and Joseph Bankman, The UCLA Tax Policy Conference: The Structure of Silicon Valley Start-Ups, 41 UCLA L. Rev. 1737 (1994).
[vii] See IRS Publication 542.