Corporations

Types of Corporations

Four main types of corporations are designated as C, S, limited liability companies, and nonprofit organizations.

Learning Objectives

Distinguish between a C corporation, S corporation, LLC and non-profit

Key Takeaways

Key Points

  • C corporation refers to any corporation that, under United States federal income tax law, is taxed separately from its owners.
  • S corporations are corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes.
  • An LLC is a flexible form of enterprise that blends elements of partnership and corporate structures.
  • A nonprofit organization is an organization that uses surplus revenues to achieve its goals rather than distributing them as profit or dividends.

Key Terms

  • shareholder: One who owns shares of stock.
  • corporation: A group of individuals, created by law or under authority of law, having a continuous existence independent of the existences of its members, and powers and liabilities distinct from those of its members.

Four main types of corporations exist in the United States:

  1. C corporations
  2. S corporations
  3. Limited Liability Companies (LLCs)
  4. Nonprofit Organizations

C Corporations

C corporation refers to any corporation that, under United States federal income tax law, is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. Most major companies (and many smaller companies) are treated as C corporations for U.S. federal income tax purposes. A C corporation has no limit on the number of shareholders, foreign or domestic. Any distribution from the earnings and profits of a C corporation is treated as a dividend for U.S. income tax purposes. Exceptions apply to treat certain distributions as made in exchange for stock rather than as dividends. Such exceptions include distributions in complete termination of a shareholder’s interest and distributions in liquidation of the corporation.

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Coca-Cola Company: Coca-Cola is a famous C corporation.

S Corporations

S corporations are merely corporations that elect to pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. Like a C corporation, an S corporation is generally a corporation under the law of the state in which the entity is organized. For federal income tax purposes, however, taxation of S corporations resembles that of partnerships. Thus, income is taxed at the shareholder level and not at the corporate level. Payments to S shareholders by the corporation are distributed tax-free to the extent that the distributed earnings were not previously taxed. Also, certain corporate penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S corporation. In order to make an election to be treated as an S corporation, the following requirements must be met:

  1. Must be an eligible entity (a domestic corporation, or a limited liability company which has elected to be taxed as a corporation).
  2. Must have only one class of stock.
  3. Must not have more than 100 shareholders.

Limited Liability Company (LLC)

An LLC is a flexible form of enterprise that blends elements of partnership and corporate structures. It is a legal form of company that provides limited liability to its owners in the vast majority of United States jurisdictions. The primary characteristic an LLC shares with a corporation is limited liability, and the primary characteristic it shares with a partnership is the availability of pass-through income taxation. It is often more flexible than a corporation, and it is well-suited for companies with a single owner.

Nonprofit Organization

A nonprofit organization is an organization that uses surplus revenues to achieve its goals rather than distributing them as profit or dividends. While not-for-profit organizations are permitted to generate surplus revenues, they must be retained by the organization for its self-preservation, expansion, or plans.

The Process of Incorporation

Incorporating a business is the formation of a new corporation.

Learning Objectives

Outline the process of incorporation

Key Takeaways

Key Points

  • Corporations can raise capital from investors through the issuance of capital stock.
  • Corporations are perpetual or durable.
  • The process of incorporation in the United States varies from state to state.

Key Terms

  • incorporation: The act of incorporating, forming a corporation or the state of being incorporated.

Incorporation is the formation of a new corporation. The corporation may be a business, a nonprofit organization, a sports club, or a government of a new city or town. Even though corporations are not people, they are recognized by the law to have rights and responsibilities like natural persons under the law. The articles of incorporation (also called a charter, certificate of incorporation or letters patent) are filed with the appropriate state office, listing the purpose of the corporation, its principal place of business and the number and type of shares of stock. A registration fee is due, which is usually between $25 and $1,000 depending on the state.

Usually, there are also corporate bylaws which must be filed with the state. Bylaws outline a number of important administrative details such as when annual shareholder meetings will be held, who can vote, and the manner in which shareholders will be notified if there is a need for an additional “special” meeting.

A corporation has a distinct name and it is generally made up of three parts: “distinctive element,” “descriptive element,” and a legal ending. All corporations must have a distinctive element, and in most filing jurisdictions, a legal ending to their names. Some corporations choose not to have a descriptive element. In the name “Tiger Computers, Inc.”, the word “Tiger” is the distinctive element; the word “Computers” is the descriptive element; and the “Inc.” is the legal ending. The legal ending indicates that it is, in fact, a legal corporation and not just a business registration or partnership. Incorporated, limited, and corporation, or their respective abbreviations (Inc., Ltd., Corp. ) are the possible legal endings in the U.S.

Legal Benefits

  • Protection of personal assets: One of the most important legal benefits is the safeguarding of personal assets against the claims of creditors and lawsuits. Sole proprietors and general partners in a partnership are personally and jointly responsible for all the liabilities of a business such as loans, accounts payable, and legal judgments. In a corporation, however, stockholders, directors and officers typically are not liable for the company’s debts and obligations. They are limited in liability to the amount they have invested in the corporation. For example, if a shareholder purchased $100 in stock, no more than $100 can be lost. Corporations and limited liability companies (LLCs) may hold assets such as real estate, cars or boats. If a shareholder of a corporation is personally involved in a lawsuit or bankruptcy, these assets may be protected. A creditor of a shareholder of a corporation or LLC cannot seize the assets of the company. However, the creditor can seize ownership shares in the corporation, as they are considered a personal asset.
  • Transferable ownership: Ownership in a corporation or LLC is easily transferable to others, either in whole or in part. Some state laws are particularly corporate-friendly. For example, the transfer of ownership in a corporation incorporated in Delaware is not required to be filed or recorded.
  • Retirement funds: Retirement funds and qualified retirements plans, such as a 401(k), may be established more easily.
  • Taxation: In the United States, corporations are taxed at a lower rate than individuals are. Also, they can own shares in other corporations and receive corporate dividends 80 percent tax-free. There are no limits on the amount of losses a corporation may carry forward to subsequent tax years. A sole proprietorship, on the other hand, cannot claim a capital loss greater than $3,000 unless the owner has offsetting capital gains.
  • Raising funds through sale of stock: A corporation can easily raise capital from investors through the sale of stock.
  • Durability: A corporation is capable of continuing indefinitely. Its existence is not affected by the death of shareholders, directors, or officers of the corporation.
  • Credit rating: Regardless of an owner’s personal credit scores, a corporation can acquire its own credit rating, and build a separate credit history by applying for and using corporate credit.

Ownership of Corporations

A corporation is typically owned and controlled by its shareholders.

Learning Objectives

Outline the structure of the ownership in corporations

Key Takeaways

Key Points

  • In a joint-stock company the members are known as shareholders and their share in the ownership, control, and profits of the corporation is determined by their portion of shares.
  • In some corporations, the legal document establishing the corporation or containing its rules determines the corporation’s membership.
  • The day-to-day activities of a corporation are typically controlled by individuals appointed by the members.

Key Terms

  • shareholder: One who owns shares of stock.
  • committee: a group of persons convened for the accomplishment of some specific purpose, typically with formal protocols

A corporation is typically owned and controlled by its members. In a joint-stock company, the members are known as shareholders and their share in the ownership, control, and profits of the corporation is determined by their portion of shares. Thus, a person who owns a quarter of the shares of a joint-stock company owns a quarter of the company, is entitled to a quarter of the profit (or at least a quarter of the profit given to shareholders as dividends), and has a quarter of the votes that may be cast at general meetings.

In some corporations, the legal document establishing the corporation or containing its rules determines the corporation’s membership. Membership in this case depends on the corporation type. For instance, in a worker cooperative, people who work for the cooperative are members, while in a credit union, people who have credit union accounts are members.

The day-to-day activities of a corporation are typically controlled by individuals appointed by the members. In some cases, this will be a single individual, but more commonly, corporations are controlled by a committee or by committees. Broadly speaking, two kinds of committee structures exist.

A single committee or board of directors is the method favored in most common law countries. The board of directors is composed of both executive and non-executive directors. The latter are responsible for supervising the formers’ management of the company.

A two-tiered committee structure with a supervisory board and a managing board is common in civil law countries. Under this model, the executive directors sit on one committee while the non-executive directors sit on the other.

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A Famous Investor: Warren Buffet is perhaps the world’s most famous investor. He owns many companies through his investment firm Berkshire Hathaway.

Structure of Corporations

Corporate structure consists of various departments and divisions that contribute to the company’s overall mission and goals.

Learning Objectives

Break down a corporation in to its structural parts

Key Takeaways

Key Points

  • Segments of corporate structure may consist of the marketing department, finance department, accounting department, human resource department, IT department, and the operational aspect of the particular company.
  • A division of a business is a distinct part of the firm, however the company is legally responsible for all of the obligations and debts of each division.
  • In a large organization, various parts of the business may be run by different subsidiaries, and a business division may include one or many subsidiaries.

Key Terms

  • subsidiary: A company owned by the parent company or holding company
  • IT: Information Technology: the use of computers and telecommunications equipment to store, retrieve, transmit, and manipulate data.

Corporate structure consists of various departments that contribute to the company’s overall mission and goals. The Marketing department is considered by some business professionals as the most important entity in the corporate structure. Without this department, sales or new customers cannot be realized. The Finance department is also vitally important, as it is responsible for acquiring capital used in running an organization. Other segments of corporate structure may consist of the Accounting department, HumanResources department, IT department, and the Operational aspect of the particular company. These main six corporate departments represent the major managing resources within a publicly traded company; though there are often smaller departments either within the major segments or in autonomous form.

Another way a corporate structure can be defined is by business divisions. A division of a business is a distinct part of the firm, however the company is legally responsible for all of the obligations and debts of each division. In a large organization, various parts of the business may be run by different subsidiaries, and a business division may include one or many subsidiaries. Each subsidiary is a separate legal entity owned by the primary business or by another subsidiary in the hierarchy. Often a division operates under a separate name and is the equivalent of a corporation or limited liability company that obtains a fictitious name or a “doing business as” certificate.

Hewlett Packard (HP) is a good example of a corporate structure including multiple divisions. The divisions of HP — e.g., the Printing & Multifunction division, the Handheld Devices division, the Servers division (mini and mainframe computers), et cetera — all use the HP brand name. However, Compaq (a part of HP since 2002) operates as a subsidiary, using the Compaq brand name.

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Corporate Structure: Hewlett Packard is an example of a corporation with multiple divisions and subsidiaries.

Another example is Google. Google Video is a division of Google, and is part of the same corporate entity. However, the YouTube video service is a subsidiary of Google because it remains operated as YouTube, LLC — a separate business entity even though it is owned by Google.

Advantages of Corporations

Shareholders of a modern business corporation have limited liability for the corporation’s debts and obligations.

Learning Objectives

List the advantages of corporations

Key Takeaways

Key Points

  • Unlike a partnership or sole proprietorship, shareholders of a modern business corporation have limited liability for the corporation’s debts and obligations.
  • Limited liability reduces the amount that a shareholder can lose in a company so it allows corporations to raise large amounts of finance for their enterprises by combining funds from many owners of stock.
  • Another advantage is that the assets and structure of the corporation may continue beyond the lifetimes of its shareholders and bondholders.

Key Terms

  • shareholders: A shareholder or stockholder is an individual or institution (including a corporation) that legally owns a share of stock in a public or private corporation.

Advantages of Corporations

Unlike a partnership or sole proprietorship, shareholders of a modern business corporation have limited liability for the corporation’s debts and obligations. As a result, their losses cannot exceed the amount which they contributed to the corporation as dues or payment for shares. This enables corporations to socialize their costs. Socializing a cost is to spread it to society in general. The economic rationale for this is that it allows anonymous trading in the shares of the corporation by eliminating the corporation’s creditors as a stakeholder in such a transaction. Without limited liability, a creditor would probably not allow any share to be sold to a buyer at least as creditworthy as the seller.

Limited liability reduces the amount that a shareholder can lose in a company so it allows corporations to raise large amounts of finance for their enterprises by combining funds from many stock owners. This increases the attraction to potential shareholders and increases both the number of willing shareholders and the amount they are likely to invest.

However, some jurisdictions also permit another type of corporation, in which shareholders’ liability is unlimited, for example the unlimited liability corporation in two provinces of Canada, and the unlimited company in the United Kingdom.

Another advantage is that the assets and structure of the corporation may continue beyond the lifetimes of its shareholders and bondholders. This allows stability and the accumulation of capital, which is then available for investment in larger and longer-lasting projects than if the corporate assets were subject to dissolution and distribution. This was also important in medieval times, when land donated to the Church (a corporation) would not generate the feudal fees that a lord could claim upon a landholder’s death. However, a corporation can be dissolved by a government authority, putting an end to its existence as a legal entity. But this usually only happens if the company breaks the law. For example, it it fails to meet annual filing requirements or, in certain circumstances, if the company requests dissolution.

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Welcoming Facebook: Facebook was able to raise $16 billion when it decided to offer shares to the public.

Disadvantages of Corporations

In many countries, corporate profits are taxed at a corporate tax rate, and dividends paid to shareholders are taxed at a separate rate — double taxation.

Learning Objectives

List the disadvantages of corporations

Key Takeaways

Key Points

  • In other systems, dividends are taxed at a lower rate than other income (for example, in the US) or shareholders are taxed directly on the corporation ‘s profits and dividends are not taxed.
  • Another disadvantage of corporations is that, as Adam Smith pointed out in the Wealth of Nations, when ownership is separated from management, the latter will inevitably begin to neglect the interests of the former, creating dysfunction within the company.
  • The fees and legal costs required to form a corporation may be substantial, especially if the business is just being started and the corporation is low on financial resources.

Key Terms

  • double taxation: Double taxation is the levying of tax by two or more jurisdictions on the same declared income (in the case of income taxes), asset (in the case of capital taxes), or financial transaction (in the case of sales taxes). This double liability is often mitigated by tax treaties between countries.

In many countries, corporate profits are taxed at a corporate tax rate, and dividends paid to shareholders are taxed at a separate rate. Such a system is sometimes referred to as “double taxation”, because any profits distributed to shareholders will eventually be taxed twice.

One solution to this (as in the case of the Australian and UK tax systems) is for the recipient of the dividend to be entitled to a tax credit, which addresses the fact that the profits represented by the dividend have already been taxed. The company profit being passed on is therefore effectively only taxed at the rate of tax paid by the eventual recipient of the dividend.

In other systems, dividends are taxed at a lower rate than other income (for example, in the US) or shareholders are taxed directly on the corporation’s profits and dividends are not taxed. For example, S corporations in the US do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must then report the income or loss on their own individual income tax returns.

Another disadvantage of corporations is that, as Adam Smith pointed out in the Wealth of Nations, when ownership is separated from management (i.e. the actual production process required to obtain the capital), the latter will inevitably begin to neglect the interests of the former, creating dysfunction within the company. Some maintain that recent events in corporate America may serve to reinforce Smith’s warnings about the dangers of legally-protected, collectivist hierarchies.

The fees and legal costs required to form a corporation may be substantial, especially if the business is just being started and the corporation is low on financial resources.

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Leeman Brothers’ Collapse: The management of Leeman Brothers was involved in presenting a misleading picture of the company which collapsed in 2008.