An Overview of Corporate Law

What Is a Corporation? What Are the Advantages and Disadvantages of the Corporate Form?

There’s inherent risk in any business enterprise, but there are many ways to minimize that risk. One of the most effective can be through the way you choose to legally structure your business. With the proper legal form, you can transfer personal liability to a separate legal entity. Forming a corporation is one way to do that.

This page discusses only corporations, but when deciding how to structure your business, there are other options to consider, including the limited liability company and partnership. A business lawyer can help you decide which form is right for you.

What Is a Corporation?

A corporation is a separate legal entity, established under state law, that has the rights to own, purchase, sell, and lease real and personal property. In many respects, a corporation has the rights of a person, to hold, purchase, sell, own, and lease property and to conduct business.

What Is the Importance of Corporations?

The corporate form provides an incentive for individuals to take risks and form commercial enterprises, allowing for a reasonable risk that often accompanies a new venture without the risk of total loss of personal wealth or net worth. Forming as a corporation also allows a business to establish responsibility under contracts and provides a convenient mechanism for funding economic ventures.

What Are the Benefits of a Corporation?

Corporations afford their owners a number of important benefits, including the limitation of personal liability, business continuity, and built-in methods for raising operating capital:

• Limitation of liability—The shareholders of a corporation are liable only for the debts and obligations of the corporation to the extent of their investment. The most a shareholder can lose is the amount spent to purchase shares in the corporation. As a general rule (though there are limited exceptions), the creditors of a corporation may not access the personal assets of shareholders to secure payment of corporate debt.
• Business continuity—A corporation is a separate legal entity, with an unlimited life, unless otherwise stated in its bylaws or articles of incorporation. Accordingly, when shareholders die, the ownership of their shares transfers, but the corporation remains the same in every other aspect.
• Easier access to capital—The ownership in a corporation is legally represented by shares of stock, which can be bought and sold. A corporation typically raises initial or additional working capital through a private or public offering/sale of stock. Once the stock is initially sold, the corporation no longer has any ownership interest or right to any portion of the proceeds when the stock is resold.

What Are the Types of Corporate Law?

The law governing corporations includes a vast body of state laws that:

• Identify how corporations are created
• Specify annual meeting and reporting requirements
• Address how corporations may be dissolved, acquired, or merged with other corporations
• Articulate the duties and rights of corporations in contractual matters
• Identify the ways corporations can raise capital

What Are the Sources of Corporate Law?

Most laws related to corporations are in the form of state statutes, written laws enacted by legislative bodies, with some degree of variation from state-to-state. Federal law, primarily the Securities Act of 1933 and the Securities and Exchange Act of 1934 (and their amendments), govern minimum standards for corporate governance rights and trading corporate stock.

What Are the Different Types of Corporations That May Be Formed?

Most corporations are formed under either Subchapter C or Subchapter S of the Internal Revenue Code.

What Is a C Corporation?

A C corporation differs primarily from other corporations in that the corporation’s income is subject to a separate “corporate tax,” in addition to any tax its shareholders must pay on distributions of income. Any corporation that is publicly traded on a stock exchange, such as the New York Stock Exchange, is a C corporation.

What Is an S Corporation?

An S corporation is typically formed in the same manner as a C corporation, under the applicable laws of the state of incorporation; however, S corporations are not subject to taxation at the corporate level. All income passes through to shareholders and is taxed only as part of their personal income. To be eligible for Subchapter S status, a corporation must meet the requirements established in the Internal Revenue Code and must affirmatively elect to be treated as an S corporation by filing IRS Form 2553.

What Characteristics Are Shared by C Corporations and S Corporations?

Both C and S corporations issue shares of stock as documents of ownership, and both limit the liability of shareholders to the full amount of any investment in the company. In addition, both can pass income to shareholders, which is then recognized by the shareholder as personal income on their tax return.

What Are the Differences Between C Corporations and S Corporations?

There are no limits on the number of shareholders for a C corporation, but an S corporation may have only one class of stock and no more than 100 shareholders. Nonresident aliens and most partnerships and corporations are prohibited from owning S corporation stock. A corporation may acquire S status only if it has been incorporated in the United States. All income of an S corporation “passes through” the entity and is recognized as personal income by shareholders. There is no tax on S corporations at the corporate level.

A C corporation may have an unlimited number of shareholders, and there’s no requirement that all shareholders be American citizens. The distributions made by corporations to shareholders will be considered personal income to the shareholders. In addition, C corporations are subject to a separate “corporate tax,” a percentage levied on corporate earnings.

What Are the Advantages and Disadvantages of a C Corporation?

Setting up a C corporation can provide the following advantages:

• Separate legal entity to assume the risks involved in business
• Continued existence of the corporation in the event of changes in ownership
• Greater opportunities to raise operating capital through the public sale of shares of stock
• Greater acceptance of the entity by banks, venture capitalists, and other lenders
• Ease of transfer of ownership through the public sale of stock
• Ability to publicly trade stock on an exchange
• Ability to provide stock options as an executive benefit

The most obvious disadvantage of a C corporation is its exposure to double taxation—at the corporate level and then again at the shareholder level (if there are distributions).

What Are the Advantages and Disadvantages of S Corporations?

Subchapter S corporations enjoy the same general benefits and disadvantages as C corporations, allowing business owners to protect personal net worth by setting up a separate legal entity. However, an S corporation avoids double taxation because it is not subject to the corporate tax. Also, an S corporation may find it harder to raise initial or working capital because its stock cannot be traded on a public exchange.

How Do You Set Up a C Corporation?

A C corporation is established by preparing and filing Articles of Incorporation with the appropriate state agency. Other essential components in the establishment of a C corporation include the preparation of corporate bylaws and the registration of the entity with state and federal tax agencies.

How Do You Set Up an S Corporation?

An S corporation is set up the same way as a C corporation, with an additional step taken once the corporation is legally formed. A C corporation will be converted to an S corporation when the entity successfully files Form 2553 with the Internal Revenue Service.

Why Would You Choose a C Corporation or an S Corporation?

One of the key considerations for choosing between a C corporation and an S corporation is the need to raise initial capital. If you don’t have sufficient investors set up, or you cannot secure bank or venture capital funding, you might choose to set up a C corporation so that you can raise funds through an initial public offering. However, if you already have sufficient capital and want to minimize the tax consequences, as well as the complexity of compliance, an S corporation is a better choice.

Summary

Setting up a corporation can help you effectively manage risk in a new business enterprise. Based on a number of factors, including the number of shareholders and your strategy for raising initial capital, you may elect to establish a C corporation or an S corporation. Consult with an experienced business law attorney before you make any commitments.