Corporations and Law

Corporations and LLCs

Corporations

Corporations are for-profit or nonprofit business entities that are separate legal persons from their owners (the shareholders). Corporations offer limited liability for their shareholders, unlimited life for the corporation, and—in the case of larger or publicly held corporations—the separation of management from ownership. Corporations are formed by filing articles of incorporation with the governing secretary of state and paying a filing fee.

A corporation is a business entity formed under state incorporation statutes. Corporations are separate legal persons from their owners (who are called shareholders). Under U.S. law, a person can be a human being or a nonhuman entity that courts consider to have some of the rights and responsibilities of a human being. A person or institution that owns part of a corporation is called a shareholder or stockholder.

Corporations can be public or private. A public corporation is one whose stock is traded on at least one national securities exchange, such as the New York Stock Exchange or NASDAQ. Stock is all the shares of a company or corporation that represent the division of ownership. Someone who owns a share of stock owns a piece of a corporation. Unlike public corporations, a private corporation (such as Hobby Lobby, also called a closely held corporation) does not trade its stock on the national securities exchanges. Instead, its stock is privately held by a small group of people. In these smaller corporations, certain provisions of state laws permit shareholders to operate as managers and directors.

Corporations are created in adherence with state law. The federal government does have regulatory oversight over corporations, however. In accordance with the federal Securities Exchange Act of 1934, public companies must file annual reports. Annual reports contain financial statements that have been audited, or checked by a reliable outside party. Annual reports also include detailed analysis of the company's performance and information about officers and directors. The corporation must deliver this report to shareholders. Public corporations must also file a Form 10-Q, a comprehensive report of a company's performance, with quarterly unaudited financials, as well as a Form 8-K, which is used to report any significant developments or events to shareholders, such as bankruptcy and leadership changes.

Reasons that companies choose to incorporate include the following:

  • Shareholders of corporations have limited liability. If the corporation suffers a substantial loss, then shareholders only risk losing up to the amounts of their investments in the corporation. Shareholders are not personally liable for the debts of the corporation or acts carried out by its executives. However, shareholders are liable for their own harms and crimes.
  • Unlike partners in a partnership, shareholders can in most cases easily buy and sell stock without the permission of anyone else in the publicly held corporation.
  • Corporations continue their existence without their founders. In a sole proprietorship, the business legally ends when the sole proprietor dies.

One benefit of a business being a corporation is that it can sell stock. For example, suppose a business owner, Emilio, incorporated his business EQUTI Inc. in 2015 in Florida. Currently, he is the sole shareholder, but he wants to take EQUTI Inc. to a higher tier and generate capital by selling stock. To do this, Emilio applies to the Securities and Exchange Commission and to one of the stock markets. His application includes a large fee in the range of $500,000. If approved, EQUTI goes from being a private corporation to a public corporation. Now EQUTI Inc. can sell stock in the company, which would generate money to expand the business.

A corporation can decide to incorporate in any state, regardless of whether it does business there. The corporation must obey the rules of the state where it incorporates. Delaware is a popular state for incorporation because it has tax policies that can lead to substantial savings for some corporations, an efficient and knowledgeable court system, and historically neutral decisions. However, corporations that primarily operate in one state will usually incorporate in that state to avoid paying double taxes and fees.

A corporation forms by filing articles of incorporation with the governing secretary of state and paying a filing fee. Each state has a statute that specifies what must be in the corporation's articles of incorporation. Most states also require the creation of corporate bylaws, which do not necessarily have to be filed with the state but must be created and abided by.

Types of Corporations and LLCs

Entities that enjoy separate legal personhood apart from their shareholders include C corporations, S corporations, nonprofit organizations, and limited liability companies (LLCs).

A C corporation is an entity, formed under state incorporation statutes, that has separate status from its owners both legally and for federal and state tax purposes. It is the default classification for incorporated entities. Benefits of a C corporation include limited liability and unlimited life. If a corporation with limited liability suffers a substantial loss, then shareholders only risk losing up to the amounts they invested in the corporation. If a corporation has unlimited life, it may continue to exist even if its founders and original stockholders die. C corporations also have no shareholder limit and certain tax advantages.

An S corporation is an entity incorporated under a state law but treated like a partnership for tax purposes, thus avoiding double taxation. Shareholders have limited liability, and the corporation is taxed as a flow-through entity. This means that all the corporation's profits and losses pass to the shareholders, who then pay tax at their individual rates. This arrangement prevents the double taxation of a C corporation. (Unlike an S corporation, in a C corporation, profits are taxed at the corporate rate and then taxed again at the individual rate after being passed on to shareholders in the form of a dividend.)

To become an S corporation, organizations must meet certain restrictions.

  • There can be only one class of stock. In other words, there cannot be some classes of stock that allow the holders to vote on the corporation's decisions and some that do not. Thus, an S corporation may not issue preferred stock.
  • There cannot be more than 100 shareholders.
  • Shareholders cannot be partnerships or corporations. They can be individuals, estates, charities, trusts, etc.
  • Shareholders must be citizens or residents of the United States.
  • All shareholders must agree that the organization should be an S corporation.

Types of Business Entities

Each type of business entity has its own advantages and disadvantages. Some organizations choose not to incorporate, especially if they are small or the business is not expected to continue after a death.
A nonprofit corporation is a business organization created for a purpose other than to make a profit; examples include hospitals, charities, religious groups, and educational institutions. Instead, a nonprofit corporation uses money earned to run its business and carry out its mission. A nonprofit corporation allows individuals and other persons to carry out transactions and own property with limited liability.

Corporate Governance

Corporate governance may present certain legal issues relating to agency theory, a board of directors, executive compensation, and ownership concentration. Corporate governance laws such as the Sarbanes-Oxley Act of 2002 have tried to align the interests of management and shareholders.

Corporate governance is a system of rules, procedures, and practices by which a corporation is controlled and directed. Each corporation is a separate legal person, but it needs management to act on its behalf. Agency theory explains the relationship between principals (owners) and agents (management) in business and is concerned with resolving problems in the agency relationship. The most prominent issue in an agency happens when the interests of the principal and the agent conflict. In the context of corporate governance, the "agency problem" arises when the corporation's officers or agents pursue a business strategy that conflicts with the long-term interest of its owners. Corporate governance can be used to shape a corporation's bylaws to prevent some of these conflicts.

The board of directors is a group of individuals elected by shareholders to oversee the activities of the corporation. The board monitors the corporation's activities and senior management's performance.

The federal government has rules governing how companies must report the pay of executives.

  • The Securities and Exchange Commission requires disclosure of executive compensation, which includes comparing how much money executives make with the corporation's performance and the compensation of other corporation employees.
  • A clawback is a policy that requires the chief executive officer (CEO) and chief financial officer (CFO) of a public company to reimburse the corporation for any profit they received from selling company stock if they did so within a year of the release of any flawed financial statements.
  • The say-on-pay policy requires that companies take a nonbinding shareholder vote on the compensation of the five most highly paid executives at least once every three years.

Another prominent mechanism of corporate governance is ownership concentration, which arises when a few shareholders hold most of a corporation's outstanding shares. Under the federal Securities Exchange Act of 1934, any holder of 5 percent or more of a publicly held corporation must report its ownership level within 10 days of reaching that level.

Since selling common stock in a company gives the buyers ownership rights in the company, becoming a public company has an effect on the governance of the company. For example, when EQUTI Inc. went public, it sold 10,000 shares. Emilio went from being the sole shareholder, or the owner, to being the chief executive officer (CEO). He bought 5,001 shares so that he is always the majority shareholder, maintaining ownership concentration. He installed a board of directors to help manage the company, but his stock amounts make him a majority shareholder when it comes to voting rights.

In response to corporate scandals such as Enron, the Sarbanes-Oxley Act of 2002 (SOX) establishes a number of rules for corporate accounting, government oversight, and financial regulations and allows investors to receive more accurate and complete financial information. Congress established the Public Company Accounting Oversight Board to ensure that investors receive accurate and complete financial information. SOX requires auditors to report to the audit committee of the client's board of directors instead of to senior management. SOX prohibits accounting firms that provide public auditing from also providing consulting services. It also states that an accounting firm cannot audit a company if a conflict of interest exists, and it requires term limits on audit partners.

What the Sarbanes-Oxley Act Requires

Management Reporting Management certifications of the accuracy of financial reports are required. Management must report on its internal controls to prevent fraud. Financial auditors external to the company must verify that managers' internal controls are effective.
Board Control High standards are imposed for audit committees. Loans to the organization's officers and directors are forbidden. Since SOX passed, corporation boards have become more independent from management.
Management and Board Behavior Faster reporting of insider trading (illegally benefiting from information the public has not yet learned) is required. The organization must disclose its code of ethics for finance officers. The management and board must follow written policies that protect people who report corporate violations.
Penalties and Enforcement The Public Company Accounting Oversight Board is established. Knowingly untrue certifications of financial reports lead to criminal penalties. Certifying a fraudulent or misleading annual report can now have penalties of over $5 million in fines plus 20 years in prison.
Independence of Auditor The audit committee must preapprove all auditor services. Auditors may not perform certain services, such as bookkeeping and human resources. A new lead audit partner must be put in place every five years or more often.

Congress passed the Sarbanes-Oxley Act to control corporations more strictly and make it more difficult for dishonest businesspeople to cover up their actions.