A corporation is a legal entity considered to be a "person" under California law and the laws of every other U.S. jurisdiction. As a legal person, a corporation has rights and obligations; it can own property and enter into contracts; and it can sue or be sued by another corporation or LLC, by human beings, by the government, and by other legal persons. A corporation is (and, with some important exceptions, is usually legally treated as) separate from its owners (shareholders or stockholders). This distinction means that doing business under the form of a corporation has many different advantages, and possibly some disadvantages, depending on your circumstances. A corporation is a good choice of entity for many businesses, though it may not be the best business entity type for all businesses. Each business has its unique circumstances, which may suggest one type of business entity over another. In either case, the goal is to choose the right entity type whose characteristics and laws best serve the needs of the owners.
If you are looking to form a business entity for a new business or startup venture, or for an existing business in Los Angeles or Ventura County, California, I can help you identify the most advantageous business structure for you, or help you transition from a sole proprietorship or another structure into a corporation. I can also help you change the state of formation ("re-domicile") of a corporation, limited liability company or other business entity.
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WHAT IS A CORPORATION?
A corporation is a business entity with a separate legal identity from its owners (called shareholders or stockholders). As a separate legal entity, a corporation can sue and be sued, enter into contracts, own assets, take out loans, and pay taxes. Corporations must have a "corporate designator" as part of their names, and often use the designation “Inc.” after the business name, but other designator suffixes are common, too (e.g., Corp. or Corporation, Ltd. or Limited, Co. or Company, among others).
Shareholders are the owners of a corporation. Their ownership interests are represented by shares of capital stock. As such, shareholders can receive corporate profits, usually in the form of dividends. However, they aren't involved with the day-to-day management of the business, at least not in their role as shareholders. Instead, the shareholders elect a board of directors. The board of directors are charged with overseeing the business goals and strategy of the corporation, and the board appoints the officers of the corporation to manage its day-to-day affairs. (Of course, members of a corporation's board of directors and officers of a corporation often are also stockholders; but, in their capacity as stockholders, they are not involved with management of the corporation's business.)
An important feature of a corporation is the "limited liability" of the owners. Limited liability is a legal principle by which shareholders are not personally liable for debts of the business or other obligations of the corporation, including obligations to pay judgments in lawsuits. Their liability is limited to their interest in the corporation ... that is, to what they paid for their shares of stock. (There are some important exceptions to this general rule of limited liability, which means the corporation's shareholder must ensure that the board of directors causes the conduct the corporation's business to done according to applicable corporate law, including the guidelines and rules (called "corporate formalities") with which the shareholders, directors and officers must comply.
Corporations can be for-profit (both privately owned or publicly traded) and non-profit. For-profit (or business) corporations file their own tax returns. If the owners of a corporation elect for it to be treated as a so-called "S-Corporation" under the U.S. tax laws, there can be significant tax savings. But, this, of course, comes with its own costs. On the other hand, if the shareholders of a corporation do not affirmatively elect for the corporation to be treated as an S-Corporation, then by default the corporation is a so-called "C-Corporation." A C-Corporation also files its own tax returns. But, unlike the S-Corporation, the C-Corporation must pay taxes on its profits; whatever is left after it pays its taxes can be distributed to the owners in the form of dividends, on which the shareholders must pay income tax. This effect is generally referred to as "double taxation," which is one reason why small business may want to elect S-Corporation status. If they qualify. C-Corporations and S-Corporations are discussed a bit more, below.
HOW IS A BUSINESS INCORPORATED IN CALIFORNIA?
The specific steps for incorporating and initially organizing a business vary among the several states. Generally, the process involves the following four steps.
- FILING A CHARTER. Usually called "Articles of Incorporation" or a "Certificate of Incorporation," this document brings the corporation "to life" -- it is like the company's birth certificate. The person who files the charter (the "incorporator"), files it with the relevant state government office (in California it is the office of the Secretary of State). The incorporator can be one of the founding shareholders, a lawyer, or another person designated by the founders. In California (and in every other state), the relevant corporation law has certain information that the state requires to be included and information that may be included in the charter.
- ORGANIZATION MEETING. California requires that after the formation of the corporation (by the acceptance of the charter by the Secretary of State), an "Organization Meeting" be held by the incorporator or incorporators (or the initial directors if properly named in the original Charter). The laws of each state include those actions that must and may occur at the meeting. It is common for a written consent in lieu of an Organization Meeting to be used, and in that consent form, for the corporation's bylaws to be adopted, its initial directors appointed (if not name in the Charter), pre-incorporation actions be ratified, and certain other actions approved.
- ADOPTING BYLAWS. A corporation's bylaws provide the internal governance rules by which a corporation must be governed by its shareholders, directors, and officers. It includes certain rights and obligations of these "principals," including addressing how elections for directors are to be held, how shareholder and board meetings (both regular and special meetings) are to be called and held, the various offices of the corporation and the authority of the officers who occupy those.
- BOARD OF DIRECTORS. The initial members of the corporation's board of directors are appointed or elected by the corporation's incorporator or incorporators at the Organization Meeting. Once one or more directors have taken their seats, they holder the initial board meeting. At this initial meeting of the board, the board typically ratifies and adopts the actions taken at the Organization Meeting; appoints directors; authorizes the issuance of stock to the founders; adopts certain forms of agreement to be used by the corporation (e.g., a form of Restricted Stock Purchase Agreement). In small corporations, it is common for board meetings to be held telephonically, or for the actions that would have been approved at a meeting to be approved instead by a written consent in lieu of a meeting.
- ISSUING STOCK. Typically, shares of stock (representing the percentage of an owner's ownership interest) are authorized to be issued to the founding shareholders at the first meeting of the board of directors. Actual stock certificates are rarely used anymore. Instead, un-certificated shares are recorded in the corporation's books and records (minutes of board and shareholders meetings and the company's stock ledger) and memorialized by an issuing document, like a Subscription Agreement or a Restricted Stock Purchase Agreement signed by the corporation and the shareholder.
Before incorporating, you should weigh the pros and cons of the business structure to decide whether it's right for your business. And, you should speak with independent legal counsel and an experience business accountant to understand the tax and legal implications of a C-Corporation, S-Corporation, Limited Liability Company, and other possible business structures.
ADVANTAGES OF A CORPORATION IN CALIFORNIA
Corporations offer many advantages, some of which are listed below.
- LIMITED LIABILITY. Because a corporation is a separate legal entity, shareholders' are generally protected from the corporation's creditors, as well as from claims made agains the business by plaintiffs in lawsuits. Any liability would generally be limited to their individual investment in the business. This means that if a corporation is sued or goes bankrupt, shareholders' personal assets are protected, and only the assets / property of the corporation are exposed to loss.
- PERPETUAL LIFE. The existence of a corporation is not dependent on the life of the owners. Unless the corporation's charter provides for less than perpetual existence, it will continue until legally dissolved. By this means, a corporation can be family owned for ma y generations.
- EASY TRANSFER OF OWNERSHIP. Shares in a corporation can generally easily be transferred, unless there is a restriction on transfer provided for in the Bylaws, in a Shareholders Agreement, or in some other contractual arrangement. While the corporate Bylaws and/or a Shareholders Agreement generally provide the specific rules for buying and selling outstanding shares, a shareholder can leave a corporation simply by selling their shares. This flexibility of ownership also ensures a business continues to operate through ownership changes.
- TAX ADVANTAGES. There can be many tax advantages of operating a business under a corporate entity. These include lower tax rates, the ability legally to deduct from otherwise taxable income expenses that may not otherwise quality as business deductions, and the possibility that the owners would be subject to a lower IRS audit risk than if the business were to be run as a partnership or a sole proprietorship, or even an LLC.
- CREDIBILITY. Business that are operated as a corporation may be viewed as more credible in the eyes of lenders, investors, vendors, and other strategic business associates. Of course, an LLC (limited liability company) may offer the credibility, as well, but even today there appears to be some lingering "cachet" that corporations enjoy that LLC's may not.
These advantages should be balanced against the potential disadvantages of incorporation.
DISADVANTAGES OF A CORPORATION IN CALIFORNIA
The disadvantages of a corporation are less numerous but they are worth giving consideration. Some of them are:
- COSTS. Incorporation (like forming an LLC) can incur greater costs and more time launching a business venture as a sole proprietorship or even a partnership (though, if done safely, structuring a partnership should be done with the advice of both a business lawyer and business accountant). Once it's up and running, a corporation is also subject to a stricter regulatory framework. This includes ongoing documentation and filing requirements, such as filing annual reports, keeping minutes at shareholder meetings, maintaining detailed financial records, and opening a separate corporate bank account.
- COMPLEXITY. Although not heavily onerous, some people new to the corporate structure can find the requirement to adhere to the law's "corporate formalities" somewhat foreign and complex. The good news is it is quickly learned in most cases, and with the guidance of experience legal counsel can readily become a relatively simple matter, so that the business owner can focus on building the business exploiting the advantages that the corporate structure allows.
- (POSSIBLE) DOUBLE TAXATION. In some circumstances, the profits of a corporation are taxed twice, both at an entity level and at a shareholder level. This can be avoided, assuming other requirements are met, by electing for the corporation to be taxed as an S-Corporation. This should be done in consultation with a business lawyer, and possibly your business accountant.
As you can see, these advantages and disadvantages may benefit or work against you – it all depends on the business and your goals. A corporate lawyer can discuss these things with you, helping you narrow down exactly what business structure will work best.
Fortunately, when it comes to corporations, there is more than one type, all of which have their own unique angle and purpose. Exploring these options can help you determine if one corporation type will help you reap the benefits but do so in a more strategic manner.
TYPES OF CORPORATIONS
Aside from being incorporated as a corporation, you may want to consider a specific type of corporation. Below are brief descriptions of specific corporation types.
C-Corporations vs. S-Corporations
The formation of a business corporation is a matter of state law. The federal laws have nothing to do this this. However, once a corporation if formed, the owners can make decision under the federal tax laws for special tax treatment. Many people have heard of so-called "S-Corporations." This name comes from the provisions of the Internal Revenue Code ("IRC") that give the rules for special tax treatment for qualifying corporations: Subchapter S, of Chapter 1, of Subtitle A of the IRC. You can see why its easier to refer to them as S-Corporations. To be considered an S-Corporation, the owners must make a special election by filing a document (called Form 2553), and it must be approved by the IRS. If such an election is not made, then by default the corporation is a "C-Corporation" (a corporation that must follow the rules under Subchapter C of the same Chapter).
Generally speaking, the profit of a C-Corporation ("C-Corp") is subject to being taxed, the tax to be paid by the corporation itself, rather than its owners. Profits that are not retained by the corporation after taxes are paid for a given tax year are distributed as dividends to the shareholders. Shareholders are taxed on their receipt of any dividends from the corporation. In this way, the income that the C-Corp earned is taxed twice, first at the corporation level, and then at the owner / shareholder level. There is no limit to the number of shareholders a C-Corp can have, and a C-Corp can have any number of classes or series of classes of capital stock (e.g., voting common stock, non-voting common stock, Series FF capital stock, Series Seed preferred stock, Series A preferred stock, etc.). There are no limitations on the type of legal persons that can be the owners of a C-Corp -- they can be individuals, other corporations, LLC's, trusts, foreign individuals and entities, etc. These differences relating to capitalization and ownership make the C-Corp an ideal structure for businesses requiring significant capital or flexibility in capital structure.
An S-Corporation ("S-Corp") differs from a C-Corp concerning these characteristics. Unlike a C-Corp, an S-Corp's profits are not taxed to the corporation (not at the federal level; states differ as to their treatment, and some cities take different positions on how to treat S-Corps for income tax purposes). Instead, the profit of an S-Corp "flows through" to the shareholders, relative to their percentage ownership. So, for example, if an S-Corp has two equal owners (50% each) and has a profit of $200,000 in a given tax year, then each owner will pay federal income tax on $100,000 of personal taxable income that is attributable to her or him, and the corporation will no federal income tax. Similarly, if the S-Corporation has a loss, the owners will generally be able to offset any other taxable income by the amount of the S-Corp's loss that is attributable to her or him. S-Corps may have only one class of stock (common stock) and may have no more than 100 shareholders. Only individuals may own shares of an S-Corporation (there are some qualified entities that are allowed as an exception). And only individuals that are American citizens or resident aliens may own S-Corp stock.
Public Benefit (or Social Purpose) Corporations
While still not very common, Public Benefit Corporations ("PBC's") are creatures of state statute that allow for some relaxation of the laws that otherwise would apply to maximizing shareholder profits. In exchange, the for-profit PBC must be operated for some recognized public good, and must comply with certain additional requirements. Not every state has a statute permitting the formation of PBC. Delaware, which many founders use for forming their new businesses, has specific provisions allowing the formation of Public Benefit Corporations. California has enacted statutes permitting the formation of "Social Purpose" for-profit corporations. While every state that allows this form of entity has its own rules, the idea behind each is similar: to recognize that some business ventures, while operated for a financial gain, are not driven solely by a profit motive, and thus may have relaxed obligations to maximize financial profit in exchange for pursuing some public benefit. In essence, it marries the goals of many charitable organizations with those of the for-profit enterprise.
Certified "B-Corporations"
A so-called "B-Corporation" is actually not a different entity type that is formed under special state law. Instead, it is a certification that was devised by a non-profit called "B Lab." Not any business can qualify for the certification. There is no special governance or tax treatment for a B-Corp. Instead, the benefits are reputational. According to B Lab:
"Certified B Corporations are businesses that meet the highest standards of verified social and environmental performance, public transparency, and legal accountability to balance profit and purpose. B Corps are accelerating a global culture shift to redefine success in business and build a more inclusive and sustainable economy.”
Non-Profit Corporations
Corporations can also be used to establish non-profit ventures such as charities, educational institutions, and religious organizations. Rather than going to shareholders, profits are reinvested in the business, so non-profit corporations are typically exempt from paying taxes. While I have extensive experience forming not-for-profit corporations, and representing their interests and advising their boards of directors, and while I do from time to time take on non-profit clients, my practice is generally limited to representing businesses.
FACTORS TO CONSIDER BEFORE INCORPORATING IN CALIFORNIA
Before you incorporate, you may want to consider the below six factors and related questions:
- COMPLEXITY. What type of business do you have and how complex is its structure or management?
- LIABILITY. How much does personal liability matter to you? How much exposure do you want for your house, car, bank accounts, boats, land, art, stocks, and other personally-owned property.
- NO. OF OWNERS. Is it just you, or are there other owners? Do you anticipate new owners in the future? Do you want to restrict or set conditions on transfers of ownership?
- CAPITALIZATION. Do you need to raise capital? How much? In what way?
- TAXATION. Double taxation is a hallmark of C-Corporations. As such, though should be given to how this affects the business.
- SURVIVORSHIP. If something happens to you (e.g., you become incapacitated in some way or die), do you want the company to survive? How should your shares be treated if you or a fellow owner should die or become incapacitated.
Considering these factors with a corporate lawyer will help identify if a corporation is right for your business.
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