Pros and Cons of Corporations
Pros
•Still fairly to cheap and easy to form and maintain, though potentially more expensive than LLCs.
•Clearly defined limited liability for owner.
•May have perceived value for marketing purposes.
•Can have tax advantages at the state level.
Cons
•Compared to LLCs, more paperwork to form.
•More formal governance requirements.
•Can have higher tax costs.
Another common business form for small businesses is the corporation. The idea of the corporation has a long history, extending back to before the colonial era. In the United States, corporate statutes granting business owners limited liability first came on the scene in the final years of the 19th century. The proliferation of corporations in the 20th century was accompanied by a swirl of related legal developments, from transformative regulations like those adopted following the 1929 stock market crash, to the complex and often subtle evolution of judicial rulings in specific cases brought by corporate shareholders. This long legal history is one of the reasons the corporation has conventionally been a popular form for sophisticated businesses: stable legal rules mean corporations are a more reliable way to manage risk.
Like an LLC, a corporation is formed by registering with a state government and grants limited liability to its owners. Compared to LLCs, corporations are more complicated to organize and involve more formalities. Also, fees associated with corporations tend to be higher than for LLCs, though some states have started piling on LLC fees to encourage more businesses to use corporations instead.
So why would a small business owner choose a corporation over an LLC? There are several possibilities. One is taxes. Both state and federal law may allow corporations to deduct certain expenses that are not deductible for LLCs or their members, even if the LLC elects to be treated as a corporation for tax purposes. State franchise taxes also can be lower for some corporations than for LLCs. Finance can be another reason to use a corporation. A business that plans to raise operating capital through an investor, rather than by borrowing, might be advised by an attorney to take advantage of the well-established rules governing corporate stock and the limited role of corporate owners. Still another reason to favor a corporation might be the way your state’s laws treat the limited liability of corporate shareholders as compared to members of LLCs. Due to corporations’ relatively long history compared to LLCs, it might be easier in some states for creditors to look past an LLC than a corporation in some situations, though this issue is rapidly fading away as the legal landscape around LLCs matures. Finally, you may conclude that a corporation just looks more professional. In some circles the branding impression of having “Inc.” instead of “LLC” after your company’s name can be worth the extra cost and hassle.
The bottom line is that the good reasons for a freelancer to favor a corporation over an LLC will tend to be specific to that freelancer’s state rules and business structure. What follows is a basic introduction to how corporations work. If your tax adviser, accountant, branding consultant, or business lawyer suggests that a corporation will be best for your situation, this chapter will help you understand the details that go with it.
Figures 4.1 and 4.2 illustrate two potential structures for a corporation, first as a tax-regarded C corporation and then as a tax-disregarded S corporation. Note that in both figures the freelancer owner simultaneously wears every hat in the business: as the company’s shareholder, director, and officer. We’ll look at how these different titles work, and how the two tax variants of the corporation work, in more detail in this chapter and later in the book.
Figure 4.1 C corporation structure chart
Figure 4.2 S corporation structure chart
A corporation is owned by its shareholders (called stockholders in some states), who purchase shares of stock from the company in exchange for cash or some other valuable property. The number of shares and amount the shareholder pays per share can be nominal, such as $1.00 per share for 10 shares. The company’s incorporator (for the initial issuance) or board of directors determines the value per share. Even if the purchase amount is minimal, the shareholder must pay for the stock in a way that can be verified, for example, by writing a personal check that gets deposited into the company’s bank account.
Corporate Stock Terminology
The details of corporate stock can be pretty confusing. Fortunately, a typical freelance business can keep it simple. A freelancer’s corporation is probably only going to need one class of stock: common stock, the default class that every corporation has. But a corporation can authorize more than one class, and each class can even have multiple series within it, all to give investors special privileges relative to other classes, such as dividend preferences, rights to appoint directors, and special treatment if the company goes bankrupt. A public company might have a dozen classes of stock (common, preferred A, preferred B, and so on) and the classes might even be broken down into series (preferred A-1, preferred A-2, and so on). If you ever see these terms crop up in your compliance forms, now you’ll know why they’re there.
A good pair of related concepts to understand is the distinction between authorized and issued shares. The number of authorized shares is set out in the articles of incorporation. It sets a limit on how many shares the corporation can issue to shareholders. For shares to be issued, the company needs to follow all the required formalities for issuing shares, as set out in the company’s bylaws and in state law, and the shareholder buying the shares needs to actually pay for them. Once issued, the shares are said to be outstanding. The percentage of the issued and outstanding shares that a shareholder owns determines her percentage ownership of the company. In other words, if the company is authorized to issue 1,000,000 shares, it doesn’t matter if you own 10 shares or 10,000 if you own all the shares that the company has issued. You are still the 100 percent owner of the company until someone else buys some shares.
The sharp distinction between a corporation’s ownership and its management is one of the key differences between a corporation and a limited liability company. Unlike an LLC, which can be managed directly by its member, a corporation cannot be managed directly by its shareholder. Instead, the shareholder elects one or more members of the company’s board of directors. A board can function just fine with a single director. The board manages the company, including authorizing important matters such as appointing officers, issuing stock, and borrowing money.
Some states require corporations to have certain officers, typically a president (or chief executive officer) and secretary, and sometimes a chief financial officer. Even if it isn’t strictly required, you might want to appoint yourself as an officer so you can use a title of your choosing on your business card and when you sign contracts. The company’s governance documents and its board of directors determine the authority of each office. Corporate officers typically have the following duties:
•A corporate president generally has sweeping authority to act on the company’s behalf, including opening bank accounts, signing contracts, borrowing money, and managing property.
•The corporate secretary manages the formal records of the company, including minutes and resolutions of the board.
•A chief financial officer (CFO) maintains the financial records of the company. Not all states require corporations to name a CFO. Where required, the CFO might be responsible for signing state tax documents or complying with state rules governing shareholder reporting.
One Person, Many Hats
You may be wondering why corporations are covered in a book intended for freelancers, because corporations seem to require so many different people. The answer is that one person can successfully be a corporation’s sole shareholder, sole director, and sole officer. However, it is important to treat each role as mutually exclusive from the others. Think of the roles in a corporation like hats. The shareholder hat should only be worn when the shareholder’s approval is required, such as to document the periodic appointment of directors. Likewise, the director hat should only be worn when a director approval is required, such as when called for by a bank, or to meet the state’s corporate governance rules. The most commonly worn hat, by far, will be the officer hat.
Under no circumstances should you sign a contract on behalf of a corporation as its shareholder! Unlike the member of an LLC, a corporate shareholder can’t be involved in the day-to-day operation of the business. That includes signing a contract as a shareholder. Doing so could be treated like a personal assumption of the contract’s obligations, and the shareholder can be held personally liable for any obligations arising under the agreement. Avoid this by signing contracts on behalf of your corporation using your officer title.
Limited Liability
Ordinarily, a shareholder does not bear personal liability for the debts and obligations of the corporation solely by virtue of being its owner. Like the member of an LLC, a shareholder of a corporation only risks what she has contributed to the company—the amount paid for stock, plus any surplus capital contributed to the company from personal assets.
Directors and officers don’t bear personal liability for the obligations of the corporation, either. The key concept to remember is that they are acting as agents of the corporation when they take actions on its behalf. Directors and officers can still be held personally liable for actions they take in bad faith, or that break the law. In theory, they can also be sued by the shareholder for breaching their duty to the shareholder or the company. You aren’t likely to sue yourself, but this point is worth bearing in mind if you are thinking about bringing in outside investors or directors.
Formation
A corporation is organized in several steps. Although the details of these steps can vary, a freelancer’s process will probably look something like this:
1.The incorporator files articles of incorporation with the Secretary of State.
2.The incorporator signs an initial organizing resolution that provides for the incorporator’s resignation from the role and can, among other things, approve the initial issuance of stock to the shareholder, including the number of shares and the price, and appoint the company’s initial director(s).
3.If not already done by the incorporator, the shareholder appoints the initial director(s).
4.The initial director(s) sign an organizing resolution approving certain preliminary matters, such as the appointment of officers.
5.Complete any required postformation compliance paperwork, like publishing a public notice of the company’s formation or filing information reports with the state.
6.Like any other business entity, a corporation will need its own business license and federal tax ID number.
Articles of Incorporation
A corporation is formed by filing a document called the articles of incorporation (or a certificate of incorporation) with a state’s business regulator, typically an office under the Secretary of State. State laws vary on the acceptable method of filing. Some require an original signature on the document filed with the state, while others allow filings to be made electronically or by fax. Articles of incorporation are public records.
The articles of incorporation are signed by the company’s incorporator. The incorporator can be the company’s owner or someone helping the owner set up the company, like a lawyer or other service provider. Until the company’s governance structure is put in place, the incorporator bears personal responsibility for the corporation. Essentially, the corporations’ liability shield isn’t working yet. It is important to take the next step in the process so the incorporator isn’t on the hook longer than absolutely necessary.
A corporation’s articles of incorporation include a few basic details that aren’t too different from an LLC’s certificate of organization. Figure 4.3 illustrates what a California corporation’s articles might look like. The American Bar Association’s Model Business Corporation Act,1 variations of which have been adopted in 24 states, requires at least the following items:
•The name of the corporation: The limits on how a corporation is named are similar to those for LLCs.2 A corporation generally needs to have a variation of “corporation” or “incorporated” (Corp., Inc., Limited, Ltd.) in it. See Chapter 6 for more about business names.
•The corporation’s authorized shares: The articles must specify the number of shares of stock the corporation is authorized to issue to its ownership. Before settling on the number of authorized and issued shares, find out if they’ll have a tax impact. Some states use a corporation’s authorized and issued shares as a component of franchise tax calculations; authorizing ten billion shares and issuing them all to yourself for $0.00000001 per share ($100 total) might be exciting, but it could result in a huge franchise tax bill with no benefit.3
Figure 4.3 Example articles of incorporation4
•Registered office and agent for service of process: Just like an LLC article of organization, a corporation’s article of incorporation must specify the official address of the company and the name and street address of the company’s agent for service of process.
•Incorporator information: The name and address of the incorporator often must be included in the articles.
For a small business, it is usually enough to satisfy the minimal requirements in the company’s initial articles of incorporation, though companies can include a wide range of other items. Sophisticated companies with institutional investors often pack their articles of incorporation with dozens of technicalities regarding shareholder rights, election and powers of directors, voting, matters relating to stock, and other details. A freelance business probably doesn’t need to worry about things that usually can only be changed through amendments to the company’s articles of incorporation, such as procedures for electing directors, or creating special voting groups among the shareholders. One option that might be a good idea to include, if state law doesn’t allow it to be included elsewhere, is a provision that allows the shareholder to take an action without holding a meeting, by signing a written resolution instead. Worst case, if a specific need arises in the future that isn’t addressed in the articles as they are originally drafted, they can always be amended.
Incorporator’s Resolution
After filing the articles of incorporation, the company’s incorporator signs an incorporator’s resolution. The purpose of this resolution is to allow the incorporator to resign as incorporator and, in some states, take important steps toward organizing the company. The incorporator may be allowed to authorize the initial issuance of stock to the company’s shareholder, by providing for the number of shares of stock that will be issued and the amount per share the shareholder needs to pay. The incorporator may also be able to appoint the company’s initial board of directors and approve the company’s bylaws. By putting the company’s governance structure in place, this resolution terminates the incorporator’s liability for the company’s debts, so it makes sense to take care of this as soon as possible after the company is formed. Lawyers usually prepare the incorporator’s resolution to be signed as soon as the articles of incorporation are filed.
If state law doesn’t let the incorporator appoint the initial board of directors of the company, the shareholder must appoint a director as soon as possible. Until a director is in place, the shareholder can be personally liable for the company’s obligations. As already mentioned, a shareholder can also be a corporation’s only director, but the formal appointment needs to be documented.
Board of Directors Organizing Resolutions
Once appointed by the incorporator or shareholder, the board of directors executes a written consent approving several important details about the company’s initial organization:
•Accepting the resignation of the incorporator.
•Appointing the initial officers of the company.
•Adopting the corporation’s tax year, usually the calendar year.
Your business lawyer may suggest adding other details to the organizing resolutions. For example, if you intend to transfer existing assets or obligations of a sole proprietorship into the corporation, it might be a good idea to document the company’s acceptance of those items in the organizing resolutions.
The company’s bank will probably also require a resolution signed by the board of directors authorizing the company to enter into a relationship with the bank. Although this resolution can be included among the organizing resolutions, it is usually cleaner to handle it as a separate document. Quite often banks will provide a form of resolution for you to sign. The bank will also need to see the company’s other organizing documents: its articles of incorporation and bylaws.
Postformation Compliance
Just like LLCs, new corporations often need to make disclosures or publish notices within a short time after the state accepts their formation paperwork. For example, California requires new corporations to submit an electronic report and $25 fee within 90 days, disclosing the name and address of the company’s director, officers, and agent for service of process.5 Some states, like Arizona, require corporations to publish a notice of formation in a newspaper of record.6 Failing to comply with these requirements can cause your corporation to be dissolved or result in costly fees, so be sure to take care of them.
Securities laws and regulations are another important source of compliance requirements for new corporations. Securities are essentially a representation of an ownership interest in a passive investment. Because a corporate stockholder doesn’t have direct management control over the company, corporate stock is a security by definition. Bonds, options, and other sophisticated financing mechanisms are also securities. Both federal and state laws impose strict requirements on the offer and sale of securities, primarily to prevent unscrupulous companies from defrauding investors. Anyone selling securities, including a new corporation, needs to comply with these regulations or fit within an exemption to them.
Fortunately, a typical freelance business will have no trouble finding exemptions for its initial issuance of stock, but even the exemptions can involve a little paperwork. Federal law exempts “transactions by an issuer not involving any public offering.”7 The founder of a new company can rely on this exemption without taking further steps at the federal level. Take care, though, before relying on this simple wording to issue stock to other people. Numerous regulations interpreting this simple phrase make relying on this exemption for issuances to third parties much more complicated than one might expect.
Unlike federal law, state securities laws, or blue sky laws, often require companies to report even the initial issuance of stock to a founder. Where required, such reports are fairly simple but often have tight deadlines and impose fees. For example, California requires small businesses to file a “Limited Offering Exemption Notice” within 15 calendar days of any issuance of a security, with a $25 fee for securities offerings of $25,000 or less.8 Failing to comply with reporting obligations can expose you to penalties, so be sure to look into your obligations before you organize.
Are an LLC’s Membership Interests a Security?
A single-member LLC can issue membership interests to its owner without worrying about securities laws. That’s because membership interests in a single-member LLC that will also be managed by the member aren’t securities. Unlike a corporate shareholder, an LLC’s sole member is allowed to have direct management control over her company. Where the LLC’s member will also manage the company, there isn’t the passive investment component that makes corporate stock a security. Essentially, a corporate shareholder’s ownership of stock is isolated under the “shareholder hat,” so even if the shareholder exercises management control as the company’s sole director and officer, the stock remains “passive” by definition. Likewise, bear in mind that membership interests in an LLC can be deemed to be securities if the member will not have an active role in the day-to-day affairs of the company.
Chances are good that a freelancer’s corporation won’t ever need to issue stock after the initial issuance. When you own all of the outstanding shares of a company there usually is little benefit to issuing more. But remember that you must comply with securities laws every time you issue or sell shares. If you plan to take on investors or sell your ownership stake to someone else, it is important to talk to an attorney about what you need to do to comply.
Management
Bylaws
Like an LLC’s operating agreement, a corporation’s bylaws set out the details of the company’s management. State procedures vary on who needs to approve bylaws. The initial bylaws can often be adopted by the incorporator. Some states require them to be adopted by the shareholder or board of directors, or both. Like an LLC’s operating agreement, corporate bylaws don’t get filed with the state and remain private. Other than banks it’s unlikely that outside parties will ask to see them. Despite being private, bylaws need to be followed as part of good governance practices. Fortunately, bylaws can be customized to minimize administrative hassles.
Although the Model Business Corporation Act requires corporations to adopt bylaws,9 many state statutes make them optional. Where bylaws are optional, if the company doesn’t adopt them then the state’s corporate statute governs the operation of the company. Even if the default rules will work for a business, it is usually a good idea to adopt bylaws anyway. The bylaws can simply reiterate the default rules, or the incorporator can opt to depart from the norm if it will better serve the business. Even a restatement of the default rules can be helpful as a reference if a question should ever arise about how the company’s management works. Here are a few provisions a freelancer might want to include, mostly to save on administrative headaches:
•If allowed by state law, eliminate notice requirements for board and shareholder meetings, or at least allow for such requirements to be waived.
•Allow shareholder and board actions to be handled by written consent instead of meetings.
•Provide that directors can be elected for the maximum term allowed by law, ideally until they resign or are replaced.
•Describe the powers of officers.
•Allow shares to be issued without creating physical share certificates.
•Provide restrictions on transferring shares, especially if the company will be owned by more than one person.
Lucy is a successful freelance branding professional who works with a wide range of business clients to design logos, name products, and create a wide range of promotional content. After meeting with her tax adviser, Lucy decides that forming a legal entity for her business could save her a lot of money. (We’ll look at how corporations are treated for tax purposes in Chapter 7.)
She weighs forming an LLC or a corporation and concludes that a corporation is her preference. One reason for this is that her state’s franchise tax regime imposes a high annual fee on LLCs that a corporation won’t need to pay. Another reason is that her state’s income tax rules will let her take deductions for her health insurance premiums. Finally, her branding instincts tell her that a corporation will look better as she promotes her new company within her industry.
Lucy hires a business lawyer to help her put together the paperwork for her corporation, which she decides to call Stupendous Branding Corp. The lawyer uses standard templates to prepare the company’s articles of incorporation, bylaws, and organizing resolutions. These documents provide for Lucy to purchase 100 shares of the company’s stock for $100 ($1 per share), an amount the lawyer recommends to give the company substance. They appoint Lucy as the company’s sole director, and also name her as the company’s president. Because Lucy’s state requires corporations to elect directors annually, the lawyer provides Lucy with a template she can use in the first quarter each year to comply. The lawyer also puts Lucy on a mailing list to be reminded of her governance obligations at the start of each year. She puts a reminder on her work calendar, along with a reminder about the company’s annual reporting deadline.
Once the company is formed, Lucy gets to work promoting her new brand. At the end of the year, she finds that her choice has paid off: her tax bill is lower, and the benefit easily covers the cost of working with professional advisers.
Just like an LLC, a corporation needs to keep its records well organized. The company’s organizing documents—the articles of incorporation, bylaws, and records of director and shareholder actions—should be kept together in a binder or file, which becomes the company’s minute book.
Also like an LLC, banks and other sophisticated businesses may call upon a corporation to deliver special approvals before entering into high-risk agreements with the company. Usually these are in the form of board resolutions; because shareholders don’t have a management role in corporations, their approvals usually aren’t needed. Situations where a board resolution is required are rare, but if they come up, the original document should be filed with the company’s records and a copy given to the business requesting it.
Laws covering corporations often impose recurring governance obligations to maintain the company’s good standing with the state and the authority of directors and officers to act on behalf of the business. These typically include annual statutory reports and governance resolutions. Corporate annual reports are usually pretty simple documents, requiring disclosure of the address of the business and its owner, directors, and executive officers. There is usually a filing fee of $25 or so, though it can be much more depending on how the state structures its fees. Most states have adopted an electronic filing process for these reports. Failure to submit a report on time can result in an expensive late fee and will cause the company to lose good standing with the state. If a business is out of good standing it can’t file lawsuits in the state or dissolve. On a more practical level, some sophisticated clients may require their contractors to be in good standing, so falling out of good standing can have a contractual effect as well.
Although many states have stopped requiring corporations to hold annual board and shareholder meetings or their written equivalent, some statutes still require corporate boards and shareholders to take certain steps on a regular basis. For example, directors sometimes need to be re-elected. Some states require boards to deliver financial statements to shareholders unless the shareholders waive the requirement. A freelance business, where the same person is the shareholder and sole director, often can handle these formalities with brief, boilerplate forms. Although these resolutions never get filed with authorities, they can be important to banks or others who want to confirm the freelancer’s authority to bind the corporation, and they are critically important for maintaining the company’s corporate separateness.
Taxes: C Corps versus S Corps
By default, a corporation is treated as a separate taxpayer from its owner. Before it distributes profits to its shareholder, the corporation pays taxes on any income it earns, and claims deductions for any of its losses. The shareholder, in turn, must pay income tax on any distributions from the company. This is referred to as double taxation. A corporation subject to this default tax treatment is called a C corporation, often shortened to C corp.
For a solo freelancer, chances are that a tax adviser will recommend making what is called a Subchapter S election with the IRS. Once the election is filed, the corporation is referred to as an S corporation, or S corp. The IRS and state tax authorities treat an S corporation something like a sole proprietorship for tax purposes, meaning the corporation does not pay separate income taxes. Instead, the shareholder receives the company’s profits and reports them on the shareholder’s personal income tax return.
In some situations, staying as a C corporation can be a better deal than electing to be an S corporation. Chapter 7 goes into more detail about why this might be, and the mechanics of subchapter S elections.
A Note about Close Corporations
A few states, including California10 and Texas11, allow a special kind of corporation called a close corporation. Aside from restrictions on transferability of shares and the number of shareholders a close corporation is permitted to have (typically, up to 35), the main distinguishing feature of a close corporation is that its shareholders are allowed to directly manage the affairs of the company without electing directors. Close corporations can often dispense with a lot of formalities of a normal corporation, such as having directors or officers, or holding regular meetings. Instead, the shareholders of a close corporation enter into a shareholders agreement to define their obligations to each other and to the company.
Close corporations aren’t particularly popular. Drafting a shareholders agreement is a relatively complicated process, especially where more than one shareholder is involved. With complexity comes cost. Close corporations also don’t typically get special advantages like lower fees or unique tax treatment. Absent a special advantage, there may be little rationale for favoring a close corporation over an ordinary C corp, S corp, or LLC.
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1 MODEL BUS. CORP. ACT §2.02 (AM. BAR ASS’N 2016).
2 Id. at §4.01.
3 Delaware is one example of a state that calculates franchise taxes based on authorized or issued shares. A corporation can choose to use one method or the other, with corporate assets factoring into the issued shares formula. In Delaware the minimum franchise tax is $175 for corporations with 5,000 shares or less of authorized stock. Delaware Division of Corporations. 2017. “How to Calculate Franchise Taxes.” https://corp.delaware.gov/frtaxcalc.shtml (accessed August 8, 2017).
4 California Secretary of State. 2017. Articles of Incorporation of a General Stock Corporation, Form ARTS-GS. www.sos.ca.gov/business-programs/business-entities/forms/ (accessed August 15, 2017).
5 California Secretary of State. 2017. Statements of Information. www.sos.ca.gov/business-programs/business-entities/statements/ (accessed August 15, 2017).
6 ARIZ. REV. STAT. § 10-203(D) (2017).
7 Securities Act of 1933, section 4(a)(2). 15 USC § 77(d)(a)2 (2017).
8 CAL. CORP. CODE § 25102(f) (2017).
9 MODEL BUS. CORP. ACT § 2.06(a) (AM. BAR ASS’N 2016).
10 CAL. CORP. CODE. § 158 (2017).
11 TEX. BUS. ORGS. CODE §§ 21.701 et seq.