A corporation is a legal business structure involving one or more individuals (owners) who are legally distinct (separate) from the business that is created under state laws. The owners of a corporation are called stockholders (or shareholders) and may or may not be employees of the corporation. Most corporations rely on a combination of debt (liabilities) and equity (stock) to raise capital. Both debt and equity financing have the goal of obtaining funding, often referred to as capital, to be used to acquire other assets needed for operations or expansion. Capital consists of the total cash and other assets owned by a company found on the left side of the accounting equation. The method of financing these assets is evidenced by looking at the right side of the accounting equation, either recorded as liabilities or shareholders’ equity.
The Organization of a Corporation
Incorporation is the process of forming a company into a corporate legal entity. The advantages of incorporating are available to a corporation regardless of size, from a corporation with one shareholder to those with hundreds of thousands of shareholders. To issue stock, an entity must first be incorporated in a state.
The process of incorporating requires filing the appropriate paperwork and receiving approval from a governmental entity to operate as a corporation. Each state has separate requirements for creating a corporation, but ultimately, each state grants a corporation the right to conduct business in the respective state in which the corporation is formed. The steps to incorporate are similar in most states:
- The founders (incorporators) choose an available business name that complies with the state’s corporation rules. A state will not allow a corporation to choose a name that is already in use or that has been in use in recent years. Also, similar names might be disallowed.
- The founders of a corporation prepare articles of incorporation called a “charter,” which defines the basic structure and purpose of the corporation and the amount of capital stock that can be issued or sold.
- The founders file the articles of incorporation with the Department of State of the state in which the incorporation is desired. Once the articles are filed and any required fees are paid, the government approves the incorporation.
- The incorporators hold an organizational meeting to elect the board of directors. Board meetings must be documented with formal board minutes (a written record of the items discussed, decisions made, and action plans resulting from the meeting). The board of directors generally meets at least annually. Microsoft, for example, has 14 directors on its board.4 Boards may have more or fewer directors than this, but most boards have a minimum of at least three directors.
- The board of directors prepares and adopts corporate bylaws. These bylaws lay out the operating rules for the corporation. Templates for drawing up corporate bylaws are usually available from the state to ensure that they conform with that state’s requirements.
- The board of directors agrees upon a par value price for the stock. Par value is a legal concept discussed later in this section. The price that the company receives (the initial market value) will be determined by what the purchasing public is willing to pay. For example, the company might set the par value at $1 per share, while the investing public on the day of issuance might be willing to pay $30 per share for the stock.
CONCEPTS IN PRACTICE
Deciding Where to Incorporate
With 50 states to choose from, how do corporations decide where to incorporate? Many corporations are formed in either Delaware or Nevada for several reasons. Delaware is especially advantageous for large corporations because it has some of the most flexible business laws in the nation and its court system has a division specifically for handling business cases that operates without juries. Additionally, companies formed in Delaware that do not transact business in the state do not need to pay state corporate income tax. Delaware imposes no personal tax for non-residents, and shareholders can be non-residents. In addition, stock shares owned by non-Delaware residents are not subject to Delaware state taxation.
Because of these advantages, Delaware dominated the share of business incorporation for several decades. In recent years, though, other states are seeking to compete for these businesses by offering similarly attractive benefits of incorporation. Nevada in particular has made headway. It has no state corporate income tax and does not impose any fees on shares or shareholders. After the initial set up fees, Nevada has no personal or franchise tax for corporations or their shareholders. Nevada, like Delaware, does not require shareholders to be state residents. If a corporation chooses to incorporate in Delaware, Nevada, or any state that is not its home state, it will need to register to do business in its home state. Corporations that transact in states other than their state of incorporation are considered foreign and may be subject to fees, local taxes, and annual reporting requirements that can be time consuming and expensive.
Advantages of the Corporate Form
Compared to other forms of organization for businesses, corporations have several advantages. A corporation is a separate legal entity, it provides limited liability for its owner or owners, ownership is transferable, it has a continuing existence, and capital is generally easy to raise.
Separate Legal Entity
A sole proprietorship, a partnership, and a corporation are different types of business entities. However, only a corporation is a legal entity. As a separate legal entity, a corporation can obtain funds by selling shares of stock, it can incur debt, it can become a party to a contract, it can sue other parties, and it can be sued. The owners are separate from the corporation. This separate legal status complies with one of the basic accounting concepts—the accounting entity concept, which indicates that the economic activity of an entity (the corporation) must be kept separate from the personal financial affairs of the owners.
Many individuals seek to incorporate a business because they want the protection of limited liability. A corporation usually limits the liability of an investor to the amount of his or her investment in the corporation. For example, if a corporation enters into a loan agreement to borrow a sum of money and is unable to repay the loan, the lender cannot recover the amount owed from the shareholders (owners) unless the owners signed a personal guarantee. This is the opposite of partnerships and sole proprietorships. In partnerships and sole proprietorships, the owners can be held responsible for any unpaid financial obligations of the business and can be sued to pay obligations.
Shareholders in a corporation can transfer shares to other parties without affecting the corporation’s operations. In effect, the transfer takes place between the parties outside of the corporation. In most corporations, the company generally does not have to give permission for shares to be transferred to another party. No journal entry is recorded in the corporation’s accounting records when a shareholder sells his or her stock to another shareholder. However, a memo entry must be made in the corporate stock ownership records so any dividends can be issued to the correct shareholder.
From a legal perspective, a corporation is granted existence forever with no termination date. This legal aspect falls in line with the basic accounting concept of the going concern assumption, which states that absent any evidence to the contrary, a business will continue to operate in the indefinite future. Because ownership of shares in a corporation is transferrable, re-incorporation is not necessary when ownership changes hands. This differs from a partnership, which ends when a partner dies, or from a sole proprietorship, which ends when the owner terminates the business.
Ease of Raising Capital
Because shares of stock can be easily transferred, corporations have a sizeable market of investors from whom to obtain capital. More than 65 million American households5 hold investments in the securities markets. Compared to sole proprietorships (whose owners must obtain loans or invest their own funds) or to partnerships (which must typically obtain funds from the existing partners or seek other partners to join; although some partnerships are able borrow from outside parties), a corporation will find that capital is relatively easy to raise.
Disadvantages of the Corporate Form
As compared to other organizations for businesses, there are also disadvantages to operating as a corporation. They include the costs of organization, regulation, and taxation.
Costs of Organization
Corporations incur costs associated with organizing the corporate entity, which include attorney fees, promotion costs, and filing fees paid to the state. These costs are debited to an account called organization costs. Assume that on January 1, Rayco Corporation made a payment for $750 to its attorney to prepare the incorporation documents and paid $450 to the state for filing fees. Rayco also incurred and paid $1,200 to advertise and promote the stock offering. The total organization costs are $2,400 ($750 + $450 + $1,200). The journal entry recorded by Rayco is a $2,400 debit to Organization Costs and a $2,400 credit to Cash.
Organization costs are reported as part of the operating expenses on the corporation’s income statement.
Compared to partnerships and sole proprietorships, corporations are subject to considerably more regulation both by the states in which they are incorporated and the states in which they operate. Each state provides limits to the powers that a corporation may exercise and specifies the rights and liabilities of shareholders. The Securities and Exchange Commission (SEC) is a federal agency that regulates corporations whose shares are listed and traded on security exchanges such as the New York Stock Exchange (NYSE), the National Association of Securities Dealers Automated Quotations Exchange (NASDAQ), and others; it accomplishes this through required periodic filings and other regulations. States also require the filing of periodic reports and payment of annual fees.
As legal entities, typical corporations (C corporations, named after the specific subchapter of the Internal Revenue Service code under which they are taxed), are subject to federal and state income taxes (in those states with corporate taxes) based on the income they earn. Stockholders are also subject to income taxes, both on the dividends they receive from corporations and any gains they realize when they dispose of their stock. The income taxation of both the corporate entity’s income and the stockholder’s dividend is referred to as double taxation because the income is taxed to the corporation that earned the income and then taxed again to stockholders when they receive a distribution of the corporation’s income.
Corporations that are closely held (with fewer than 100 stockholders) can be classified as S corporations, so named because they have elected to be taxed under subchapter S of the Internal Revenue Service code. For the most part, S corporations pay no income taxes because the income of the corporation is divided among and passed through to each of the stockholders, each of whom pays income taxes on his or her share. Both Subchapter S (Sub S) and similar Limited Liability Companies (LLCs) are not taxed at the business entity but instead pass their taxable income to their owners.