Guest Author - Consuelo Herrera, CAMS, CFE
Clients frequently ask their accountants about advantages and disadvantages of a corporation. Bringing awareness on some aspects of the incorporation process may be relevant to those seeking your advice. Incorporating a business is a big deal. It entails, hopefully, a long-term relationship among shareholders or partners depending on the type of legal entity. When an individual decides to do business as a sole proprietorship, he or she takes on full liability for contracts to the extent that this liability reaches even personal assets. When two or more individuals decide to create a corporation, they become the shareholders and they appoint the initial board of directors and enact the corporation’s initial bylaws.
A corporation has express and implied powers. Express powers are the US Constitution, state constitution, state statutes, articles of incorporation, bylaws, and board resolutions. The implied powers are determined by a corporation’s ability to accomplish its purposes. On the other hand, corporate officers have both implied and express authority. Express authority to contract for the corporation and implied reasonably authority necessary to carry out their duties.
A corporation is a legal entity independent of its owners. As stated by the Internal Revenue Service, IRS, in forming a corporation, prospective shareholders exchange money, property, or both, for the corporation's capital stock. A corporation generally takes the same deductions as a sole proprietorship to figure its taxable income. For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity.
The IRS norms that the profit of a corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. Many complain about the “double-taxation” however, this is a trade-off where the benefits exceed the cost in case a lawsuit arises. Shareholders would have limited liability versus full liability if the entity where a sole proprietorship entity.
During the process of incorporation, shareholders may become personally liable for any contract in the corporation's name. This is called improper incorporation. To avoid this, the courts have created legal figures that protect shareholders:
1) De Jure Corporation. A corporation that complies with the mandatory statutory requirements of incorporation is deemed to be a Jure corporation. Such status cannot be attached by anyone, including the state.
2) De Facto Corporation. If the corporation fails to comply substantially with mandatory requirements the court might recognize its existence as de facto. Third parties cannot challenge the existence of the corporation.
3) Corporation by Estoppel. If not a de facto or de jure corporation. If a third party entered into a contract believing he or she was dealing with a corporation, the courts will not allow the third party to hold the shareholders liable on that contract.
Since the passage of the Sarbanes-Oxley Act many board members are aware of their duties over the financial reporting process and the organization’s activities. Boards of Directors are protected under the Business Judgment Rule. Example, they are not held accountable when dividends are declared and paid making a corporation insolvent if they relied on assurances from other board of directors’ members when they did so. If a corporation declares and pays dividends even though it is in the verge of insolvency the shareholders may be forced to payback those dividends.
When corporations are created ideally should have not be disputes that give rise to lawsuits, however, shareholders do suit their corporations. There are two types of shareholders suits: a) representative suits which are direct suits against the corporation by shareholders to prevent a corporation act, and b) derivative suits which, are suits brought by shareholders as representatives of the corporation against directors, officers or outside partners.
Another point worth to note is that courts may disregard the corporate status. This is called "pierce the corporate veil.” When it happens, courts hold a shareholder personally liable. It is triggered when the corporation was undercapitalized when formed, never made a profit, or was “thinly” capitalized, the shareholders commingle personal assets and transactions with business assets and transaction, or the corporation is used to perpetrate fraud.
Help your client make an informed decision before they opt a legal entity for their organization. Instruct them that it is worth seeking legal advice before taking the final step since becoming a shareholder of a corporation entails intricacies that should not be taking blindly.