T. Randolph Catanese, Esq. © 1999. All Rights Reserved.
The first article in this series discussed choice of entities for the entrepreneur and the start-up company. These entities involve the sole proprietorship, partnerships, and various corporate forms. This article will address why corporations are the preferred entity for the start-up venture.
Corporations are recognized as separate legal entities from the individual owners or shareholders. The law recognizes the corporation just like it recognizes the individual. That means corporations are recognized as parties to contracts, they can be parties in lawsuits, and they have something under the law that individuals do not have, and that is continuity of life (or simply they can exist into the future even after the shareholders who compromise the owners of the company pass away).
Corporations come in various sizes and shapes. Under Federal tax law some corporations are known as “C” corporations (for Chapter C of the Internal Revenue Code) and some are known are known “S” corporations (under Chapter S of the Internal Revenue Code). A C corporation generally speaking is taxed at one level and does not permit pass-through of income or losses to its respective shareholders. Whereas, an “S” Corporation has its profits and losses passed through directly to the individual shareholder(s) of the corporation.
Whether the corporation for tax purposes is identified as a C corporation or an S corporation, for state purposes the corporation is still recognized as a separate entity and provided the corporation is properly organized and adequately capitalized it will provide for limited liability to the shareholders.
When a corporation is formed it is important that it be adequately capitalized and properly documented to avoid claims by potential litigants of alter ego. Alter ego is a claim by a plaintiff that the individual shareholder or shareholders of the corporation should not be entitled to stand behind the corporation and claim no liability individually since the corporation was nothing more than their alter ego. The courts generally will accept an alter ego argument if the plaintiff can establish that the corporation was not adequately capitalized to carry on its business and/or its organizational minutes, by-laws and other documentation were not completed and kept in an orderly fashion. (Those boring shareholder and directors’ minutes need to be completed on a yearly basis and inserted into the corporate minute book. Even if the minutes simply confirm that the corporate officers and directors were authorized to act and to carry on the duties of the corporation, nonetheless they need to be completed and made part of the corporation’s minute book.)
Another key benefit to a corporation is the fact that it allows for the creation of equity and debt classes. Corporations have the right to issue various types of equity. Typically, this would take the form of preferred stock and common stock. Each class of stock may have separate series with differing rights and preferences. Corporations also have the right to issue different debt instruments as well. The fact that corporations have the ability to issue equity and debt gives the entrepreneur greater opportunity to raise capital to finance the company’s business. Moreover, it is the availability of equity which gives the capital provider an incentive to give capital since an exit plan may include a second round of financing (at a higher valuation of the company’s stock) or an ultimate initial public offering or buy-out (again at a higher valuation of the company’s stock). Capital providers want to know that they have the opportunity to maximize the return on their equity investment and corporations permit this type of exit strategy. In short, equity in a corporation, although it is privately held, has a far better chance to be liquidated than an interest in a partnership.
Another point to keep in mind between using a C corporation or an S corporation is the availability of accumulated tax losses. Since an S corporation passes through all income and losses, many times an investor would prefer to invest in a C corporation that has accumulated tax losses since those tax losses will offset future earnings. In effect, the investor would prefer to invest in a C corporation with accumulated tax losses since those tax losses will offset future earnings thereby increasing revenue available for reinvestment into the corporation or for a distribution as a dividend.
Lastly, formation of the corporation is relatively simple. Most states have streamlined filing processes, typically through the filing of Articles of Incorporation. The state requirements for the first meetings of incorporator, directors and shareholders are normally met by a meeting of any length and the preparation of relatively brief minutes. By-laws for the corporation are also not too difficult to prepare. Most banks will permit an account to be established with them upon presentation of filed Articles of Incorporation.
For the reasons stated above, corporations make imminent sense for the start-up company. They eliminate personal liability, permit easy capital formation and also provide tax benefits.
In the next article in this series, limited liability companies will be discussed. They will be compared against partnerships and corporations.