Welcome to LearnLawBetter.
In this first episode in a six-part series on corporations, I’m going to walk you through
some of the issues you will encounter when creating a new business entity.
Though I will be dealing primarily with corporations, you will also learn a bit about other business entities,
like limited liability companies and partnerships.
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Formation deals with the issues surrounding the creation of a business entity.
The earliest business model was the sole proprietorship, which is what someone creates when they go
into business by themselves and does not create a sperate business entity.
The second oldest business model is the general partnership, which is when two or more people
go into business without creating a formal business entity,
such as the limited liability company or a limited partnership.
We are not going to be looking at sole proprietorships or general partnerships since those are models
that large businesses typically do not use.
So let’s look at corporations.
The concept of the corporation has existed since the times of ancient Rome, initially
used as a way to recognize that individual church bishops did not own church property
individually. It came to be more than just being something applicable to the church.
More recently, corporations as we know them began to be created in the 1800’s.
A corporation is a legal entity, separate from its owners, that is created by state
statute so that the owners may engage in any legal enterprise without fear of personal
liability.
They are very easy to create.
All you have to do is go to the website maintained by any State’s Secretary of State and fill
out some forms.
For example, in Delaware you can find a form, cover letter and a one page articles of incorporation
that you can submit to create a corporation, along with paying the filing fee.
I will use Delaware because it is the state where most large and medium
size businesses choose to incorporate, generating fees close to 20% of the entire state
budget.
In addition to filing with the Secretary of State, every corporation must have a registered
agent in its state of incorporation. And also in every State in which it conducts business.
So for less than $200, anyone can form a corporation.
Now in the past, large businesses were almost exclusively operated as corporations.
But that is not the case today.
Businesses now have several options in lieu of the corporation, such as the Limited Liability
Company, Limited Liability Partnership, and a few others we're just not going to examine.
When someone decides to go into business there are several considerations in
choosing a particular entity:
Limited liability for the owners, taxes, management flexibility, well developed
law, and ability to raise capital and money.
The primary reason these business entities are chosen is because they provide limited
liability for their owners.
Now by limited liability, I mean that the only thing that owners can lose is their financial
investment in the business.
Creditors of a failed business entity cannot sue the owners personally to recover their
losses.
Corporations, limited liability companies, and limited liability partnerships provide
their owners with this limited liability shield.
This is in contrast to the sole proprietorship and general partnership, where the owners
are individually liable for all of the debts of the business.
The second factor that people consider when creating a business entity involves its taxability.
Corporations must pay federal income taxes on its earned income, and then shareholders
pay federal income taxes on that same income when they receive dividends from the corporation.
This is very often referred to as double taxation.
Limited Liability Companies and Limited Liability Partnerships do not pay an entity level tax,
with all of their profits and losses passed along to the owners of the business.
Now some of you may have heard about the S-Corporation.
Congress created the S-Corporation as a way to relieve the double tax problem for small
corporations that have 100 or fewer owners.
If a corporation meets the requirements to elect S-Corporation status, then the owners
are only taxed once as all corporate profits and losses are passed through to the individual
owners.
Other than tax treatment, the S-Corporation is just like any other corporation.
So we're really not going to talk about the S-Corporation any further
other than, again, to mention its tax status.
The third factor to consider when creating a business
entity is management flexibility.
By management flexibility I am referring to how the business entity decision makers interact
with the business entity.
For example, corporate law was created over the past one hundred years.
There are laws that require a board of directors, rules that tell the board of directors what
they can and can’t do, rules that require the board to meet on a regular basis, and
many other rules that regulate the corporation.
For example, suppose that John Smith is the President of a large corporation and he is asked
to serve on another Board of Directors—both of these companies are large companies
that compete with each other.
You can imagine the potential for conflicts of interest as John Smith is privy to information
from his employer and the confidential information he gets from serving on a seperate board.
The law governing corporations requires that John not use the confidential information
he picked up on the board with his employer.
And this opens John to a lawsuit for violating his duty of loyalty to the board he serves on
even though he may
have gotten the same information from his employer.
Because corporate law is well-developed, decision makers at corporations are constrained in
what they can and cannot do.
In contrast, decision makers at limited liability companies and limited liability partnerships
have significantly more flexibility because their conduct is regulated by private contract law
rather than state statutes.
For example, a limited liability company’s operating agreement can allow decision makers
to compete with the company, which would not violate any law.
That kind of flexibility is very appealing to decision makers that serve multiple businesses.
The fourth factor involves the availability of well-developed law.
One reality of life, especially for large businesses, involves lawsuits between business
owners and business management.
When there is a full body of law, uncertainty in litigation is minimized.
Many businesses prize a well-developed body of law, so those companies choose to create
corporations.
Corporate law has over 100 years of history, with many statutes and even more case law.
A statute is law created by the legislature and case law involves law created by judges—both
apply equally to businesses.
Limited liability companies, on the other hand, are fairly new and have very little
law.
Also, limited liability companies are primarily governed by their operating agreements, so
there is always the chance that in litigation a jury might interpret a contract in a way
that the business did not anticipate.
This factor takes us back to Delaware, which is the legal home to most large businesses.
Early in the 20th century, Delaware realized that corporate friendly laws, corporate friendly
courts, judges focused solely on corporate law, and a corporate friendly legislature
would result in corporations choosing to incorporate in Delaware.
This has resulted in a well-established body of corporate law that no other state comes
close to matching.
All over the country, there are lawyers that never look at the corporate law of their home
states, but instead they are experts in Delaware corporate law.
To understand this phenomena, you also need to understand one legal doctrine called the internal
affairs doctrine.
This doctrine holds that a corporation’s internal affairs are governed by the laws
of the state of incorporation.
The practical effect of this doctrine is that corporations located in any state can incorporate
in Delaware and have Delaware law apply to their internal governance affairs, regardless
of what state or federal court they are sued in.
For example, Bank of America Corporation has its headquarters in Charlotte, NC but is incorporated
in Delaware.
If Bank of America is sued in North Carolina over a corporate director’s purported breach
of duty, the North Carolina court will apply Delaware corporate law.
The Fifth factor involves the ability to raise money.
Corporations are familiar to almost every investor, in a way that limited liability
companies and limited liability partnerships are not.
In reality, it is not that much harder to invest in these types of entities.
Most investors understand that they can buy shares in a corporation, but they find it more
challenging when they own a limited liability ownership interest.
Also, most investors can go online and quickly buy and sell corporate stock—not as easy
for the other business entities.
So if a business knows that they will want to access capital markets, they will often
choose the corporate form so that they can raise money when they are ready to go public
with a stock offering on some exchange, like the New York Stock Exchange.
Finally, a note on where to find the rules that corporations create for themselves.
As you recall, a corporation files its articles of incorporation when it is created.
The articles of incorporation provides things like the corporate name and initial business
address, who the original incororaters are.
But it can provide much more detailed information, such as the types of officers in the corporation, the number of shares,
really just about anything else that the corporation wants to place into the articles of incorporation.
The important point here is that the articles of incorporation act as the constitution for
the corporation, so the rules in that document will trump any other rules the corporation
may try to create.
Also, the articles of incorporation may only be amended by a vote of the shareholders.
The second important corporate document is called the by-laws.
This document is created and amended by the board of directors.
The bylaws tend to me more detailed than the articles of incorporation and provide
guidance to the board of directors.
For example, the bylaws may provide that a board of director’s meeting will be governed
by Robert’s Rules of Order, how many directors are needed to establish quorum, or how often
the board will meet.
Even where they're going to meet.
Some corporations say that the board of directors will only meet in a particular State.
All that would generally be placed into the bylaws.
And with that, we are now done with corporate formation.
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