When a group of people decide to start a business together, a likely form is a corporation. While a corporation can be one of several types, all share key benefits that make this entity particularly appealing. There are also weaknesses that need to be carefully evaluated, so the best form can be chosen. So let’s dive in and dissect this business form.

In its simplest form, a corporation is an organization formed under the auspices of a state government for the purpose of operating a business. As a separate legal entity, the corporation can be sued and can do anything under the law that individuals can do.

As a separate legal entity, the corporation has many powers and abilities. For example, a corporation can own property in its own name, unlike a partnership. It can issue stock to shareholders as a vehicle for raising capital. It can continue indefinitely because it is not required to terminate at the death of a shareholder, unlike a partnership.

There are many classes of corporations. The differences stem from the source of the corporation’s authority, its relationship to the public, and its activities. Here’s a summary of some types:

♦ Public corporations are government entities such as cities and counties that are created to perform a governmental function.

♦ Private corporations can be one organized for charitable purposes or for business purposes. This is the broadest grouping and covers everything from companies that are traded on stock exchanges to charities. A private corporation is often called a public company in the business context. In either case, it’s a company that’s shares are bought by private investors. In a legal sense it is not a public company, because that designation is reserved for companies performing a quasi-governmental role.

♦ Quasi-public corporations exist to carry out a government mandate, but may also have private investors. Sallie Mae is an example. Regardless of who owns stock, the corporation must carry out its government-directed duties.

♦ Public authorities are companies owned by the government to provide services. Examples of this type include the Maryland Transit Authority and the Delaware River Port Authority.

♦ Domestic corporations are those that are incorporated and that operate in a state.

♦ Foreign corporations are those that are incorporated in one state but also operate inside a second state. For example, if you are in Illinois, a company that is incorporated under Illinois law is a domestic corporation. An Indiana corporation that is doing business in Illinois is a foreign corporation.

♦ Special service corporations are governed by special laws because of the specialized areas in which the corporations operate. These can include insurance, banking, and savings and loans. Because of the nature of these industries, federal and state governments and agencies heavily regulate them.

♦ Close corporations are held by a single or small group of shareholders, and the shares are not traded on a public exchange. These are often mom-and-pop companies that stay in the family. But the pool of investors is always small.

♦ Subchapter S-corporations are a type of corporation that grow out of the IRS code. By checking a box on Form 2553, the corporation will be treated as a partnership for tax purposes if it meets the following criteria: it is a domestic corporation with 100 or fewer shareholders; the shareholders are individuals, estates, or exempt organizations; and it has one class of stock. An S-corporation cannot have nonresident alien shareholders. It also cannot be an ineligible corporation such as a bank or thrift institution that uses the reserve method for bad debts, an insurance company subject to take under another section of the code, a professional corporation or a domestic international sales corporation.

♦ Professional corporations are those that are organized so that the members can practice a profession. This type of corporation is usually limited to lawyers, doctors, accountants, and architects. This form is similar to a limited liability partnership, in that participants are shielded from liability except for their personal liability for their malpractice or negligence. Professional corporations will have PC or P. C. in the name.

♦ Nonprofit corporations are formed for purposes other than making a profit. Most often the purpose is charitable in nature. The most common forms are hospitals, universities and colleges, nursing homes, and organizations that support the arts. In their operating documents, the nonprofit purpose must be clearly stated. It’s important to note that a nonprofit corporation is not automatically a 501(c)(3) with all the tax benefits. A nonprofit corporation has to file extensive paperwork with the IRS, and the IRS must approve the application before the corporation can receive a 501(c)(3) designation.

Regardless of the type of corporation, the power to create and regulate the corporation stems from the government. While most corporations are created under state law, it’s possible to create one under federal law. While there is a model act, the Revised Model Business Corporation Act, states have not consistently adopted it. Therefore, each state’s law must be carefully reviewed when setting up a corporation.

Once formed, corporations are a separate legal entity, which provides key liability protection to the shareholders. To achieve that protection, the steps necessary for formation must be followed carefully. Because the corporation has a separate identity, it has the same powers as an individual. It can do anything necessary and convenient to conduct its business.

A corporation has the following specific characteristics and powers:

Occasionally a corporation will engage in an ultra vires act, which is beyond the scope of its authority. Ultra vires acts are rarer today than 100 years ago, since states have given corporations such broad powers. The corporation statutes often list every power a business would need to conduct their business. As long as an action is within the stated purposes of the company, the action will not be ultra vires. An example: a company cannot operate a bank, even if it’s just for employees, unless it has the required charters. If it does so, that would be an ultra vires act.

Each state’s corporation statues provide detailed information on the steps required to create a corporation. While each state’s laws may have variations, the following process is common when creating a corporation. The key is to understand the role of the promoter and the liability that person may accept as it acts for the yet-to-be-formed corporation.

Usually a corporation is created after one or more promoters complete the start-up steps. The promoters look for financing, may sign contracts on behalf of the not yet created corporation, and take other steps necessary to create the corporation.

The promoter accepts liability as it promotes the corporation. A corporation is not liable on contracts made by the promoter unless it affirmatively takes steps to adopt the contract. Think of it this way: until the promoter has completed his job, there is no corporation. Thus, the corporation can only accept the liability after the fact by ratifying the contracts or actions of the promoter.

The promoter is liable. Whoever the promoter contracts with is entering that contract with the promoter and thus can seek damages from the promoter for any breach or negligence. The only time the promoter will not be liable is if the promoter’s contract exempt him.

Here’s an example. Donovan has been hired to promote a new high-tech venture. As part of his promoting responsibilities he finds a storefront for the company to lease. Sandy, the landlord, knows that Donovan is signing the lease on behalf of this new venture, but there is no agreement between Sandy and Donovan that he will not be liable if there is a problem with the lease. Eighteen months after moving in, the venture folds, and the premises are vacated six months early. Donovan is liable for any unpaid rent.

A promoter is also liable for torts, the negligent acts he commits in connection with promoting (I’ll discuss torts in detail in Chapter 25). A promoter also cannot make secret profits on his promoting activities. His role is one of a fiduciary to the corporation and its shareholders. If the promoter makes a secret profit, he must surrender it to the corporation. For example, if Donovan owned land that is perfect for the venture’s new plant, he can’t sell it to the venture at a profit, because that would be obtaining a secret benefit at the expense of the venture. At the same time, if a landowner offers him a commission bonus for choosing his land for the venture’s plant over another, Donovan must also turn over that bonus commission to the venture.

Anyone can act as an incorporator for a corporation. This role differs from the promoter in that the incorporator signs and files the appropriate paperwork with the state. The incorporator can be the promoter or two very distinct roles. Once the paperwork and filing fee are filed with the appropriate state office—often the secretary of state—that official ensures that the forms comply with statutory requirements. If it does, then the documents are accepted and a stamped copy is returned to the incorporator.

To be incorporated, the incorporators must file articles of incorporation with the appropriate state entity. The articles must state …

If the incorporation steps are properly followed, a corporation de jure—by operation of law—is created. If there is a minor defect, it will still be treated as a corporation de jure. Usually, a state will recognize the corporation as valid if the secretary of state has filed the articles of incorporation.

A de facto corporation is created when a defect in the incorporation is so substantial that it cannot be ignored. However, because of the actions of the company or board of directors, the corporation will be treated as if it did in fact properly exist. Usually, a court will look to see whether incorporators did three things: acted in good faith to incorporate, had the legal right to incorporate, and acted as if he or she were incorporated.

A de facto corporation may also exist when the corporation has dissolved but continues to function as a corporation. The law steps in to treat the corporation as if it were legal to protect people who conducted business with the corporation during that time.

A corporation by estoppel arises if third parties thought the business was a corporation that would now profit if the third party was allowed to deny the existence of a corporation.

A corporation can be dissolved only after several steps are followed. First, a corporation’s board must take formal corporate action to dissolve. That decision must be recorded in minutes and ratified by the shareholders. Then a notice must be filed with the appropriate state office. Statutory notice must also be given to the corporation’s creditors. Then all creditors’ claims must be processed by the corporation. Any remaining assets must be sold or distributed. Once these steps are completed, the corporation must file articles of dissolution.

A corporation can also be dissolved by judicial action. This is most likely to occur when the board of directors deadlocks, which the shareholders are unable to break. Finally, if the corporation is in serious financial trouble, it may enter bankruptcy and be reorganized.

Once corporations are formed, they can pool their resources to create new entities. There are generally two ways companies do this: mergers and acquisitions.

Mergers occur when two companies combine. One company offers its stock or cash to the shareholders of the other company. Let’s take Company A and Company B. Company A wants to expand into a new geographic region. Rather than create its own distribution system, A purchases B. By merging with A, B ceases to exist while A retains its charter and identity.

A merger can originate from within one of the merging companies, or the merger can come from outside investors. If outside investors push the merger, it is called a two-step merger. The first step in a two-step merger is for the outside investor to acquire voting control by acquiring stock of the target company. The second step is that the target company and another company already controlled by the outside investor merge. While this process sounds complicated, it can actually be simpler than a one-step merger because the offer time period is shorter and the SEC filings are less burdensome.

The decision to merge is usually made by two companies that are equals. The board and shareholders decide that economies of scales, greater sales revenue and market share, or broadened diversification or increased tax efficiency can be obtained.

A consolidation occurs when two companies come together and a third company is born. Each of the original companies ceases to exist. Instead, a new company is created with the assets and property of the original companies.

Shareholders may object to the proposed mergers and consolidations. If a shareholder chooses that route, she can ask a court to determine the value of her stock. If anybody does not cooperate with the appraisal process, the courts can penalize that party by assessing attorney fees and court costs.

An acquisition occurs when a much larger company takes over a smaller one. There is an inherent inequality in the balance of power between the two companies. The larger company purchases the other—and while these can be friendly, the takeover can also be hostile.

A conglomerate defines a parent company’s relationship with its subsidiary corporations, when the subsidiaries are not engaged in the core business of the parent.

If the subsidiaries are related to the parent’s business, it is called an integrated industry rather than a conglomerate.

If the parent is not engaged in production or services, it is a holding company. The parent exists only as a vehicle to manage the various subsidiaries.

Regardless of the type, each subsidiary is a distinct corporation. That means each will have its own board of directors and bylaws. Antitrust laws may step in to prevent a merger or acquisitions that will have anticompetitive impacts on the economy. See Chapter 4 for more on antitrust law.

Successor corporations, the corporations that remain after a merger, acquisition, or other consolidation, can be liable for the debts and obligations of its predecessors. With mergers and consolidations, typically the corporation that continues the business of the merged or consolidated corporation obtains all the rights and liabilities of the prior corporation. The reason is that someone must be responsible if something goes wrong with the merged company’s products after the merger. The law will not allow a vacuum to develop regarding that liability.

If the assets of the prior corporation were obtained through an asset sale, the purchaser is not liable for the obligations of the predecessor. However, if a corporation tries to hide a merger or consolidation as an asset sale, the courts will not allow liability to be avoided.

One of the great benefits of the corporate entity is that the shareholders are shielded from personal liability for the acts of the corporation. There are exceptions to this general rule, the main exceptions being piercing the corporate veil and the corporation as alter ego.

In rare circumstances, a court may pierce the corporate veil if the corporate form has been ignored by the shareholders or managers. By piercing the corporate veil, the court determines that the shareholders or directors of a corporation should be liable for the acts or debts of the company. To determine whether the veil has been pierced, the court will look at the following factors:

Sometimes the court will find that the corporation is merely the alter ego of a wrongdoer. As such, there is no liability protection for the shareholder or owner. In this case, the corporation is so dominated by the board, owner(s), or shareholder(s) that the distinction between individuals and company evaporates. Even here, the courts will require a high degree of fraud or injustice, because it is important that shareholders have certainty of limited liability absent wrong doing.