What is a Corporation?

Definition:

A corporation is a type of legal structure that allows people to operate a business with certain benefits, protections, and tax rules.

🤔 Understanding corporation

The businesses we know as consumers come in many different forms. A corporation is one of them — It’s a legal structure that’s meant to allow the people behind it to conduct their business with protections from certain risks. For example, if a group of people founded a corporation, and later that corporation was sued for some amount of money, it may lose some or all of its assets to settle the case. However, its founders would not generally be personally liable for losses, other than for their own investment in the company (aka limited liability). This legal separation can allow an individual or a group of people to mitigate some of the risks they take when investing time and money into a business. Like people, corporations can make and borrow money, enter into contracts, get entangled in lawsuits, and follow the laws that govern them. Unlike some other types of business ownership structures, such as partnerships or limited liability companies (LLCs), corporations pay income tax on their profits.

Example

Let’s say five people decide to go into business together and start an eco-friendly water bottle company. The founders have big plans to grow the company and someday list it on a major stock exchange. They decide to form a corporation — More specifically, a C corps, which can be costlier and more work to operate than some other types of corporations, but is a common structure for many businesses, especially ones that intend to go public some day. (Another corporation type, S corps, cannot have more than 100 shareholders.)

Years later, an animal rights group sues the corporation for $10M claiming that its water bottles contain a toxic chemical harmful to wildlife. The corporation loses a year’s worth of profits in the lawsuit. Its owners lose their original investment in the process, but by law, because the corporation is a separate entity, the owners generally aren’t liable for any more.

Takeaway

A corporation is kind of like a landmark...

Like Paris’s Eiffel Tower, San Francisco’s Painted Ladies, or Seattle’s Space Needle, many landmarks begin as an idea of one or a few people. But over time, landmarks take on a life of their own, independent of its original creators or even the city it exists in. A corporation works in a similar way. A company might start out belonging to just a few owners, but after it incorporates (becomes a corporation), it legally becomes an entity all its own, separate from its owners or shareholders.

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How is a corporation formed?

Forming a corporation can look slightly different depending on what kind of business you’re operating and what its needs are. Generally speaking, the process involves a series of decisions, including where it will be located and who will oversee it, as well as registering the business with the government.

Here are some common steps likely to come up when forming a corporation:

Choose the business structure. A corporation is just one of several types of legal structures available to those starting a business. Other types include sole proprietorships, partnerships, and limited liability companies (LLCs). Each structure comes with its own set of benefits and regulations. And even within corporations, there are several options to consider, as discussed in the section below.

Choose a location. Like any other kind of business, a corporation's location is important because it can determine the taxes your business may have to pay, any licenses it may need to obtain, regulations it will need to follow, and any financial incentives or benefits it may gain.

Come up with a name. A corporation’s name can generally be any name, but typically it can’t be a name that’s already in use by another company that’s registered in the same state.

Obtain a federal employer identification number (EIN). The EIN is like a company’s Social Security Number Most corporations are required to pay taxes, and need to request a federal employer identification number from the IRS.

Select directors. Depending on the state where you’re forming your corporation, you may be required to select a board of directors who will oversee the company and its interest. In publicly traded corporations, the board of directors are typically supposed to represent the interests of the company’s shareholders. Some states also require corporations to have a certain minimum number of people on their board.

File articles of incorporation. These are filed with the state’s secretary of state and may sometimes be known as “certificates of incorporation” or “charter.”

Depending on the kind of business, and your familiarity with the regulations, it may be helpful to consider hiring a professional, such as a business counselor or attorney, to make sure you meet all requirements necessary to forming a corporation.

How does a corporation work?

A corporation is a legal designation that assigns a company a specific ownership structure. Once a company incorporates (aka goes through the process of becoming a corporation), the assets and liabilities of that company become legally separated from the people who own it. This means that if the corporation takes on debts or faces a situation like a lawsuit, only the corporation itself is liable — It generally can’t make a claim to the personal assets of the owners if the corporation is unable to pay its debts.

It may help to see how this differs from the way other ownership structures work. For example, in a limited partnership structure, one general partner typically takes on unlimited liability, while all other partners have limited liability. (Think of a small law firm or a private medical practice with several doctors.) The profits of a limited partnership are generally “passed through” to the partners, meaning each partner pays personal income tax on their portion of profits, which are usually outlined in a partnership agreement.

Or consider a sole proprietorship, another type of ownership that’s generally meant for a business with a single owner. (Think of a hairdresser or a musician running a one-person business.) In a sole proprietorship, the owner is still legally tethered to their business, which means that if the company is unable to pay off its business loans through its own profits, the owner’s personal assets could be at risk of seizure.

In some circumstances, a company might choose to combine multiple structures, so that their ownership follows one model while their tax obligations follow another (e.g. an LLC following the tax requirements of a corporation). But this approach is less common and can be difficult to set up.

What are some of the different types of corporations?

When you think of a typical corporation, it’s common to think of a large company like Walmart or Apple. But in fact, those large companies are one of several types of corporations out there. While they share some things in common — For example, most businesses are required to register with their local and federal governments. That said, each type of corporation looks a bit different when you look under the hood, with different regulations about what taxes to pay, how to report their finances, and how large they can grow. These rules can vary depending on the state in which the company is located.

Here are the most common types of corporations:

C corporations (C corps) are what we might often think of when we think of a “corporation” — They can include a wide range of companies, such as a local grocery chain or giants like Google or Amazon. C corps generally offers owners more protection than other ownership structures, in the sense that the law treats it as a completely separate entity from the people who own it. This benefit can also come with a higher cost. For example, a C corps’s profits can be taxed twice: first on its corporate profits, and again if it pays any dividends to shareholders. The C corps structure allows owners to sell shares of the company, so it may be appropriate for a business that may want to go public some day.

S corporations (S corps) are like the cousin of the C corps — They’re similar in that S corps are also treated as a separate entity independent of its owners. But there are a few important differences. For one, an S corps cannot have more than 100 shareholders. In most states, the profits of an S corps can be “passed through” to the owners’ personal income, meaning they aren’t subject to an additional corporate tax as is the case for many C corps. In order to get S corps status, a company must file an application with the Internal Revenue Service, a process separate from registering with the local or state government.

B corporations (B corps) are for-profit businesses that are also driven by a mission, which means that they’re generally required to demonstrate both profit and public benefit. They’re generally taxed in the same way C corps are. In some states, B corps are required to file an annual report not only disclosing its finances but also how it carried out its mission.

Close corporations are similar to B corps, but they tend to be smaller companies and typically can’t be traded publicly, though this too depends on the state.

Nonprofit corporations generally include organizations that are solely mission-driven, such as charities and certain religious or academic institutions. Nonprofits are tax exempt — They aren’t required to pay taxes on its profits, but they are required to follow specific rules that govern how they can spend their profits. For example, nonprofits can’t pay dividends or donate to political campaigns. They’re also called 501(c)(3) corporations, in reference to the IRS tax code that exempts them.

What are some advantages of corporations?

Corporations are treated as an entirely separate, distinct legal entity from the person or people who own it. This separation offers a pretty significant advantage over some other kinds of ownership structures: If the company is in debt or faces another liability, like a lawsuit, its owners can be protected from risk to a certain degree.

It might help to think about this in the context of another type of ownership structure. Take a sole proprietorship, for example. Under a sole proprietorship, a business is still tethered to its owner; in the eyes of the law or tax agencies, the business and owner are not seen as two distinct entities. That means the owner can be personally liable for their company’s debts or liabilities.

By contrast, owners of a corporation have limited liability, which means if the company is in debt or faces legal trouble, the company alone is responsible. Its owners can only be held liable for their investment in the company — Their personal assets would otherwise remain separate and thus protected from that risk.

Many corporations (namely C corps) can also operate independent from their shareholders, meaning if one or more leaves the company or sells their shares, the business could go on. Aside from their independent structure, many types of corporations can sell shares to a larger pool of investors, even on the public market, which can be important for a business that intends to grow and sustain over a long period of time.

What are some disadvantages of corporations?

While the independence of many corporations can offer certain protections and benefits for owners, the structure isn’t ideal for everyone. One potential drawback is that forming a corporation can cost more than other ownership structures. Some corporations may also have to pay taxes twice. First, the corporation itself may have to pay taxes on its profits; and second, if the corporation pays dividends, shareholders may have to pay again as part of their personal income tax.

In addition to being potentially costlier, corporations can require more work to operate and maintain. They’re often subject to financial reporting and record-keeping requirements that are more extensive than other types of ownership structures.

What is the difference between a corporation and a company?

A company is a generic term that refers to a wide variety of commercial businesses, like a bread company or a shipping company. A company might be a one-person operation, like an accountant with their own firm, or it could be a large international enterprise with millions of employees.

This is different from a corporation, which is a special legal designation that assigns a company a specific ownership structure. A company’s owners can go through the process of “incorporating” to legally separate the business from their personal assets, which can offer the owners some degree of protection against legal or financial liability, depending on the chosen ownership structure (e.g. corporation, LLC, sole proprietorship).

Here’s another way you might think of it: a corporation is one type of company that is structured to be treated as an entity separate from its owners.

How does a corporation end?

A corporation can end either voluntarily or involuntarily. If it’s voluntary, a corporation may decide to close down through a vote of its shareholders, after which it would typically need to notify the Secretary of State or follow a certain set of court orders. In some cases, corporations can end involuntarily through a government action, which often results from failing to pay its taxes or debts to creditors. Voluntary or not, a corporation that’s shuttering usually goes through a process of liquidation, in which its remaining assets are sold in order to settle remaining debts.

Disclosures: Information presented here is for informational purposes only and is not to be construed as tax or investment advice. Further, the mention of individual companies is not a recommendation to transact in any security.

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