Encyclopedia of Business and Finance | Corporations

A business corporation is a legal entity permitted by law in every state to exist for the purpose of engaging in lawful activities of a business nature. It is an artificial person created by law, with many of the same rights and responsibilities possessed by humans. Corporations are widely prevalent in the United States; today, virtually every large enterprise is a corporation.

RIGHTS AND PRIVILEGES OF A CORPORATION

Within legal guidelines, corporations may issue stock, declare dividends, and provide owners with limited liability.

Stocks A corporation can issue and attempt to sell stock. Every share of stock owned represents a share of the corporation's ownership.

From the standpoint of stock sale, there are two kinds of corporations: public and private. With a public corporation, anyone can buy shares of stock, which may very well be traded on a stock exchange. With a private corporation, however, sale of stock may be limited to stipulated persons, such as members of the principal stockholder's family.

A corporation can own "treasury stock"; that is, it may repurchase its own stock that it had previously issued and sold.

A corporation may even give its stock away for any reason; for example, as a donation to a charity, or as a reward to employees for industrious service.

Dividends A corporate board of directors has the authority to declare and pay dividends in the form of cash or stock. Cash dividends are ordinarily payable from current net income, although net income "kept" from previous years may also be used. A common name for net income kept is "retained earnings." Recipients of stock dividends receive shares of stock in the corporation, thereby increasing the total number of shares they own. Stock dividends are declared from capital stock that has been authorized but not issued.

Rules exist regarding eligibility for receipt of a dividend. For example, assume that a cash dividend is declared on August 15, payable on September 15. If Stockholder A owns the stock on August 15, he or she receives the dividend on September 15. If Stockholder A sells the stock on August 27, Purchaser B buys it "ex-rights," meaning that on September 15 the dividend still goes to Stockholder A. Purchaser B would not receive a dividend until the next one is declared, perhaps on November 15.

Recipients of cash dividends pay income tax as of the year the dividends are received. Income tax on stock dividends, however, is postponed until the recipients sell the stock.

Occasionally, corporations split their stock. However, this does not change the value of the shareholder's shares on the corporation records or the corporation's net worth.

A stock split is often a good sign as it is often done to reduce the price of a stock that has risen to a point at which its marketability is impaired.

Limited Liability If a corporation suffers large financial losses or even terminates its existence, the shareholders might lose part or all of their total investment. However, that is ordinarily the extent of their loss. Creditors cannot satisfy their claims by looking to the personal assets of corporate shareholders as they can with a sole proprietorship or an ordinary partnership.

Limited liability can be advantageous because it encourages investment in the corporation. With personal assets of $1.1 million, a potential investor might willingly invest $50,000 in a corporation knowing that no risks exist beyond the $50,000.

The limited liability advantage, however, can be lost if the owners directly engage in the company's management and play an influential role in causing corporate losses.

Additional Rights of a Corporation Corporations have the basic right to conduct a business in which they sell products or services and to engage in either a profit-seeking or a nonprofit-seeking enterprise.

Corporations have the right to own, sell, rent, or lease real or personal property.

Corporations may sue other business entities, such as another corporation, a partnership, or a sole proprietorship.

Corporations may merge with other corporations.

Example of Stock Split

2 for 1 Stock Split	Smith, A Shareholder Owns	Value of Smith's Shares on Corporation Records
		Per Share	Total Value
Before	100 shares	$80	$8,000
After	200 shares	$40	$8,000

Corporations may make contracts with either another business or a person.

Corporations may hire or discharge employees of any rank, from entry-level employees to the chief executive officer (CEO).

Corporations may borrow money, and they often do so by issuing corporate bonds. Owning a corporate bond does not grant the bondholder any form of ownership in the company. Instead, corporate bondholders have actually loaned money to the corporation, virtually always with a stated interest rate and with terms regarding dates and methods of repayment. Bondholders may ordinarily sell their bonds to other persons, most often through stockbrokers.

In addition to issuing bonds, corporations may borrow directly from any loan source, such as banks. On occasion, corporations raise needed cash by authorizing and selling additional stock.

Corporations may make any lawful investment. They often invest in the stock and/or bonds of other corporations, personal or real property, mutual funds, money market accounts, certificates of deposit, and government securities.

REQUIREMENTS OR LIMITATIONS OF A CORPORATION

Corporations are subject to risk, to suits, and to income tax liabilities.

Risk By engaging in business activities, corporations are at risk, great or small. Profit-seeking corporations may very well find the large profits they seek. But they risk huge economic losses and even bankruptcy.

Suits Corporations may be sued by any business, including other corporations. And they may be sued by individuals or groups of persons.

Income Tax Corporations must pay federal and state income taxes on the net profit they make during a calendar or fiscal year. People who receive cash dividends must also pay income tax for the year they are received. Thus it is often said that corporation profits are subject to double taxation. Corporations receive no deduction for any cash dividends that they pay. Recipients of stock dividends, however, postpone payment of income tax on stock dividends until they sell the stock.

REGULATION OF CORPORATIONS

Corporations are subject to two kinds of regulation: (1) regulation by the state in which they are incorporated and (2) regulation by the individual corporation's articles of incorporation and bylaws.

State Regulation Corporations are regulated by business corporation laws that exist in all fifty states. Although the statutes prescribe what corporations may and may not do, they are written in broad and general language. In essence, then, the states permit articles of incorporation to be written in a manner that permits corporations to engage in business for almost any legal purpose.

Articles of incorporation are filed publicly and are available to the public. They are subject to amendment. Bylaws are not filed publicly. Consequently, they tend be more detailed than articles of incorporation.

Board of Directors Members of the board of directors make the major decisions of the corporation. When corporations are formed, they draw up Articles of Incorporation, usually for approval by shareholders. The board of directors also draws up the initial and ensuing bylaws.

Board members are most often shareholders and officers of the corporation. They are elected by the shareholders. They may be "internal" directors or, for reasons of good public relations or of obtaining of expertise, may work on the "outside" and be selected on the basis of their prominent role in the community.

Policies made by the board of directors are carried out by the corporation's executives, who direct the work of employees under their jurisdiction.

CLASSES OF STOCK

Corporations ordinarily have two classes of stock:(1) common and (2) preferred. The two classes differ in many respects but both also share a number of common characteristics. There is no limit to how many classes of stock a corporation may have.

Common Stock Common stockholders participate more in the governance of a corporation than do preferred stockholders. This is accomplished by giving common stockholders the right to vote for members of the board of directors as well as on major decisions (e.g., a merger with another corporation). Common stock, however, can be issued without voting rights.

Cumulative voting, which permits shareholders to cast one vote for each share of common stock owned in any combination, is prevalent. In an election for members of the board of directors, for example, a shareholder owning 2000 shares of common stock could cast all 2000 votes for one candidate or divide them in any way among candidates (e.g., 400 votes each for five candidates). Cumulative voting offers some protection for smaller stockholders.

The market value of common stock tends to fluctuate more than that of preferred stock.

Preferred Stock Preferred stockholders are not ordinarily granted the voting rights given to common stockholders. They cannot participate in elections for members of the board of directors or in major decisions of the corporation.

However, preferred stockholders are almost always given prior rights over common stockholders in the matter of dividends.

Dividends for preferred stockholders are often stated in advance and do not tend to fluctuate as much as those for common stock. Preferred dividends may be stated as a percentage of par value or as a dollar amount per share.

However, preferred dividends are not guaranteed in the same sense as is bond interest. Neither preferred nor common stock dividends can be paid without approval of the board of directors. And boards may "skip" declaring dividends if the directors feel the financial situation so warrants.

Preferred stock is often "cumulative." With this provision, a preferred stock dividend that is not declared or paid is considered to be "owed." As long as the preferred dividend is "owed," no common stock dividend may ordinarily be declared or paid. But even if the preferred stock is not cumulative, a frequently applied policy is that common stock dividends cannot be declared as long as the preferred dividends are "in arrears."

Sometimes preferred stock is "convertible." Shareholders who own convertible preferred stock may, at a price announced when the stock is purchased, turn in their preferred stock and receive common stock in its place. Assume, for example, that an investor purchases preferred stock at $36.50 per share. The stock is convertible four years from its issuance at a ratio of 3:1; that is, three shares of preferred stock can be traded at the shareholder's option for one share of common stock. At the 3:l ratio, after discounting any related transfer costs, the preferred stockholder would find it profitable to convert if the common stock value rises above $109.50 per share ($36.503).

Preferred stock may be "callable." At the option of the corporation, callable preferred stock may be surrendered to the corporation, usually at a price a little above par value (or a stated value). If the stated value is $50, the callable price on or after a specified date might be $51.25. If the stock's market value rises to, say, $55, it might be profitable for the corporation to call for its surrender.

Occasionally preferred stock is given the right to "participate" with common stock in being granted dividends above a stated value. For example, assume the board of directors declares a regular preferred stock dividend at $3 per share and a common stock dividend at $13 per share. With participating rights, it would have been stipulated that preferred stockholders would receive $1 per share more for every additional $5 given to common stockholders.

If a corporation closes down its operation, preferred stockholders have prior claim over common stockholders upon dissolution of the assets. A sufficient amount of the corporation's assets would need to be turned over to the preferred stockholders before common stockholders could claim any part of the assets. In practice, however, assets of a closed-down corporation are rarely sufficient to pay off the preferred shareholders in full.

RELATED FORMS OF BUSINESS OWNERSHIP

Five types of business entities have regulations similar to those of corporations.

Professional Corporations Professional corporations, organized under corporation laws of their respective states, involve incorporation by persons engaged in professional practice, such as medical doctors, lawyers, and architects. They are granted limited liability against claims from their clients, except for malpractice.

Not-for-Profit Corporations Not-for-profit corporations, formed under the nonprofit laws of their respective states, have members instead of stockholders. Any income made cannot be distributed to the members.

Some apply to the Internal Revenue Service for tax-exempt status, becoming "501(c)(3)" organizations, which permits donor gifts to be declared tax-deductible.

Closed Corporations Closed corporations, not permitted by statute in all states, limit shareholders to fifty. They permit the firm to operate informally either by eliminating the board of directors or curtailing its authority. Closed corporations also restrict transferability of the owners' shares of stock.

Limited-Liability Companies Limited-liability companies enjoy the benefits of limited liability while being taxed like a general partnership. Owners' net income is taxed at an individual personal rate rather than at the rate of a corporation (taxation of both corporate net income and dividends).

Not all states permit formation of limited liability companies. They are neither a partnership nor a corporation. They generally have a limited life span. Management must be by a small group. States do not restrict the number or the type of members. Unlimited transferability of ownership is not permitted.

S Corporations S corporations' major benefit is that they are taxed like partnerships. The owners' income tax is based on their share of the firm's total net income, whether or not it is distributed to them. The second huge benefit is limited liability.

However, an S corporation is limited to thirty-five shareholders, none of whom can be nonresident aliens. Only one class of stock may be issued or outstanding. The S corporation may own only 80 percent of a subsidiary business firm.