Questions Frequently Asked About Corporations

Should my new business be organized as a corporation, a partnership or some other form of business entity?

Choosing a form of business entity depends to some extent on the type of business and the objectives of the founders. Corporations are the most popular and familiar form of business entity and have a number of advantages, including limited liability, separate and continuing existence and centralized management; their disadvantages include increased regulatory requirements and the need to observe corporate formalities. While limited partnerships offer some of the same advantages, as well as greater flexibility in some respects, business persons and the public are often more comfortable dealing with corporations.

What is an S corporation and how does my business become one?

An election to be treated as an S corporation permits a corporation to be taxed generally in the same manner as a partnership the tax attributes of income, losses, deductions and credits are passed through to the corporation’s stockholders. Under this tax treatment, the business avoids the “double tax” imposed on the earnings of C corporations and on the sale of C corporations’ appreciated assets. The term “double tax” refers to the tax payable first by the corporation relating to its profits and then by the stockholders upon any distribution of earnings or proceeds. In an S corporation, only one level of tax, payable by the stockholders, is imposed on the corporation’s profits. To become an S corporation, all the stockholders must sign Treasury Form 2553, which must be filed with the Internal Revenue Service (IRS) on or before the fifteenth day of the third month of the corporation’s taxable year in order for the election to be effective for that year.

How much money should/must I put into my corporation for its initial capital?

While a minimum level of initial capitalization is important to ensure that the corporation will be respected as a separate legal entity, there is no fixed dollar level especially if the business is properly insured against the risks normally attendant to its activities. Rather, the founders should look to the requirements of their business plan and put in (or reserve) the amount of money necessary to achieve their initial goals. This may mean setting aside enough money to both set up the business and let it operate until it begins to achieve positive cash flow or matures enough to seek an outside source of funding. Unless the founders confront this issue up front, usually through a detailed business plan, the business may quickly hit a cash crunch that may change the balance of power among the founders or, if there is no more cash to be found, sink the business.

Should our investments in the business be structured as debt or as equity?

The answer again depends on the corporation’s level of capitalization. If the IRS deems a corporation to be too thinly capitalized and if the debt has certain other characteristics, the IRS may re-characterize debt to stockholders as equity-resulting in the loss of deductions to the corporation (e.g., the normally tax-free repayment of principal would be treated as a taxable dividend). But within the guidelines for an appropriate level of capitalization, there may well be advantages to the stockholders and the corporation from dividing their investment between debt and equity. Furthermore, because of the roles to be played by the founders and their differing levels of wealth, some founders may contribute more cash (while others bring technical expertise, etc.), even though the founders consider themselves equal “partners.”

Is a business plan really necessary?

A business plan provides an important road map of how a business should be run and what it will need to earn a profit, as well as being used for evaluating and fine-tuning the business after it is established. Although many entrepreneurs regard a business plan as a selling document they need only when courting a bank or investor, the exercise of researching and writing a detailed plan before a business is launched is crucial to the ultimate success of the business. Having said that, there are many successful businesses that were launched without a detailed business plan and many excellent business plans that produced failed businesses. The plan is more a matter of process than result; the exercise serves to reduce risk, or at least allow the founders to acknowledge risks, by critically examining all aspects of the idea.

Should I authorize preferred stock in my charter?

It is often a good idea to authorize “blank check” preferred stock in the articles of organization. This is a class of stock that is labeled “preferred” but has no specified terms. A provision in the charter expressly authorizes the board of directors to set the terms of this stock (such as voting rights, conversion features, special covenants, dividends, redemption rights, etc.) and file a charter amendment creating different series of preferred stock. A blank check provision will allow the company to negotiate with sophisticated investors (such as venture capitalists) for an infusion of capital without requiring a stockholder vote. However, remember that the issuance of preferred stock will immediately terminate the company’s status as an S corporation.

Should the founders sign a stockholders agreement?

In most cases, especially if the corporation has elected to be an S corporation, some form of stockholders’ agreement is in everyone’s best interest. At a minimum, the agreement provides a framework to preserve an S election and provide for the payment of taxes; it should also address delicate questions such as the death, divorce, insolvency or incapacity of a stockholder and also address the particular concerns of the founders, such as board seats, rights of first refusal, call rights and voting arrangements.

Why are so many corporations formed in Delaware?

For many years Delaware had one of the nation’s most permissive and flexible corporation statutes from the standpoint of management. While many such provisions have since been adopted by other states, including Massachusetts, there are a few distinct advantages to incorporating a non-local business in Delaware. A very practical advantage is Delaware’s provision allowing stockholder actions to be taken by majority written consent; in Massachusetts written stockholder actions must be unanimous so that sometimes a formal meeting must be called and held to accomplish a stockholder action. Delaware also has a highly developed body of corporate legal decisions and somewhat lower filing fees.

What are blue sky laws and do I have to worry about them?

Blue sky laws are the state securities laws that govern the offer and sale of securities, including equity and debt of start-up companies. The laws generally apply to the offer and sale of securities to the residents of a given state. Before beginning efforts to raise capital, the business founders should consult an attorney to advise them on the available exemptions and the requirements of each state in which the company intends to offer its securities. Most states will permit offerings to a limited number of residents, but may impose information and filing requirements on the offer or.

Should I obtain director and officer insurance for my business?

Director and officer insurance can be very comforting to your directors (especially if outside directors) and officers but can be expensive or even unavailable to new businesses. While the business is closely held, many of the concerns your directors and officers may have can be addressed by ensuring that the corporation is properly capitalized, observes all corporate formalities, has proper ordinary liability insurance and has adopted, in the corporation’s charter or bylaws, the broadest available indemnity and exculpation provisions. In addition, some companies choose to sign indemnity agreements with each director that go somewhat further than the charter or bylaw provisions and give the director a right of action against the corporation, should he or she suffer damages as a result of his or her service as a director.