Chapter 2

How Corporations Work

 

Kinds of Corporations................................................................................ 36

Nonprofit Corporations.......................................................................... 36

Professional Corporations.................................................................... 38

The Close Corporation........................................................................... 40

The Business Corporation.................................................................... 41

Corporate Statutes...................................................................................... 41

Business Corporation Act..................................................................... 41

Other Laws............................................................................................... 42

Corporate Filing Offices............................................................................. 43

Corporate Documents................................................................................ 43

Articles of Incorporation......................................................................... 43

Bylaws...................................................................................................... 44

Stock Certificates.................................................................................... 45

Minutes of the First Directors’ Meeting................................................ 45

Corporate Powers....................................................................................... 45

Corporate People........................................................................................ 46

Incorporators............................................................................................ 46

Directors................................................................................................... 47

Officers..................................................................................................... 59

Shareholders........................................................................................... 61

Capitalization of the Corporation............................................................. 63

Sale and Issuance of Stock...................................................................... 65

How Many Shares Should You Authorize?....................................... 65

Par Value States..................................................................................... 66

Payments for Shares.............................................................................. 68

Stock Issuance and Taxes.................................................................... 68

Stock Issuance and the Securities Laws................................................ 70

State Securities Law............................................................................... 70

Federal Securities Laws........................................................................ 76

 

This chapter introduces you to the structures, procedures, and legal rules you need to know to form a profit-making corporation and keep it running.

To help you understand where a business corporation fits in the corporate landscape, we begin by briefly describing other types of corporations, including nonprofit, professional, and close corporations. Then we cover the basic legal paperwork and procedures that you must undertake to form and operate a business corporation, including the issuance of shares to your initial shareholders. This background information will help you follow the specific instructions we provide in the later chapters for preparing corporate articles, bylaws, and minutes, and making your first stock issuance. This chapter also helps you understand any corporate or securities statutes you may wish to browse in your state’s Business Corporation Act or Securities Act.

Understanding and paying corporate taxes is covered in the next chapter, Chapter 3.

 

Kinds of Corporations

State law classifies and regulates different types of corporations. This book shows you how to form a business corporation (a few states call it a “profit corporation”). Essentially, a business corporation is one that engages in any lawful business that is not specially regulated under state law (such as the insurance, banking, or trust business).

Before discussing the rules that apply to busi­ness corporations—the type most readers of this book will want to form—let’s look at a few other types of corporations that are set up and operated under special state rules. You must follow unique procedures to form one of these types of corporations, which are not covered in this book.

 

Domestic Versus Foreign Corporations

When browsing your state’s corporate statutes, you may run into the terms domestic corporation and foreign corporation. A domestic corporation is one that is formed under the laws of your state by filing articles of incorporation with the state’s corporate filing office. A corporation that is formed in another state, even though it may be physically present and doing business in your state, is classified as a foreign corporation in your state’s corporation statutes. In this context, foreign means out of state, not out of the country.

 

Nonprofit Corporations

A nonprofit corporation (in some states called a not-for-profit corporation) is formed under a state’s Nonprofit Corporation Act for nonprofit purposes. In other words, its primary purpose is not to make money for its founders, but to do good work—for example, to establish child care centers, shelters for the homeless, community health care clinics, museums, hospitals, churches, schools, or performing arts groups. Most nonprofits are formed for purposes recognized as tax-exempt under federal and state income tax laws. This means that the nonprofit doesn’t have to pay corporate income tax on its revenues, that it is eligible to receive tax-deductible contributions from the public, and that it qualifies to receive grant funds from other tax-exempt public and private agencies.

State law as well as federal tax-exemption requirements typically prohibit a nonprofit corporation from paying out profits to nonprofit members, except in the form of reason­able salaries to those who work for it. When a nonprofit dissolves, the members are normally not allowed to share in a distribution of the nonprofit’s assets. Instead, any assets remaining after the nonprofit dissolves must be distributed to another tax-exempt organization. Special types of nonprofits may be recognized under state law that allow people to own, in one fashion or another, corporate assets, so they can receive a portion of these assets when the nonprofit dissolves. For example, a nonprofit homeowners’ association or nonprofit trade group may give each member a proprietary interest in the assets of the nonprofit. But these special nonprofits do not enjoy the same benefits as a qualified tax-exempt nonprofit. They may be eligible for an income tax exemption, but they normally do not qualify to receive tax-deductible contributions or public or private grant funds.

Nonprofit corporations, like regular business corporations, have directors who manage the business of the corporation. The nonprofit corporation can also collect enrollment fees, dues, or similar amounts from members. Like regular corporations, a nonprofit corporation may sue or be sued; pay salaries; provide various types of employee fringe benefits; incur debts and obligations; acquire and hold property; and engage, generally, in any lawful activity not inconsistent with its nonprofit purposes and tax-exempt status. It also provides its directors and members with limited liability for the debts and liabilities of the corporation and continues perpetually unless steps are taken to dissolve it.

There are key differences between forming and operating a nonprofit and a regular business corporation:

• To form a nonprofit, in most states you must file special nonprofit articles of incorporation. These are normally available for downloading from your state corporate filing office website. (See your state sheet for contact information.)

• Nonprofit bylaws typically contain provi­sions similar to those of business corpo­ra­tions. However, nonprofits typically set up a number of special committees to handle nonprofit operations, and nonprofits routinely schedule more frequent meetings of directors than their commercial counterparts. Also, nonprofits replace shareholder provisions with member provisions, which specify the rules for membership meetings and the qualifi­cations, responsibilities, and rights of members. Of course, nonprofit bylaws do not contain provisions relating payouts of profits (payment of dividends). The state Nonprofit Corporation Act typically follows or is in close proximity to the state Business Corporation Act in the corporate statutes. So you can usually use the citation to your state’s Business Corporation Act to help you locate the Nonprofit Corporation Act. (A few states include nonprofit as well as business corporation statutes in a consoli­dated General Corporation Act.) See Appendix A for information about locating corpo­rate laws.

• A critical part of forming and operating a nonprofit is obtaining a federal and state income tax exemption and making sure to operate the nonprofit in a way that meets the tax exemption requirements. The requirements for obtaining a state income tax exemption should be posted on your state tax agency website. (See Appendix A.)

 

related topic

For more information about nonprofit corporations. For all the forms and instructions you need to organize a nonprofit corporation in your state, including step-by-step instructions on preparing nonprofit articles and bylaws and applying for and obtaining your federal 501(c) (3) nonprofit tax exemption, see How to Form a Nonprofit Corporation, by Anthony Mancuso (Nolo). (California readers should see Nolo’s How to Form a Nonprofit Corporation in California, also by Anthony Mancuso.)

 

Professional Corporations

Most states have special requirements for forming a corporation whose owners will provide state-licensed professional services. The list of particular professions to which these rules apply varies from state to state, but typically lawyers, doctors, other health care professionals, accountants, engineers, and architects must follow these special rules when they incorporate. Other professionals ranging from acupuncturists to massage therapists may also be included.

 

tip

How to find out whether you must form a professional corporation. If you plan to form a corporation to render professional services, check your state’s corporate filing office website (see Appendix A) to see what professions must incorporate as professional corporations. If this information is not posted, send the office an email asking if your profession must incorporate as a professional corporation. If your profession is not on the state’s professional corporation list, you can establish a regular business corporation—the type this book shows you how to form.

 

If your profession is on the professional corporation list in your state, you must file special professional corporation articles of incorporation to form your corporation, not the standard articles for a business corporation discussed in this book. In many states, profes­sional corporation articles are available for downloading from the corporate filing office website. (See Appendix A for information on how to find your state’s website.)

In addition to the rules set out in this book that apply to business corporations, the following rules and requirements typically also apply to the formation and operation of professional corporations:

• The name of a professional corporation normally must include a special designator such as “Professional Corporation,” “P.C.,” or the like, and must meet any additional professional business name requirements imposed by the state licensing board that oversees the profession.

• In addition to professional corporation articles, you may be required to file a certification from the state licensing board showing that all shareholders hold current professional state licenses.

• Generally, the corporation must be formed to render only one professional service, but some professions are allowed to form a corporation to render more than one professional service in related fields. For example, a licensed surgeon may be allowed to incorporate a professional corporation together with a licensed orthopedist.

• The corporation must render professional services only through licensed members, managers, officers, agents, and employees.

• Each licensed professional must carry the amount of liability insurance specified under the rules that apply to the profession.

• Generally, licensed shareholder/employees of professional corporations remain personally liable for their own negligent or wrongful acts, or acts of those under the professional’s direct supervision or control, when performing professional services on behalf of the corporation. The limited liability shield of the corporation does, however, normally protect professionals from personal liability for the negligent acts of other professionals in the incorporated professional practice. (And, as for other corporations, the liability shield protects professional shareholders from personal liability for the regular commercial debts and other business liabilities of the corporation.)

 

Professionals That May Have to Incorporate Under Special Rules

Here is a typical list of professions that must incorporate as professional corporations, rather than as regular business corporations, in many states: Accountant Acupuncturist Architect Attorney Audiologist Clinical social worker Dentist Doctor (all medical doctors including surgeons) Marriage, family, and child counselor Nurse Optometrist Osteopath (physician or surgeon) Pharmacist Physical therapist Physician’s assistant Podiatrist Psychologist Shorthand reporter Speech pathologist Veterinarian

 

The Registered Limited Liability Partnership (RLLP): An Alternate Choice for Professionals

All states allow certain professionals to form a Registered Limited Liability Partnership (RLLP). The RLLP is similar to a regular general partnership, legally and for tax purposes, but it also provides each RLLP partner with the limited liability protection of a professional corporation. Specifically, like a professional corporation, the RLLP gives its partners immunity from personal liability for the malpractice of other partners in the firm—though each professional partner remains personally liable for that partner’s own negligence. The RLLP also may protect its owners from personal liability for the regular commercial debts and other liabilities of the business, depending on state law. Owners of an RLLP are taxed individually on business profits (like sole proprietors or nonprofessional partners), while a corporation is a separate taxable entity. If you are considering incorporating a professional practice but may prefer pass-through taxation of business profits, give the RLLP your consideration (and consult your tax adviser). Forms and instructions for creating an RLLP should be available from your state’s corporate filing office website. (See Appendix A.)

 

 

caution

Flat corporate income tax rate for certain professionals. Whether you form a regular business corporation or a professional corporation to render professional services, an important IRS tax provision may apply to you. Specifically, Internal Revenue Code §§ 11(b)(2) and 448(d)(2) provide that professionals engaged in the fields of health, law, engineering, architecture, accounting, actuarial science, or consulting are subject to a flat 35% federal corporate income tax rate. This rate is applied to any taxable income left in the corporation—that is, income not paid out as salary or fringe benefits to the professionals and other employees of the corporation—at the end of the corporation’s tax year. In other words, these professionals, unlike the owners of regular business corporations, do not enjoy the benefit of keeping taxable income in the corporation at the lower corporate income tax brackets of 15% to 25%. (See Chapter 3.) For this reason, professionals who expect to retain income in their corporation often prefer to organize themselves as an RLLP to obtain limited liability protection and avoid the flat 35% corporate tax. Income earned in an RLLP, as in a partnership, passes through the entity and is taxed at regular individual income tax rates of the owners, which may be lower than the flat 35% professional tax rate.

 

The Close Corporation

Many states have enacted laws, usually as part of their Business Corporation Act, that allow for the organization of a special type of business corporation, called a “close corpo­ration” or “statutory close corporation.” These laws permit corporations with a small number of shareholders—usually no more than 35—to operate without a board of directors according to the terms of a specially prepared share­holders’ agreement. In other words, the owners of a close corporation can dispense with normal corpo­rate formalities and operate their corpo­ration under a shareholders’ agreement, similar to the way in which owners of a partnership operate their business under the terms of a partnership agreement.

 

Close Versus Closely Held Corporations: Confusing Legal Jargon Made Simple

Don’t confuse the legal term “close corporation,” discussed in this section, with the term “closely held corporation.” The latter is a loosely used business term, not found in corporate statutes. Closely held corporation is usually used to describe any small, privately held corporation owned and operated by a closely knit group of founders, such as a family or small group of business associates. Put another way, a closely held corporation is simply an incorporated small business, not one that has adopted special rules allowing shareholders to proceed without corporate formalities. However, the term closely held corporation does have a special tax meaning. Under Internal Revenue Code §§ 469(j)(1), 465(a)(1)(B), and 542(a)(2), a closely held corporation is defined as one where more than 50% of the value of the corporation’s stock is owned by five or fewer individuals during the last half of the corporation’s tax year. This special tax classification has no connection to state corporate statutes.

 

Operating a close corporation under a share­holders’ agreement can provide business owners with a great deal of flexibility. For example, the shareholders’ agreement can dispense with the  need for annual director or share­holder meetings, corporate officers, or even for the board of directors itself, allowing share­holders to manage and carry out the business of the corporation without having to put on their director or shareholder hats. And, as in a partnership, profits can be distributed without regard to capital contributions (stock ownership); thus a 10% shareholder could, for example, receive 25% of the profits (dividends). Special tax rules apply to this sort of special allocation of business profits; your tax adviser can fill you in on the details if you want to know more.

Despite the benefits of informality and flexibility, most incorporators don’t want to form close corporations. Indeed, it is estimated that less than 2% of all business corporations are formed as close corporations. Why hasn’t the close corporation business form caught on in the states that allow it? There are a number of reasons.

To begin with, most incorporators do not want to operate their corporation under informal or nonstandard close corporation share­holder agreement rules and procedures. In fact, many incorporators form a corporation to rely on the traditional corporation and tax statutes that apply to regular business corporations. (By doing so, they know what is expected of directors, officers, and share­holders—for example, they can simply follow the rules set out in their state Business Corporation Act to call and hold meetings of directors and shareholders without having to design their own procedures.) Second, shares of stock in a close corporation normally contain built-in restrictions on transferability, and most incorporators do not want their shares to be restricted in this way. Third, it is costly and time-consuming to prepare a shareholders’ agreement. It’s much simpler and less expensive to adopt standard corporate bylaws.

 

related topic

For more information about close corporations. Your state corporate filing office website should tell you whether you can form a close corporation in your state and, if so, how to do it. Typically, you must add special provisions to your articles of incorporation to elect close corporation status, prepare and adopt a special shareholders’ agreement that follows the requirements set out in your state’s Business Corporation Act, and prepare special stock certificates that contain language that limits the transfer of the shares represented by the certificate.

 

The Business Corporation

This is the type of corporation that this book shows you how to form. In the remainder of this chapter we’ll review the statutes (laws), required documents, state offices, and other features on the legal landscape you’ll encounter on your way to forming your own business corporation.

 

Corporate Statutes

Each state has many laws that regulate the organization and operation of a business corpo­ration. The portion that governs most areas of corporate operation is the state’s Business Corpo­ration Act (BCA). Appendix A explains how you can locate your state’s corpo­rate statutes online. This section simply provides a summary of how the state BCA and other business laws will affect your corporate life and tells you how to locate the laws if you need to look something up.

 

Business Corporation Act

Most of the laws that govern corporations are contained in your state’s business corporation statutes, usually titled the “Business Corpo­ration Act” (BCA) or “Business Corporation Law.” The BCA spells out the essential rules for forming and operating a corporation. For example, the BCA explains the requirements for preparing and filing articles of incorporation to form the corporation, the rules for prepar­ing and changing corporate bylaws, and the basic rights and responsibilities of corporate directors, officers, and share­holders. The BCA explains when and how directors and share­holders meet to approve corporate decisions, and how much leeway a corporation has in setting its own rules that vary from the BCA requirements. We cover BCA director, officer, and shareholder rules in more detail in the remaining sections of this chapter.

 

The Model Business Corporation Act

The basic corporate statutes of many states contain the same, or quite similar, rules for organizing and operating business corporations. The reason for this uniformity is that a number of states have adopted some, most, or all of the provisions of a standard law: the Model Business Corporation Act. The Act undergoes periodic changes, which states are free to enact

 

Other Laws

In addition to the Business Corporation Act, other state laws regulate special areas of corporate activity. These include the following.

Securities act or blue-sky law. This law contains each state’s rules and procedures for offering, issuing, selling, and transferring shares of corporate stock and other securities within the state. The term “blue-sky law” is derived from the sometimes underhanded, and often colorful, practices of corporate con artists who, in return for an investment in their latest get-rich-quick undertaking, would promise the “blue sky” to unsuspecting investors. The securities laws of each state attempt, through registration and disclosure requirements, to tone down the picture painted by stock promoters to a more realistic hue.

Appendix A shows you how to find the Web address of your state’s securities law office, where you can usually find a link to your state’s securities law. 

For more information on securities laws and procedures, see “Stock Issuance and the Securities Laws,” below.

State Tax or Revenue Code. Most states impose corporate income or franchise taxes that are based on the amount of taxable income earned in the state by a corporation. Your corporation pays these taxes in addition to federal IRS income taxes. Each state’s Tax or Revenue Code typically contains the state’s income or franchise tax rules.

Tax statutes are even more off-putting than legal statutes. We think you’ll get the most useful information directly from your state’s tax publications, forms, and other instructions posted on your state’s tax agency website. Appendix A shows you how to find your state’s tax office online. 

Other state and local laws. Other state laws affect the operations of all businesses, whether or not they are incorporated. For example, state and local building codes, professional and occupation licensing, environmental laws, local ordinances, zoning laws, and other laws and regulations may apply to your business and its operations.

 

related topic

Laws that apply when forming a business. For an excellent resource on the various state laws and regulations that apply to forming all types of businesses, corporate and noncorporate, see The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo), available in both national and California editions.

 

Corporate Filing Offices

Each state has a corporate filing office where you file paperwork (and pay fees) to create or dissolve a corporation. Typically, this filing office handles all state business filings, including limited partnership and limited liability com­pany (LLC) filings as well as business corpo­ration and nonprofit corporate filings. Through­out this book, we refer to the office that accepts corporate filings as the corporate filing office. Typically, the official name of this office is the Corporations Division of the Secretary (or Department) of State. The main corporate filing office is located in each state’s capitol city. Some states maintain branch offices in secondary cities as well.

Appendix A explains how to locate your state’s corporate filing office online. The best way to obtain the latest corporate filing and fee infor­mation and the latest corporate filing forms is to visit your state’s corporate filing office website. Most state corporate filing office websites provide corporate statutory forms such as Articles of Incorporation, Amendment of Articles, Change of Registered Agent, or Registered Office Address, and the like. Many state websites also contain links to the state’s corporate tax office and state employment, licensing, and other agencies.

 

tip

For a faster response, contact the filing office via email. Corporate filing offices typically respond to email inquiries much faster than they respond to snail mail or telephone messages. (It’s not uncommon to have to wait a day or more to get a telephone call through to a busy state filing office.) In short, if your question is not answered on the filing office website, send the office an email inquiry. (You will find the email address on the state filing office website.)

 

Corporate Documents

The primary corporate legal documents are articles of incorporation, bylaws, stock certif­icates, and minutes of meetings. This section introduces you to each in turn.

 

Articles of Incorporation

The key corporate organizing documents are the articles of incorporation. In some states, the articles go by a different name, such as the corporate charter or certificate of incorporation. A corporation comes into existence when its articles of incorporation are filed with the state corporate filing office. The filing of articles is the only legal filing necessary to create a corporate entity. However, you’ll want to follow up after filing articles by preparing and adopting bylaws, holding a first meeting of directors, and issuing stock to your initial shareholders. These additional steps are necessary to make sure the legal organization of your corporation is complete.

The articles normally contain basic structural information, such as the name of the corporation, the names and addresses of its directors, its registered agent and registered office address, and the corporation’s capital stock structure. The information that must be included is typically established by a section of the state Business Corporation Act titled “Contents of Articles of Incorporation.” Standard state articles forms contain all required provisions. State articles statutes also normally list optional provisions that you can include in your articles, such as provisions to implement a complex stock structure with different classes or series of shares. (We discuss adding optional provisions to articles in Chapter 4.)

 

Example:

The Equine Equity Investors Corporation adds an optional provision to its articles that sets up a multiclass stock structure consisting of Class A Voting shares and Class B Nonvoting shares. Another optional provision is added that requires a vote of two-thirds of each class of stock for the approval of amendments (changes) to the corporation’s articles or bylaws.

Most corporate filing office websites provide a downloadable, ready-to-use articles of incorpo­ration form that you can use to establish your business corporation. This book provides an articles form for use in Iowa and Nebraska, the only states that do not offer a standard articles form. For those two states, we include specific instruc­tions to help you fill in the forms.

 

Bylaws

After articles of incorporation, a corporation’s bylaws are its second-most important docu­ment. You do not file bylaws with the state. They are an internal document that contains rules for holding corporate meetings and carry­ing out other formalities according to state corpo­rate laws. Bylaws typically specify how often the corpo­ration must hold regular meetings of direc­tors and shareholders, as well as the call, notice, quorum, and voting rules for these meetings. Also, bylaws usually contain the rules for setting up and delegating authority to special committees of the board of directors, the rights of directors and shareholders to inspect corporate records and books, the rights of directors and officers to insurance coverage or indem­nification (reimbursement by the corpo­ration for legal fees and judgments) in the event of lawsuits, plus a number of other standard legal provisions.

Many of the procedures set out in corporate bylaws are controlled by statutes in your state’s Business Corporation Act. For example, most states require corporations to hold an annual meeting of shareholders to elect or reelect the board of directors to a one-year term of office. In your bylaws, you set the date of this annual meeting. Similarly, most states require written notice of shareholders’ meetings to be delivered to each shareholder no less than ten nor more than 60 days prior to the date of the meeting. In your bylaws, you can specify the exact number of days required for providing notice of shareholders’ meetings. If you do, your notice period must fall within this ten-to-60-day range.

This book provides fill-in-the-blank bylaws (both tear-outs and on CD-ROM) that you can use for your corporation.

 

Use Bylaws Instead of Articles for Corporate Operating Rules

Some states let corporations choose whether to place corporate operating rules and procedures in the articles of incorporation or bylaws. It’s always best to use the bylaws because you can change them easily—without the need for filing your changes with the state. For example, many states allow you to place super-majority quorum or voting rules for directors’ or share­holders’ meetings in either document. If you use the bylaws for this purpose, you can change these provisions by amending your bylaws at a directors’ or shareholders’ meeting. But if you put these provisions in your articles after the directors or shareholders approve the changes, you must file a formal amendment to the articles with your state’s corporate filing office

 

Stock Certificates

A new corporation issues stock to its founders and initial investors. Stock ownership is usually documented by stock certificates given to each shareholder. Today, many states do not require the actual completion and delivery of paper stock certificates to shareholders, but we think it continues to make sense to issue certificates. A stock certificate is tangible evidence of a person’s ownership rights in your corporation, and most founders and investors expect to receive one after buying shares in a new corporation.

State law sets out the very basic content requirements for stock certificates. Normally, the minimum information necessary is the name of the corporation, the state where the corporation was formed, the name and number of shares issued to the shareholder, and the signature of two corporate officers. We provide ten tear-out stock certificates in Appendix C. Blank certificates that comply with your state’s requirements may be available in local stationery stores. If you want custom-printed certificates, a local legal printer will prepare your certificates for a higher cost. We provide specific information on how to issue the initial shares of your corporation in “Sale and Issuance of Stock,” below.

 

Minutes of the First Directors’ Meeting

After filing articles and preparing bylaws, the initial board of directors meets to formally approve the bylaws, approve the issuance of stock to initial shareholders, appoint corpo­rate officers, and handle other essential corpo­rate start-up tasks. If the initial members of the board are not named in the articles, the incorporator—the person who signed and filed your articles—prepares a written “Incorporator Statement” in which the incorporator appoints the initial board members prior to its first meeting. Once the board has been named—either in the filed articles or the incorporator statement—the board of directors can hold its first meeting. The actions taken by the board at its first meeting should be documented by written minutes that are filed in the corporate records book.

Chapter 4 of this book shows you how to prepare an incorporator statement (if you need one) and minutes of your first board meeting. (This book contains forms you can use for both purposes.)

 

resource

For help with corporate minutes. For simple forms that you can use to record subsequent board and shareholders meetings, together with more than 80 resolutions you can adopt to handle the approval of standard legal, business, and tax decisions reached at these meetings, see Nolo’s The Corporate Records Handbook, by Anthony Mancuso.

 

Corporate Powers

Each state’s Business Corporation Act gives business corporations carte blanche to engage in any lawful business activity. In legalese, “lawful” doesn’t just mean noncriminal; it means not otherwise prohibited by law. Generally this means that a corporation can do anything that a natural person can do. However, in most states, it is not lawful for a regular business corporation to engage in the banking, trust, or insurance business. If you want to set up one of these special financial corporations, you will need to follow special procedures—for example, obtain the written approval of your state’s banking or insurance commission, and prepare and file special articles of incorporation with the state.

Here’s a partial list of things that a business corporation may do. These powers do not need to be listed in your articles and bylaws:

• Engage in any lawful business.

• Adopt, amend, and repeal bylaws.

• Qualify to do business in any other state, territory, dependency, or foreign country.

• Issue, purchase, redeem, receive, or other­wise acquire, own, hold, sell, lend, exchange, transfer, or otherwise dispose of, pledge, use, and otherwise deal in and with its own shares, bonds, and other securities.

• Assume obligations, enter into contracts, incur liabilities, borrow and lend money, or otherwise use its credit, and secure any of its obligations, contracts, or liabilities by mortgage, pledge, or other encumbrance of all or any part of its property, franchises, and income.

• Make donations for the public welfare or for community fund, hospital, charitable, educational, scientific, or civic or similar purposes. (Like individuals, business corporations are allowed to make charitable donations.)

• Establish and carry out pension, profit-sharing, stock-bonus, share-pension, share-option, savings, thrift, and other employee retirement, incentive, and benefit plans.

• Participate with others in any partnership, joint venture, or other association, transaction or arrangement of any kind, whether or not such participation involves the sharing or delegation of control with, or to, others.

• Adopt, use, and alter a corporate seal. (A corporate seal is simply a stamped or embossed design showing the name of the corporation and its state of formation.) Although state law does not require the use of a corporate seal, some corporations use the seal on formal corporate documents, such as stock certificates, to signify formal approval of the document by the corporation.

 

tip

Your corporation can engage in more than one line of business. Although state BCAs don’t specifically say so, it is clear that a business corporation can engage in as many lines of business as management sees fit. You do not need to set up a separate corporation for each line of business.

 

Corporate People

While a corporation is considered a legal “person,” capable of making contracts, paying taxes, and otherwise enjoying the legal rights and responsibilities of a natural person, of course it needs real people to carry out its business. State BCAs classify corporate people in the following ways:

• incorporators

• directors

• officers, and

• shareholders.

As we explain below, state statutes—and occasionally courts—give each of these corpo­rate people different rights and responsibilities.

 

Incorporators

Your incorporator is the person who signs your articles of incorporation and files them with state corporate filing office. The incorporator is not required to be an initial director, officer, or shareholder of the corporation—nor must the incorporator be a resident of the state. The only legal requirement for incorporators is that, in many states, the incorporator must be at least 18 years old.

Even though it is not required, we recom­mend that you pick one of your initial board members as your incorporator. This helps to ensure that the entire board of directors, which must pick up the reins of management immediately after the corporation is formed, is in the corporate formation loop right from the start. It also means that any correspondence between your new corporation and the state corporate filing office will reach at least one director.

 

 

One Person Can Wear Several Corporate Hats

In all states, one person may simultaneously serve in more than one corporate capacity. For example, if you form your own one-person corporation (most states allow this), you necessarily will be your corporation’s only incorporator, director, and shareholder, and you will fill all the required corporate officer positions. Exceptions: In Alaska and Tennessee, the corporate president and secretary offices must be filled by different individuals. In Maryland, the president and vice president must be different. In all states, a business corporation may have just one director and one shareholder. However, in some states, the number of directors cannot be less than the number of shareholders if the corporation has three or less shareholders (California, Massachusetts, Ohio, and Utah). In these states, if your corporation has three or more shareholders, you must have at least three directors, and if you have two shareholders, you need at least two directors. If you have just one shareholder, then you could have just one director. In Massachusetts, these are default rules that you can override in your articles of incorporation. For example, if allowed for in your articles, you could have a corporation in Massachusetts with two or three shareholders and just one director.

 

Directors

Under each state’s Business Corporation Act, directors are given the authority and responsibility for managing the corporation. Let’s look at some of the common features of state law that apply to directors.

 

Director Qualifications

State law does not impose residency or stock ownership requirements on directors. Your dire­c­tors can come from any state and need not be shareholders. The only director requirement in some states is an age requirement—in these states, directors usually must be at least 18 years old (which is a good idea anyway, to make sure your director can legally make decisions).

The directors meet and make decisions collectively as the board of directors. In all states, the board may consist of one or more individuals. Many state BCAs specifically say that a director must be a natural (real) person, as opposed to another corporation or limited liability company (LLC). Even if your state’s BCA doesn’t say this, it is understood in all states that only real people may be elected as board members.

 

Director Meetings

In most states, directors must meet at least once each year. One reason for this requirement is that most state BCAs specify that directors must be elected (or reelected) for a one-year term at an annual meeting of shareholders. (See “Shareholders,” below.) Once the board is voted in or continued in office at the annual shareholders’ meeting, the newly elected or reelected board holds its annual meeting. At this meeting, board members accept their election to the board, then transact any business planned for the meeting.

The date, time, and place of the annual directors’ meeting is normally specified in the bylaws. State BCAs usually allow the annual meeting to be held without having to give each director prior written notice of the meeting, but we think it’s a good idea to provide written notice of all meetings, including annual board meetings. Directors, particularly newly elected ones, may not note or remember the annual director meeting date specified in the bylaws. Of course, boards often meet more frequently than once per year, particularly in larger corporations with multimember boards. (See “When Do Directors Meet?” below.)

Additional meetings are called special meetings. State law typically requires that directors receive written notice of the date, place, and purpose of all special meetings of directors.

 

Don’t Start Business Until You File Articles

If you act as an incorporator for your corpo­ration and do not limit your activities to preparing and filing articles, be careful. State courts usually say that a corporation is not bound by the incorporator’s contracts with third parties prior to actual formation of the corporation, unless the contracts are later ratified by the board of directors or the corporation accepts the benefits of a contract—for example, uses office space under a preincorporation lease signed by an incorpo­rator. Worse, the incorporator may be personally liable on these preincorporation contracts unless the incorporator signs the contract in the name of the corporation only and clearly informs the third party that the corporation does not yet exist, may never come into existence, and, even if it does, may not ratify the contract. So, a suggestion: If you must arrange for office space, hire employees, or borrow money before you form the corporation, make it clear that any commitments you make are for and in the name of a proposed corporation and are subject to ratification by the corporation when, and if, it comes into existence. The other party may, of course, refuse to do business with you under these conditions and tell you to come back after the corporation is formed. Again, this is usually the best approach to preincorporation business, anyway—namely, to postpone business until after your articles have been filed and approved by the state. Once this happens, all contracts should be signed in the name of the corporation by a corporate director, officer, or employee. (See “How to Sign Corporate Documents From Now On” at the end of Chapter 4.)

 

Director Voting

Under state law, board members are given one vote each when making board decisions at directors’ meetings. The BCA in most states normally sets the quorum requirement for board meetings—that is, the number of directors who must be present to hold a board meeting—at a majority of the full board. However, in most states, your bylaws can change this default rule and specify a greater- or less-than majority quorum rule for directors’ meetings. State law also typically provides a majority-voting rule for the approval of board decisions at a meeting. This means that the board approves decisions at a meeting by the “yes” vote of at least a majority of the directors present at the meeting. Again, this majority rule is usually a default state rule; you are normally allowed to specify a different director approval rule in your bylaws.

 

When Do Directors Meet?

In a small, closely held corporation, the directors meet mostly to satisfy the state BCA’s minimal meeting requirements. This normally means an annual meeting at which the newly elected or re-elected board members accept their positions for the upcoming year and approve appropriate business objectives or strategies for the upcoming year. Many small boards also call special meetings during the year to conduct business in a formal setting, or when board approval must be sought under the BCA to make legal decisions, such as amendments to corporation articles or bylaws, issuance of corporate shares, declarations of dividends, appointments of officers, and the like. Other items of business necessary to run the corporation from day to day are normally handled by board members outside the boardroom in their capacities as corporate officers or in other supervisory corporate capacities. The holding of a minimal number of board meetings is the rule in sole-owner or family-managed corporations. In larger corporations the board typically meets more frequently to review corporate performance and goals, not just to satisfy state BCA legal requirements. For example, the board of a larger corporation may meet quarterly or even monthly to discuss corporate policies and objectives and to establish and hear back from board committees. Since members of larger boards often come from outside corporations and financial institutions that have invested in the corporation, frequent meetings of the board help the corporations keep these investor representatives informed on current corporate performance.

 

Example:

Tie-Dyed RetroFitters, Inc., is a retro clothing store owned and managed by its four founders. The corporate bylaws establish a four-person board, with a quorum for board meetings specified as a majority of the authorized number of directors. Therefore, to hold a directors’ meeting, three of the four directors must attend. A majority of those present at a meeting must approve a decision—remember, at a minimum, a quorum must be present. If all four board members attend a meeting, three directors must approve a decision proposed at the meeting. If a minimum quorum of three attends, then two of the three must approve a decision proposed at the meeting.

 

caution

Some states set a minimum quorum requirement for directors. In many states, your bylaws cannot establish a quorum of directors that is less than one-third the number of the full board. Look up your state’s BCA in a section labeled “Directors’ Meetings” to find out your state’s minimum director quorum rule.

 

In addition to approving decisions at meetings, directors can also take action by written consent. Under state BCAs, this written voting procedure is allowed for all types of director action—that is, any type of action that directors can approve by voting in person at a real meeting. This means that the directors can individually or collectively date and sign a form that says they approve a particular item of business, without the need to hold a face-to-face meeting. State BCAs normally require the signature of all directors on a written consent form of this sort—obtaining the signed consent of a simple majority of directors is not sufficient under most state statutes. Look in your state BCA for a section with the title “Directors’ Action by Written Consent” or “Directors’ Action Without a Meeting” to see how many directors must sign a written consent form in your state.

 

Board Committees

In smaller corporations, the owners who also run the corporation as officers or other supervisory personnel make up the full board of directors. In larger corporations, the board may include individuals who are not involved with day-to-day corporate operations. These outside direc­tors, who may be representatives of venture capital groups or financial institutions that have provided capital or financing to the corporation, rely heavily on reports of board committees to get the information necessary to make good decisions. For example, the compensation committee of a larger corporation may report regularly to the board to propose the granting of salary increases, bonuses, and stock options to deserving corporate employees. Similarly, a special finance committee may be established by the board to review corporate performance in one or more lines of its business.

State BCAs recognize the need for these committees to help the board get its work done. Here is a typical statute:

In performing the duties of a director, a director shall be entitled to rely on informa­tion, opinions reports, or statements, including financial statements, prepared or presented by a committee of the board, as to matters within its designated authority, which committee the director believes to merit confidence.

The above statute is typical in that it allows directors to rely on committees if the director is satisfied that a committee report merits confidence. State BCAs also allow a board to delegate its managerial authority to special types of committees, called executive committees of the board. These are committees made up of two or more board members, and often other corporate personnel such as officers, that take responsibility for one or more areas of board decision making. Larger corporations may set up one or more committees of this sort to handle ongoing areas of corporate management. The full board may meet less frequently to review overall corporate policy, while the committees of the board meet regularly to handle their assigned areas of responsibility.

State law limits the types of authority that can be delegated to an executive committee of the board. Typically, an executive committee cannot, without full board concurrence, amend the articles or bylaws, approve a corporate dividend, or take other specified major corporate actions. Here is a typical BCA statute covering executive committees:

Executive Committees of the Board: The board may, by resolution adopted by a majority of the authorized number of directors, designate one or more committees, each consisting of two or more directors, to serve at the pleasure of the board. Any such committee, to the extent provided in the resolution of the board or in the bylaws, shall have all the authority of the board except with respect to: (1) the approval of any action which also requires the approval of shareholders; (2) the filling of vacancies on the board; (3) the fixing of compensation of directors for serving on the board or any committee of the board; (4) a distribution by the corporation [typically, this is defined elsewhere in the Act as a dividend or other payment out of the profits and earnings of the corporation to shareholders]; and (5) the establishment of other committees of the board or appointment of members to these other committees.

Despite the restrictions, executive committees are permitted to handle a variety of corporate decision-making matters, including hiring and payroll decisions, corporate projects and operations, and a variety of management and overview tasks that would otherwise be handled by the full board.

 

 

Appointing an Executive Committee to Handle Employee Compensation

Designating a special executive committee of the board to handle employment compen­sation and payroll tax decisions can have a collateral tax benefit: It helps insulate directors who do not serve on the committee from personal liability for any unpaid corporate payroll taxes. We’ve already mentioned that potential personal liability for tax debts is one of the exceptions to corporate limited liability. (See “The Corporation” in Chapter 1.) Here’s how this exception works. Federal tax law permits the IRS and state income and payroll tax agencies to aggressively seek to collect unpaid corporate payroll taxes from “responsible persons” in a corporation. In its collection efforts, the IRS often claims that board members who approve of compensation to corporate employees, or specifically approve paying taxes to the IRS or state, are personally responsible for income or payroll taxes not paid by the corporation. Whether the IRS wins these arguments depends on the overall facts and the extent of a director’s involvement in running the corporation. In a small, closely held corporation, it’s difficult for a board member who also serves as a principal corporate officer to deny being a responsible person—after all, the board member probably has the power to make the corporation pay its taxes if it has the funds to do so. But in a larger corporation with outside directors on its board, the outside directors are less likely to be viewed as “responsible persons” if compensation and tax decisions are delegated to a special compensation or finance committee consisting of the more active board members. This helps them avoid personal liability in case of a payroll tax deficiency or dispute

 

Directors’ Duties

Directors are required under state BCA statutes to exercise care in making management decisions and act in the best interests of the corpo­ration. If a court decides that a director has violated these duties, the director may be held personally liable for any resulting financial loss to the corporation or its shareholders.

 

Duty of Care

The first and foremost duty owed by a director to a corporation is the statutory “duty of care.” Here is a typical state BCA statute that defines, in general terms, a director’s duty of care:

A director must act in good faith, in a manner the director believes to be in the best interests of the corporation and its shareholders and with such care, including reasonable inquiry, as an ordinarily prudent person in a like position would use under similar conditions.

This is a very broad standard. Courts interpret it to mean that a director is allowed to make mistakes that lead to financial loss for the corporation and its shareholders without fear of personal legal liability, as long as the director had good reason for making the decisions. And, as discussed in “Board Committees,” above, one good reason may be that the director relied on the apparently reliable reports of a board committee.

The duty of care Is normally easy to fulfill. The standard for the directors’ duty of care is fairly lenient. A director has to be negligent (careless), almost to the point of flagrant inattention or fraudulent disregard of the financial implications of board decisions, to violate the statutory standards. And in small corporations, even if the standard is violated, personal liability problems are rare. This is because the people who have legal standing to seek damages for a director’s violation of the duty of care are those whose have been harmed financially by a director’s bad decision making—namely, its shareholders. In a closely held corporation where all board members also are the corporation’s only shareholders, it is unlikely that one director will sue another. But it’s not unheard of, particularly if one or more directors officially disagreed with a corporate decision they felt was too risky an