Incorporation 101: What Is S-Corporation?

What is an S-Corporation?

It is a regular corporation that has 100 shareholders or less and that passes-through net income or losses to its shareholders for tax purposes (similar to sole proprietorship or partnership). Since all corporate income is “passed through” directly to the shareholders who include the income on their individual tax returns, S-Corporation are not subject to double taxation.

An eligible domestic corporation (C-Corporation) can avoid double taxation (once to the shareholders and again to the corporation) by electing to be treated as an S-Corporation. Generally, an S-Corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S-Corporation’s shareholders include their share of the corporation’s income or loss.

S-Corporation vs. C-Corporation

  • Like C-Corporations, S-Corporations are separate legal entities from their shareholders and, under state laws, generally provide their shareholders with the same liability protection afforded to the shareholders of C-Corporations.
  • Unlike C-Corporations, for Federal income tax purposes taxation of S-Corporations resembles that of partnerships. Thus, income is taxed at the shareholder level and not at the corporate level.
  • Certain penalty taxes (e.g., accumulated earnings tax, personal holding company tax) and the alternative minimum tax do not apply to an S-Corporation.
  • Unlike a C-Corporation, an S-Corporation is not eligible for a dividends received deduction (a tax deduction received by a corporation on the dividends paid to it by other corporations in which it has an ownership stake).
  • Unlike a C-Corporation, an S-Corporation is not subject to the 10% of taxable income limitation applicable to charitable contribution deductions.

Who Can Form an S-Corporation?

S-Corporations are more suitable for small and family businesses, and for those who starts their business with small investment. Also, some existing businesses qualify for S-Corporation status.

To form S-Corporation or to change your existing C-Corporation into S-Corporation (also called “Election of S-Corporation Status”) certain conditions need to be met:

  • S-Corporation cannot have more than 100 shareholders.
  • All shareholders must be either U.S. citizens or residents, estates, or certain trusts.
  • Can only have one class of stock. Preferred stock is not allowed.
  • Profits and losses must be accorded to owners in proportion with their ownership stake.
  • Must use the calendar year as its fiscal year unless it can demonstrate to the IRS that another fiscal year satisfies a business purpose.
  • Shareholders cannot deduct losses in excess of their investment.
  • The corporation cannot deduct fringe benefits given to employees who own more than 2% of the entity.

S-Corporation Advantages

  • Forming S-Corporation generally allows you to pass business losses through to your personal income tax return, where you can use it to offset any income that you have from other sources.
  • Shareholders are not subject to self-employment taxes. These taxes, which add up to more than 15% of your income, are used to pay your Social Security and Medicare taxes.
  • When you sell your entity, your taxable gain on the sale of the business can be less than it would have been had you operated the business as a regular corporation.

Taxation of S-Corporations

As already mentioned above, S-Corporations are not subject to tax rates. Instead, S-Corporation passes-through profit (or net losses) to its shareholders and those profits are taxed at individual tax rates on each shareholder’s Form 1040. The pass-through (sometimes called “flow-through”) nature of the income means that the S-Corporation’s profits are only taxed once – at the shareholder level. The IRS explains it this way: “On their tax returns, the S-Corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss”.

S-Corporations therefore avoid the so-called “double taxation” of dividends in most states. There are however two exceptions to this rule:

  • California: There is a franchise tax of 1.5% of net income of an S-Corporation (minimum $800). This is one factor to be taken into consideration when choosing between an LLC and an S-corporation in California. On highly profitable enterprises, the LLC franchise tax fees, which are based on gross revenues, may be lower than the 1.5% net income tax. Conversely, on high gross revenue, low profit-margin businesses, the LLC franchise tax fees may exceed the S-Corporation net income tax.
  • New York City: S-Corporations are subject to the full income tax at a 8.85% rate. However if the S-Corporation can demonstrate that a portion of its business was done outside the city, that portion will not be subject to the additional tax.

Retaining Profits of S-Corporation

S-Corporations are allowed to retain their net profits as operating capital. However, all profits are considered as if they were distributed to shareholders, and as a result shareholders might be taxed on income they never received (whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out).

Converting S-Corp Back to C-Corp

S-Corporation status is not permanent and can be reversed back if so desired. For example, if the business becomes more profitable and there are tax advantages to being a regular C-Corporation, S-Corporation registration status can be dropped after a certain amount of time.

Business Legal Liability – How to Prevent Piercing the Corporate Veil

A corporation is a separate legal entity recognized by the national and state governments, and the Internal Revenue Service. In a properly run corporation, the shareholders, officers and directors (the company principles) are distinct and separate from the corporate entity, whether a “C,” “S,” or LLC. This provides a “corporate veil” that protects the principles from liability during a lawsuit against the corporation.

As a matter of course plaintiffs in a suit against the corporation also name the principles as defendants whenever possible. This allows the plaintiff to try and include the assets of these individuals in the settlement of the case. Thus the plaintiff will attempt to pierce the corporate veil to make sure there are enough assets to satisfy any judgments from the suit. Yet one of the reasons for forming a corporate entity (C, S or LLC) is to avoid this condition or liability to the principles.

If the principles of the company formally treat the corporation as a separate legal entity, the court will uphold the status of the corporate veil and limit the suit to the corporation, and not include the principles in any judgment. Federal or State Securities Exchange Commission (SEC) investigations typically follow the same approach. The determining factor is how well the principles maintained the separate entity status. If the various corporate formalities are not consistently followed then these are grounds for piercing the veil and holding the principles personally liable.

The smaller the company the more difficult it is to take the time to observe the following formalities, but it only takes one law suit, or the threat of one, to see the value. This can be especially hard if the entrepreneur has been operating as a small business or solo operator for some time, and has not developed the more formal, larger company practices. Once these processes get set in place they will become habits and are easier to maintain. As the company grows many of these best practices actually get easier to implement as the appropriate systems get put in place.

Annual Filings:

Maintain any annual corporate filings of the annual report and fees as required by your state.

Corporate Bylaws

The Corporation must adopt a set of bylaws, or operating agreement for an LLC, which provide a written statement of how the internal affairs of the corporation will be handled. Included in the bylaws are the set time and place of regular shareholder meetings and meetings of the board of directors. For an LLC, which can have a Board of Advisors, this can also be stipulated even though the Advisors do not have the same legal status as “C” corporation Directors. The more a LLC operates like a “C” corporation, the stronger the veil.

Corporate Minute Book

This book contains a written record of actions by the shareholders and directors and is the record that the Bylaws/Operating Agreement was followed. At a minimum, it must include annual minutes reflecting the election of directors by the shareholders. Any significant corporate activities, including corporate business plans, major contracts, borrowings, purchases, and the payment of compensation to officers, should be reflected in the minutes of the meetings.

Board of Director Meetings

Annual board meetings do not provide much oversight. For start-up companies it is highly recommended that monthly BOD meetings be used to manage per the business plan and approve major decisions which are then recorded in the Corporate Minute Book (File or Log). LLCs can do the same with the Board of Advisors or an Operating Committee.

Stock Ledger Book

The corporation must maintain an accurate and current stock ledger book (or membership units for a LLC). This book shows who has been issued stock/unit certificates, the number of shares/units issued, and the value received by the corporation for the issuance of its stock/units.

Conducting Business in Corporate Name

When doing business with third parties, the officers and directors must make it clear that they are acting on behalf of the corporation and not in their individual capacity. Correspondence should be sent out under the proper corporate letterhead or stationary, and contracts should be entered into only with the proper corporation as a signatory. That is the signature block should indicate both the principle’s formal title and the company name.

Bank Accounts

Avoid any appearance of co-mingling of funds. Corporate bank accounts and accounting records must be separate and distinct from the individual. A corporate bank account cannot be treated as if it was the account of an individual officer or director (as often happens with solo or small business owners). Corporate income and assets must be separately accounted for on the company books. One of the biggest mistakes made is to move money and property back and forth between themselves and their corporation without properly accounting for such movement in the corporate records/accounting system. This is a fatal mistake, and the corporate entity will be disregarded by the court.

CFO Check Signing

This is a hard one for many small business owners transitioning to a larger business structure. The Founder/CEO should no longer sign any checks, instead have the CFO or another officer plan ahead and sign all checks and use a system like QuickBooks to print the checks. A two-man rule for signing checks is valuable, but most banks will not enforce this rule so your CFO must be charged with this responsibility. This should also be at least a quarterly audit item.

Payroll Processing

Until you can afford your own payroll department, for any payroll checks use a payroll processor to issue the checks and calculate the appropriate withholding deductions and maintain the appropriate escrow accounts.

Corporate Credit Card

Get a business credit card, and/or debit card, to keep track of all non-check payments. Have your accountant/CFO reconcile them monthly.

Expense Reports

Use an expense report system for all payments to individuals other than compensation. This provides a written documentation for any audits. Be especially careful of all travel and business meeting expenses.

The formal procedures to maintain the corporate veil can be cumbersome to small companies, but are worth their weight in gold should there be any kind of law suit against the corporation or an SEC investigation against the principles. In any lawsuit the plaintiffs will typically name the company principles, and try to pierce the corporate veil to assess the liability directly to the officers and directors. Consistent use of formal procedures can provide the needed protection.

Disclaimer: This is not legal advice. Seek competent legal counsel for both general corporate and SEC related issues, which are far more extensive than these best practices.

Different Types of Corporations

In the balance of economics, the incorporation can not only be a beneficial decision, it can also be the demise. Certain aspects should be taken into consideration before even starting the process, including which direction to go. As the owner of a company you need to be willing to take sensible risks to continue your movement forward.

Let’s explore the five main types of corporations. On each, we will discuss their pros and cons. What liability risks each type offer, and where you fall in regards to taxes on each.

S Corporation

In the very basic of terms, an S Corporation is a company that has decided to use Sub-chapter S of the IRS Code as proposed in Chapter 1. This means the corporation does not pay income taxes. They in turn divide all profit and losses among their shareholders who in turn must report it on their income taxes.

From the stand point of taxes, you immediately limit the amount of taxation your company will receive. Unless you also classify yourself as a C Corporation, mixing both of these puts you into a double taxation bracket that will become costly for all parties involved. This is largely due to your profits being taxed and then your shareholders profits being taxed as well.

If an S Corporation has employees, as opposed to independent contractors, they are required to still pay FICA taxes on the employee’s payroll. The employee must still pay all required State, County and Federal taxes as required by law.

Since the S Corporation does not have to pay taxes on its profits, the burden remains on the shareholders of the company. The largest portion of which is the owner or co-owners of the company. So if you own 50% of the available shares, you will be required to pay 50% of the profit or loss tax on your company for the year.

Here are some key factors you must keep in mind if you are choosing to become an S Corporation:

You must be eligible to claim S Corporation Status. Which means you must be a domestic corporation or be a registered LLC. Only one stock class is allowed. The maximum number of shareholders your company can have is 100. (Spouses can be claimed as a single shareholder, as can direct family members that are descended from a common ancestor. They in turn have to agree to this classification however.) All shareholders must be U.S. Residents and must be natural people. You cannot have shares to corporations or other companies, with a few minor exceptions. Such as a 501(c) (3) corporation. Every profit or loss should be applied proportionately to each shareholder. For example, if you make a $500 profit, a person with 25% interest in the company would receive $125.00.

Outside of the tax benefits you should also remain aware of the liability that an S Corporation carries. Although it is classified as a company where Shareholders have limited legal liability, it doesn’t mean it is completely free from legal liability.

They are still responsible for the company based on their share percentage in the following circumstances, and have the potential to have their loss exceed if the following are found:

A Court determines the company is fraudulent. Corporate formalities have been neglected. Starting capital must have been enough for initial success. Personal assets have been added to cover expenses.

All officers, employees, agents and directors of the company are help personally responsible in the events that any liability arises as a result of their services. However, certain individuals in those categorizes can get indemnified for a cost. It will however only cover costs and expenses that arise from certain tasks. It does not remove legal responsibility.

Additionally, the company as whole can be protected from one person’s mistakes through insurance several companies offer in regards to liability. Any company dealing with potential bodily injury should register for insurance.

C Corporation

Next, we will look at C Corporations. In very basic terms, A C Corporation is a company that is designated to be taxed under Sub-chapter C of the IRS Code. A majority of companies act as C Corporations. If you miss the minimum requirements of an S Corporation by one qualification, it is typically where your company fits best.

The main difference between the C Corporation and the S Corporation is the number of individuals allowed to “own” the company. Meaning you can have more than 100 shareholders.

Additionally, other corporations can own shares in the C Corporation, as well as foreign and domestic shareholders. This is considered a universal shareholder account. But unlike an S Corporation, the C Corporation is taxed on its profits. In turn the Shareholders are taxed on their earnings after that.

However, before a C Corporation can be formed, the following steps must be done: A Corporation Name must be established based on State Rules. All Director Positions must be filled in advance. The Articles of Corporation must be completed with the fees posted. An approved corporate bylaw must be completed with a plan to follow. One initial meeting must have occurred with the board of directors. Stock Certificates must have been issued for the initial owners. License and Permits must be obtained and approved. You must keep records of annual reports and meetings on file at all times.

Liabilities for a C Corporation are similar to the S Corporation.

Limited Liability Company (LLC)

In the most basic of concepts, this is a company is a partnership company with corporate elements blended in. This type gives little liability to the actual owners of the company. In reality it is also not an actual Corporation, rather it is an unincorporated association. While you are protected from most liabilities that arise, any fraudulent or misrepresentations are not protected as determined by a court of law. This also means any individual hiding behind an alter ego.

Most LLC can operate with the tax rules of either an S Corporation or a C Corporation depending on how the owner(s) prefer to have their income handled. Ideally handling it as an S Corporation provides the best solution for most individuals considering a LLC when it to taxes. So a benefit is the pass-through taxation available.

The liability on a LLC is a little stricter than those of the corporations as well. While personal property cannot be seized for failure of the business to pay, the limited liability is only from a financial stand point. The following items are your biggest concerns of liability. The company results in bodily harm of any individual. You personally guarantee a loan for the company. Taxes for employees are not paid that you have withheld. Any illegal or fraudulent activity. Using the LLC as an extension of your personal affairs.

Sole Proprietor

This is the most simple of business structures. A sole proprietorship is an individual that is the business entity. This means there is no legal distinction between the individual and the company. Any profit or loss of the company is the tax responsibility of that individual, and they are responsible for all legal instances that arise as a result of their business.

A benefit to these types of business is they are very easy to start up. There are minimal regulations, and the owner has more of a say in how the company is run. However, it can be a financial burden for anyone attempting to run the company.

Most banks tend to shy away from loaning to sole proprietors, as they don’t tend to be as successful as major corporations. Since the owner has the financial backing for the company they are legally responsible for all financial loans associated with the business.

Limited Liability Partnership (LLP)

Simply put this is a partnership where each of the partners
has a limited responsibility in the company. Depending on what State you are opening one of these companies will determine the maximum number of partners you may have.

None of the partners in a LLP are responsible for the actions of the other partners, thus liability remains on a single partner for their business. However, as a whole they must elect one individual who maintains unlimited liability for the Corporation as a whole. At the same time, each of the partners runs the business together as a whole.

All profits in a LLP are divided among the partners evenly, and they are responsible for income tax depending on the amount of income.

As a result of Limited Liability Partnerships in the United States, the Uniform Partnership Act was created to help govern the LLP as it moved across States.

Nevada Corporation

Nevada is different from other States in several ways when it comes to a corporation. The legal system here offers you the ability to allow the board of directors to run your company while protecting you without piercing the corporate veil. There are numerous laws protecting businesses in Nevada that aren’t seen in other States.

No matter where in the country you operate, if you are incorporated in Nevada you are protected by Nevada laws if anyone attempts to pursue legal action against your company. Nevada’s law is very directly beneficial to the corporation, which has many safeguards in place to prevent costly unwarranted lawsuits to occur.

Outside of the $200 Business License Fee in Nevada you will not be charged franchise tax, corporate income tax or personal income tax by the State. This means outside of federal tax obligations you will have no additional tax liability.

However, crime especially theft is higher statistically in Nevada. As a result cases of employee theft and fraud are among the highest of anywhere else in the United States.

Delaware Corporation

Forming a Corporation in Delaware is a wise decision. As over 60% of the major Fortune 500 were incorporated here, you can imagine the stable economic situation available. This is a place to thrive and build your company.

With that in mind the legal system is also setup to understand the Corporation laws more than any other state. This will provide fair and quick trials if anything goes before a judge in regards to your corporation. In fact, Delaware has created a Delaware Court of Chancery to handle all of these issues. They handle all the proceedings that occur as a result of business practices.

Another benefit, Delaware has many of the major credit card banks that relax on the interest rates provided here for corporations. You will of course have to use banks that are created under Delaware Law and not Federal Law to receive these benefits.

You also receive the internal affairs doctrine protection. If your business is created in Delaware you are protected by the laws of Delaware even as you expand across the country. Thus making any company especially a credit repair company even more protected in this State.

Best of all there is no income tax in Delaware. While you still have Federal Taxes, Delaware does not tax on income. So you end up with more profit from your income.

On the flip side of all this, Delaware does tax heavily on bank items. Interest on bank accounts and banking items are taxed higher here than anywhere else in the country. Another negative item is you are taxed heavily on any unclaimed services or property in regard to your business. This includes unused gift cards and other items.

If your company becomes a franchise, you are taxed a heavy franchise tax. This is to discourage existing corporations from trying to pull into the economy to catch a break.

With the information provided, you should be able to make a reasonable and sound decision on the best area to start your new business. Backed with information, both in the realms of pros and cons, you should be able to decide which business is right for you to begin. An attorney that specializes in business law will also be able to offer you fine tuned details on what route would be best for you as well. As all factors of a business have different items to consider.

Insider Secrets about Corporations: Or, Why Should I Incorporate?

-“Why should I incorporate? I can just do this business as a sole proprietor, right?”

-“Isn’t it complicated and expensive to form a corporation?”

-“I run my business with my spouse, and we have a partnership. Why would we need to have a corporation?”

These have to be the most frequently asked questions that I–and my own financial and legal advisors–get from our clients. The vast majority of people who operate small business or home-based business are sole proprietors or mom-and-pop shop-type partners. Yet, leading authorities on small business estimate that at least 90% of all small business and home business entrepreneurs would benefit from incorporating and using a corporation as an essential component of their overall business structure.

If this is true, why do so many entrepreneurs elect to operate as sole proprietors and general partners anyway? And why would you be better off incorporating?

The answer to the first question is usually either (1)ignorance of the tremendous risks of operating in this manner or (2) lack of familiarity with corporations and other legal entities and the ease with which they can be established. I should add that if the sole proprietorship is perilous, the partnership is more than twice as bad. This is because the partnership is by default a general partnership, in which each partner is responsible for all actions of the company, including decisions made by the other partner in which she did not participate. Now that’s frightening!

To answer the second question, we must first establish what a corporation is precisely. A corporation is an artificial legal entity that is separate from its owner/shareholders in the eyes of the law. The wealthy have learned that there are at least three major advantages that make the corporation an
essential component of your business structure.

1. Asset Protection.

The single most important benefit of the corporation is protection it affords for your personal assets.

The corporation is created when you file appropriate documents–“Articles of Incorporation” in the United States–to the appropriate state legal authorities. A corporation cannot be formed through some private agreement between the parties who elect to form it. It can only come into being by the state in which it is formed creating it, and it has the rights and obligations established by the laws of that state.

Most important here is the notion of the corporate veil–this is the shield that separates your business assets and activities from the private person and assets of the owner/shareholder(s). Because the corporation is a separate legal person, if you are a consultant or translator, for example–or own a small store–and someone claims that that they have suffered injury from your business (say, from a poor translation or a slip on your wet floor), and files a lawsuit, only the assets of your business are in jeopardy. The claimant cannot touch your personal residence or your automobile if these are owned by you and not your corporation.

There are significant differences among individual states and the degree of protection that they afford to the corporate veil. In California, for instance, there are a number of occasions–too many for comfort–in which the corporate veil has been pierced, thus allowing financial predators to seize the personal assets of an entrepreneur. This is almost never happened in Nevada, making it the state of choice for entrepreneurs seeking asset protection.

We will be devoting a separate article to the Nevada corporation in depth in a future issue of this eNewsletter. It is important to note for now that an additional advantage of the Nevada corporation for many is that Nevada has no state income tax. If you use a Nevada corporation to conduct business in your own home state outside Nevada (such as California, our own home state), you may still be subject to state income tax. Because of the superior asset protection afforded by the Nevada corporation, however, it may still be worth while for you to establish a Nevada corporation. Large numbers of entrepreneurs from other countries as well as other states establish Nevada corporations for precisely this reason.

2. The S Corporation versus the C Corporation: Know Which is Right for You

The issue of the personal service corporation only comes up with respect to the C corporation. The other type of corporation is an S corporation, which, like the limited liability company and the limited partnership is a pass-through entity. That is to say that the corporation is itself not taxed as an entity–instead the net income passes through to the shareholders (such as a husband and wife), and is taxed on the individual tax returns of the shareholders/owners.

There are situations in which establishing an S corporation would be preferable to using a C Corporation. If you have significant income from a job, for example, and you anticipate significant losses in early years and you don’t anticipate that your business will earn over $150,000, an S corporation will be your best choice. However, there are limitations on who can be members of an S corporation, and there are limits on employee benefits in an S corporation.

A sophisticated business structure will probably make use of both the C and the S corporation. On the other hand, because of the nature of corporations, you will never want to use either type of corporation to hold real estate. Instead you will want to use a limited liability company or a limited partnership. However, if you are a real estate investor, there might still be room for an S- or C-Corporation in your overall business structure. For example, a corporation could be used to manage your properties held in another entity.

Or–and this is a strategy that could be used for conducting various sorts of business-the corporation could be part of another business entity. For example, if you wish to operate a limited partnership, you will need to have a general partner. But the general partner is responsible for all decisions made and all liability resulting therefrom–the general partner, in short, has unlimited liability. Thus, an intelligent option is to use an S- or C-corporation to be the general partner. This way you have a general partner with the limited liability associated with the corporation.

3. Know How to Manage Your Corporation Properly to Keep the Corporate Veil Intact

Regardless of where you establish your corporation, you will need to make sure that you observe appropriate formalities–otherwise your corporate veil can be pierced very easily, thereby defeating the entire purpose of setting it up. Even if you have an accountant who handles your bookkeeping and tax returns, it remains your responsibility to assure that you are doing this correctly.

This involves holding regular meetings and maintaining minutes in your record book, issuing stock certificates, and other formalities.

The Personal Service Corporation

A final issue that may arise, particularly for independent consultants, translators, and other professionals, concerns the “Personal Service Corporation.” There are two separate categories of professionals who may be affected by this problem: Those, such as lawyers, accountants, psychologists, and health care professionals, who are required by their state laws to incorporate as professional corporations. These corporations are automatically classified by the IRS as personal service corporations.

In addition, the IRS has broadened the definition of “personal service” to include any work, such as translation or consulting, that is personally rendered by the owner/shareholder. This is of particular concern if you are operating on your own as an individual or as a couple. If 95% or more of your earnings come from work in that personal service activity, the corporation becomes qualified as a personal service corporation.

The reason that this is of concern is that a personal service corporation incorporated as a C corporation is subject to a flat 35 percent tax rate and to a lower ceiling ($150,000) for application of the accumulated earnings tax (normally $250,000). However, this is not an insurmountable obstacle to enjoying the benefits of incorporating:

1. First, the other advantages of incorporating still render the C corporation preferable to operating using another structure, such as the sole proprietor. It may be especially attractive if otherwise a high earning couple might be subject to a higher tax bracket.

2. Secondly, it is possible to structure your activities so that more than 5% of the activity is derived from work that falls outside the scope of personal services rendered by the owner/shareholder. For example, a translator or consultant might have a branch of the business involved in network marketing–as a medical professional might have a health food store or other income producing activity–so that the corporation is no longer qualified as a personal service corporation.

As you can see, the corporation is an extremely valuable tool, one that the wealthy have used extremely effectively. If you are operating as an independent entrepreneur and are not using a corporation or the popular alternative of the limited liability company, you are most likely handicapping yourself, limiting your profitability and paying excessive ta
xes. With the resources that we have available today, especially over the internet, there is no reason that the average individual cannot easily begin to take advantage of this valuable tool. We currently have 3 entities that we formed ourselves and that cost us just the cost of the various resources that we purchased plus the filing fees required by the State of California and postage to get these set up. And we have made sure to obtain the proper forms through the sources we list on our Resources page so that we can maintain the legality of these entities.

“Can’t I wait and start out as a sole proprietor or partner and incorporate later?” we are often asked.

Certainly, if you don’t mind exposing all your personal assets to risk, paying higher taxes, and finding yourself more likely to be subject to an IRS audit. Some people prefer to do things the hard way–but, armed with the right information and resources, there’s no reason why you should have to.

Even if you decide to allow a tax attorney to help you with the formalities, it is better to do so armed with the knowledge you need to judge whether the recommendations she makes are in fact in your best interest.

At the very least, you’ll know enough to head immediately for the nearest exit if any “expert” you consult tells you that you “don’t need” to establish a legal entity to run your business.

Copyright 2006 Azur Pacific Associates

Corporate Law Adviser – Justification of Criminal Sanctions For Violations of Corporate Governance


1. Corporate governance is concerned with the separation of ownership and control that results when a company is publicly listed and, therefore, has too many owners who cannot all control the company at once, and as such, they hire professional managers to do so. It has been defined, thus:
“The system through which those involved in the company’s management are held accountable for their performance, with the aim of ensuring that they adhere to the company’s proper objectives”.

It is generally accepted that the law plays a key role in corporate governance particularly in the provision of shareholder protection and the reduction of expropriation that is the result of the separation of ownership and control. However, on the importance of role of criminal law in enforcing good corporate governance there are more than one view. Effectiveness of criminal sanctions in deterring corporate governance violations.

2. In order to deter certain undesirable conduct, the criminal law has traditionally employed such sanctions as imprisonment, fines, and the stigma of criminality. While the effectiveness of these sanctions in criminal law generally has been debated, it has been persuasively argued that they can effectively deter corporate crime. Since corporations are primarily profit seeking institutions, they choose to violate the law only if it appears profitable. Profit maximising decisions are carefully based upon the probability and amount of potential profit, so a corporate decision to violate the criminal law would generally include a calculation of the likelihood of prosecution and the probable severity of any punishment. Making these costs sufficiently high should eliminate the potential benefit of illegal corporate activity and, hence, any incentive to undertake such activity.

2.1 Improper corporate conduct could be deterred by applying criminal sanctions either to the corporation itself or to its officers and employees. A corporation cannot, of course, be imprisoned but there may be stigma of criminal label attached to it. Such stigma could influence corporate behaviour if it led to diminished profits.

2.2 A system of fines imposed on corporations should also adequately deter illegal corporate activity as long as the fines are large enough to force the corporation to disgorge all benefit gained from illicit conduct.

2.3 It is possible to deter corporate misbehaviour by applying criminal sanctions to individuals in the organisation. Since businessmen fear the stigma of criminality for both personal and economic reasons, such penalties might be effective deterrents. Indeed, the fear of criminal indictment or investigation, even in the absence of conviction, may effectively deter corporate officials.

2.4 Corporate civil sanctions and even individual civil fines will be inadequate when an individual is motivated to violate the law by reasons other than corporate benefit. He may seek, for example, to enhance his position within the corporation or even to use his position to violate a law which he believes is unjust. Thus, any additional deterrence which is needed to supplement a system of civil fines could only be obtained by imposing criminal sanctions on such blameworthy behaviour by individuals.

2.5 Criminal law also empowers other law abiding individuals – whether the Board of directors, senior management, or other professionals – to stand up to less well intentioned colleagues or, at a minimum, to resist going along with misconduct.

2.6 The survival and long-term profitability of corporations is no longer a private interest which merely affects those who deal with the corporation at a primary level, for instance investors, but also a public interest affecting the welfare of stakeholders such as employees to whom it provides jobs and pensions. The Government, therefore, has a responsibility to ensure that employees as well as other stakeholders of the corporation are protected from the fraudulent acts of managers who do not act in the best interests of the company. The success of the corporation is, therefore, a public interest that, to a certain degree, ought to be protected through State regulation.

2.7 Research has confirmed that criminal sanctions are the only mechanism that can protect investors from large scale fraud or theft. Every country uses harsh criminal punishments to deal with cases like Enron and Parmalat. This suggests that criminal punishment is a generally accepted way of protecting shareholders from expropriation and risk-taking in corporate governance.
Dangers in the application of criminal sanctions

3. Some commentators have expressed doubts about the effectiveness of criminal sanctions for violation of good corporate governance. They believe that the criminal sanctions to corporations and individuals are ineffective deterrents to violations of good corporate governance norms.

3.1 The use of criminal sanctions to regulate business activities is generally perceived as being an over-reaction that is likely to discourage directors from taking the risk that is necessary to run a business, thereby slowing down economic growth and interfering with profitability.

3.2 The use of criminal sanctions is an expensive way of enforcing regulation, which has a high burden of proof and as such is prohibitive to those seeking remedies for expropriation, as shareholders are required to demonstrate the director’s culpability.

3.3 Criminal sanctions cannot provide restitution to shareholders and employees who have lost their jobs.

3.4 The difficulty in pinpointing responsible persons in the corporate structure lessens the likelihood that a businessman will in fact be convicted of criminal activity. Thus, corporate crime may not be adequately deterred by criminal sanctions designed for individuals.

3.5 The criminal law is being used to regulate behaviour that is not in and of itself morally blameworthy and in some cases imposes sanctions in the absence of fault. The use of criminal sanctions for purely regulatory purposes represents a severe departure from the traditional aims of the criminal law-deterrence and retribution.

3.6 The type of activity which results in criminal liability in the corporate setting is different from other criminal activity; the primary concern is often with the supervisors and managers rather than with the direct actors. Thus, corporate officials may be held liable for acquiescing in, or for recklessly or negligently tolerating, the illegal activity of subordinates.

3.7 Criminal sanctions are imposed on a corporation, an artificial entity which can possess no state of mind, in the absence of some theory which ascribes fault to the corporation itself, rather than only to its officers, directors, and employees, the concept of mens area in criminal law is itself challenged.

4. Given the range of policy issues raised by corporate governance, and variety of industries and firms involved, government decision makers will need to understand thoroughly the effects that different regulatory actions can have. There are arguments both in favour and against the use of criminal sanctions to be imposed against the violators of corporate governance norms. As per the existing laws of our country there are various provisions fixing the criminal liability of the wrongdoers in cases of fraud and misconduct, etc. Indian Penal Code affixes penal liability for any fraud or breach of trust committed by the companies and even various individual sections of the Companies Act impose penalties for violations of certain norms which are part of good corporate governance.

But these provisions have merely remained on paper and their implementation has often remained a big headache for the government. However, scandals and scams such as Satyam’s case have been a reality even in the present times. Even though section 23E of the Securities Contracts (Regulation) Act, 1956 imposes penal liability on the company for any violation of the condition of listing agreement, which includes clause 49 of the Listing Agreement and relates to corporate governance, but the fact remains that such liability is imposed on the company itself which directly affects the stakeholders in the company and are in fact the real victims of violation of good governance.

Business Relationships As They Relate to Corporate America


As we form business relationships, the question arises to whether a sole proprietorship or corporation is needed. For a definition purpose, a corporation is a legal entity, separate from its shareholders, created under the authority of the legislature. As an entity, a corporation is responsible for its debts. The shareholders are not responsible for the corporate debts. Shareholders risk is limited to the amount of their investment. The ownership interests of the corporation are represented by shares, which are freely transferable. Management control of a corporation is centralized in the board of directors and officers acting under the direction of the board’s authority. Shareholders generally elect the board, but they cannot control the activities of the board and have no power in management of corporate business.

Corporations have distinct differences than partnerships. Partnerships are governed by the Uniform Partnership Act (UPA). Partnerships are not legal entities, but aggregates of two or more persons engaged in a business. With corporations, shareholders are limited their investments. In partnerships, each partner is subject to lunlimited personal liability for all debts of the partnership. Know your goals in what you want and research each before deciding on a partnership or corporation (refer to my March 2003 article in Chiropractic Products “Partnerships”).

A corporation, as a legal entity notwithstanding the death or incapacity of its shareholders can have a perpetual duration. Partnerships are not able to perpetuate. If a corporation goes bankrupt, any debts owed by the corporation may, under certain circumstances be subordinated to the debtors. This means the debts would have to be paid before the shareholders get any money. This came about in a case (Taylor vs. Standard Gas and Electric Corp.) and is called “Deep Rock Doctrine”. Formation or organization of a corporation is completed under “general corporate law” or “business law” statutes of the state in which you are incorporating. Usually a corporation is organized by the execution and filing of the “certificate of articles” of incorporation by the person or persons forming the corporation. The articles must show the names of the shareholders, address and name of the corporations registered agent, name and the address of each person forming the corporation. Optional provisions may include:

1. Purpose of the incorporation
2. Names of board of directors and management powers
3. Par value of shares or class of shares.

Corporations can engage in any legal business without spelling out a long list of corporate purposes. Most states confer certain powers for every corporation whether of not those powers are stated in the articles, Typically a corporation is grated the following:

1. Purpetual existence
2. To have the ability to sue and be sued
3. Have a corporate seal
4. To acquire, hold, dispose of personal and real property
5. Appoint officers
6. Adopt and amend by-laws
7. Conduct business in and out of state
8. To make contracts
9. To make donations

When A corporation acts beyond the purpose and powers it is called “Ultra Vires”. This is not a defense in tort law or liability to escape civil damages by claiming the corporation had no legal power to commit a wrongful act. This also applies to criminal liability. A corporation must act within its powers and purpose as stated in state statues. Most state statutes prohibit the use of Ultra Vires as a defense in a suit between contracting parties. However, if a contract has been performed and has resulted in a loss to the corporation, the corporation can sue the officers or directors for damages for exceeding their authority. If the corporation refuses to sue, a shareholder may bring a derivative suit. States may sue to enjoin the corporation from transacting unauthorized business. If the prevailing party wins, they may be entitled to compensatory damages.


Generally the powers to manage the corporation belongs to the board of directors and not the shareholders. The shareholders cannot order the board of directors to take certain actions in managing the corporation. However, shareholders approval is required for certain fundamental changes including: amendment to the articles of the corporation, mergers, and sale of substantial assets and dissolution of the corporation. Shareholders also have the power to remove a director for “cause”. Shareholders also have the right to:

1. Ratify certain kinds of management transactions
2. Adopt non-binding resolutions
3. Right to adopt and amend by-laws

A “Close” corporation is defined by ownership by a small number of shareholders, have no general market for the stocks, have limitations of the transfer of the stocks and adopt special governance rules. In this respect a close corporation is similar to a partnership. Most states define a close corporation by the number of shareholders. Each state varies as to that number. In California it’s 35 shareholders, in Delaware it’s 30.


Original directors are those persons who initially set up the Corporation. The shareholders at the annual meeting elect board members, which can also be the original directors if there are no other shareholders. Once elected, shareholders can only be removed for “cause”. Cause may be fraud, dishonesty, etc. Directors can be removed by the shareholders without cause if there is specific authority to do so in the articles of incorporation.

The director that is to be removed is entitled to a hearing before a final vote on removal is cast. Courts generally do not have the authority to remove directors, but some courts have taken the position of removing directors for specific reason such as fraud or dishonest act. Each director has a fiduciary relationship to the corporation and must exercise the care of ordinary prudent and diligent person would act under similar circumstances. Courts vary on what constitutes a bad decision by a director that would breach his or her duty to the corporation. When a director has not exercised proper care, he can be held liable from corporate losses suffered as a direct and proximal result of his breach of duty. Injury and causation must still be shown when duty is breached. There can also be criminal misconduct that would make a director or officer liable. There are a variety of types of corporations you can establish. Make sure you set up the proper type of corporation that will meet your particular needs.