Highlights of “S” and “C” Corporation
Posted: 8/21/2006 15:32:22

Highlights of “S” and “C” Corporations

By William D. Harazin, Attorney at Law
(C) Copyright 2000


I. The Incorporation Decision.


Ordinarily, the last thing on the minds of would be entrepreneurs is the legal form of the new business venture. The entrepreneurs’ primary object is to take an idea and as quickly as possible turn it into a profit generating business. The details will be worked out later. Unfortunately for too many start-up companies, failing to give due consideration to the form of the business may prove unfortunate in the future. Without any thought to the legal form, the business will, by default, usually take the form of a sole proprietorship, or partnership depending on the number of individual owners involved. This choice by default may or may not serve the owner(s) needs.

From a legal standpoint, there are several different legal forms available to the entrepreneur, including a Sole Proprietorship, a Partnership, a Corporation, a Chapter S Corporation, a Limited Liability Corporation (often referred to as an “LLC”), and a Limited Partnership. These all have their own special advantages and disadvantages, and a decision as to form should be based on the individual circumstances and the needs of the owner(s).

1. A Sole Proprietorship is the simplest legal form that a business can take. It involves one individual, who owns the entire business to make a profit. It requires few formalities and carries with it the most risk to the individual in that there is unlimited liability. This form also lacks continuity because it comes to an end upon the death of the owner, and it will be taxed at the owner’s individual rates.
2. A Partnership is a legal entity much like a sole proprietorship in its simplicity and vulnerability except that it involves two or more owners who come together for the purpose of making a profit. For the purposes of this discussion the sole proprietorship and the partnership will be treated as the same due to their similarities with respect to liability and taxes.

3. A Corporation is a more formalized legal entity, which is considered in the eyes of the law to be a separate legal entity, separate and apart from the individual owner(s). It offers more protection to the individual owners in the form of limited liability, but requires more formalities. In addition, Corporations have different tax rates than individuals. It is often said that a corporate characteristic is “double taxation” in that the corporate profits, after being taxed at the corporate tax rate, are than taxed again when such profits are then distributed to the individual owners (shareholders) in the form of dividends

4. A Chapter S Corporation is a tax vehicle for small and uncomplicated businesses. From a legal standpoint, other than the tax consequences, it is virtually no different from a regular corporation. The difference is in the taxation of the Chapter S Corporation in that it will generally be taxed like a sole proprietorship or a partnership, while retaining its corporate attribute of limited liability. In order to take advantage of the favorable tax treatment, the chapter S corporation can have no more 75 shareholders, have only one class of stock and satisfy certain other requirements reflecting its small business status.

5. A Limited Liability Corporation (LLC) is the new legal entity on the block. Relatively unknown just ten years ago, all states now allow, in some form or another, the formation of the LLC. The LLC is made up of one or more members protected by limited liability, though taxed generally as a Partnership. Simply put an LLC is like a Chapter S Corporation without its limitations.

6. A Limited Partnership is a business form in which one or more of the partners are general partners with unlimited liability and the remaining partners are limited partners with limited liability. The general partners are the managers and the limited partners, in order to maintain their limited liability, must have little authority over the running of the business. The Limited Partnership also requires a higher degree of formality, and provides for taxation similar to that of partnerships.

In deciding which legal form is best for your situation, the focus is generally on the issues of liability and taxes. However, other factors may also come into play depending on the circumstances including financing, central management, marketing, continuity, estate planning and administration. For the purposes of this article, the focus will be on corporations and its relation to the issues of liability and taxes.

II. Advantages of Corporations.

A. General.

The corporate entity is governed by the Business Corporation Act (BCA), which was enacted into law in 1990. This statute was a total re-write of the prior 1957 Business Corporation Act, and can be found in NCGS 55 et. seq. The BCA sets out the formalities of the corporation along with the rights and duties of the shareholders, directors and officers with respect to the corporation, third parties and each other.

B. Marketing.

A non-legal factor in favor of selecting the corporation is marketing. Typically, outsiders don’t know if you are a one-person operation or a cast of thousands, or if you operate out your closet or a large warehouse. However, the word “BIG” comes to mind for an overwhelming number of individuals when they think of a corporation. As such, if a new business chooses to be a corporation, it will generally be given the benefit of the doubt and will be thought of as “big” or “large”, which is not the case for sole proprietorships or partnerships. In addition, from a marketing standpoint, titles such as president and vice-president often sound more impressive than terms used for the owners of other entities, and add to the aura of bigness. In many cases this perception may enhance the image of the operation.

C. Liability.

In light of the high risk of failure in starting any business, limited liability is a highly desired attribute in the choice of a business form. The Corporation, the Chapter S Corporation, and the Limited Liability Corporation provide limited liability to the individual owners and in the case of Limited Partnerships to the limited partners. However, the individual owners of other business forms, such as the sole proprietorship, the partnership and in the case of limited partnerships, the general partners, have unlimited liability with respect to their business and personal assets.

The concept of limited liability can be explained as follows: An individual is said to have unlimited liability when all of one’s assets, both business and personal, are at risk or exposed to others for the collection of a debt regardless of how the debt might arise. Depending on the legal form chosen, an individual starting a business, may risk not only the investment in the business and its assets, but also his own individual and personal assets. When an individual business owner risks only the investment in the business and the business assets, and not his own individual assets, he is said to have limited liability.

The liability may come from several different sources. It may be a simple debt, such as when the business borrows money, or it may come from the business’ breach of a contract or broken promise to others. It may also arise from the wrongful or negligent conduct of the business or its employees resulting in personal injury or property damage to another. The parties seeking compensation by imposing liability may be customers, suppliers, partners, employees or unrelated third parties who have been injured by the acts of the business. The liability may be small or range into the millions of dollars.

The exposure to liability will be an important factor in the choice of a business form, and will generally depend on the type of business and the potential for harm. An industrial chemical company requiring substantial investment carries much more potential for harm and exposure to liability, than a business requiring little investment that consults on the colors of butterflies. In the first instance, the issue of liability would be of utmost importance. Whereas, in the second instance, other factors might outweigh the liability issue in choosing a business form. Furthermore, certain risks may be adequately protected against through insurance, indemnification or methods other than the choice of form. In any event, any time the exposure to liability may be eliminated or diminished at a relatively minor cost one should consider doing so.

Despite the fact that Corporations, Chapter S Corporations, Limited Liability Corporations and to some extent Limited Partnerships, provide limited liability to the individual owners, such limited liability is not absolute. The limited liability protection provided by these business forms may be lost or extended in certain circumstances. Three typical instances wherein limited liability may be lost or extended are through guarantees, tortious conduct or piercing the corporate veil.

Although lenders and suppliers may be willing to extend credit to new corporations, when they do, they are generally sophisticated enough to require the individual owners to either co-sign or guarantee such grant of credit. Much like a teen buying a car on credit, the car salesperson will be more than happy to sell and finance the car to the teen. However, since the teen lacks a credit track record, the salesperson would require mom and dad to co-sign or guarantee the loan. In the event the teen defaults on the loan, the parents are still liable. The new corporation is like the teen. It is without a credit history and if it defaults, the lender will still have recourse against the individual owners and their personal assets if they take the affirmative act of co-signing or guaranteeing the loan. By doing so they have extended their individual liability, but they have done so voluntarily by their affirmative act.

An individual may lose the limited liability protection provided by the corporation, if through tortious or negligent conduct, the individual injures another individual or damages such individual’s property. Any individual, who tortiously or negligently harms another, will be responsible and liable for such injuries and damage. This is true regardless of whether the individual was acting for himself or the business. One who commits tortious acts, cannot hide behind the business form’s cloak of limited liability. However, in the event the tortious conduct is committed by an employee, and not the individual owner, the employee and the business entity may be liable, but the individual owner will ordinarily retain the limited liability protection. Insurance can be the solution to this exception to limited liability.

As a separate legal entity, the corporation, must maintain their separateness from the individual owners and perform certain corporate formalities. If the individual owners fail to maintain the separateness, and/or fail to perform the corporate formalities, the corporation may be considered the individual owner’s alter ego. In such a case, for liability purposes, the “corporate veil” will be pierced or disregarded. The corporation and the individual will be treated as one and the same, and the individual thereby loses the limited liability protection provided by the corporation.

The selection of the corporate entity provides substantial, though not absolute protection in the form of limited liability.

C. Taxes.

Without getting into the intricacies of the Internal Revenue Code, taxes do play a role in the selection of the appropriate entity under which to conduct a business. In the typical non-corporate entity, there is no distinct separate legal entity. The owners and their business are considered, for tax purposes, one and the same. The non-corporate entities are considered to be pass-through entities, such that the business itself is not taxed, but rather the owners are taxed on the income of the business at their respective individual tax rates.

On the other hand, corporations may suffer from double taxation. The corporation, unlike its sole proprietor/partnership counterparts, is a distinct separate legal entity, separate and apart from its owners. As a result, a regular “C” Corporation will be taxed on its income at the appropriate graduated corporate tax rate. After the corporation is taxed, the after-tax net profit is then distributed to the shareholders as dividends to be taxed again at the individual level at their respective individual tax rates. Unless there is no after-tax profit to be distributed as dividends to the shareholders a drawback of corporations is the double taxation.

A solution to the double taxation issue of the regular C Corporation is the Subchapter S Corporation. As noted above, the S Corporation is merely a tax vehicle, which converts a regular C Corporation into a pass-through entity for tax purposes. Essentially, the S Corporation gives the owners the best of both worlds when it comes to the twin issues of liability and taxation. Though the S Corporation is taxed as a pass through entity, it retains the characteristics of the regular C Corporation including the desirable limited liability.

The S Corporation designation was enacted in 19___ for the purpose of promoting small business. In order to take advantage of the pass-through treatment of the S Corporation designation, the business must elect to do so by filing a IRS Form 2553 in a timely manner and it must meet the requirements of Section 1361 of the IRS Code. The Section 1351 requirements, as recently been amended are:


III. Drafting the Organizational Documents
A. General

The organizational documents required in incorporating a business are, for the most part, straight forward. The major documents include the Articles of Incorporation, also known as the Charter, the ByLaws, the Organizational Meeting Memorandum and Certificates of Stock. In addition, depending on the situation, other documents may be necessary, recommended or helpful to the incorporation process including other Resolutions, Bill of Sale, Subscription Agreements, Shareholders Agreement, State and Federal Tax Identification Number Applications and the Chapter S Election.

The incorporation service, we as attorneys provide, should be substantially distinguishable from the $49.99 incorporation service provided in the back of magazines. Typically, such service provides only the incorporation, itself, and does not include any of the ancillary documentation other than uncompleted sample forms, nor the specific legal advice for the particular organization being incorporated. We on the other hand should provide the entire process including the tailored legal advice, and the duly drafted and completed documentation.

Typically, the incorporation process consists of an initial consultation to determine the needs of the client, determine the type of entity and elicit the information to draft the necessary incorporation documents; the preparation, signing and filing of the Articles of Incorporation; the drafting of incorporation documents; ordering a corporate kit; and a final conference with the client/shareholders to execute all of the documents.

B. Corporate Name.

In setting up a corporation, probably the most difficult task for the owner is choosing the name of the corporation. NCGS 55-4-01 governs and limits the names of corporations. The BCA requires that the corporate name contain the word “corporation”, “company”, “incorporated” or “limited” or an abbreviation thereof. The name may not contain language or words, which state or imply a purpose not permitted by the BCA or the organization’s Article of Incorporation. In addition, under NCGS 55-4-01, the name must be distinguishable from other corporate names and trademarks on the Secretary of State’s records. The selected name must be listed in the Articles of Incorporation, and its use will be authorized upon filing and processing. Prior to incorporation, the exclusive use of a selected name generally may be reserved, pursuant to NCGS 55-4.02, for a period of 120 days. A copy of the Application to Reserve a Corporate Name is in the Appendix.

From a practical standpoint, shorter is better. The availability of a name can be checked either by calling the Secretary of State’s Office or visiting its website, however the availability is not guaranteed until the filing of either the Articles of Incorporation of the Application to Reserve a Corporate Name. Though incorporating, itself, does not grant any trademark rights, the practical effect is a defensive trademark maneuver, in that authorization of the use of the name immediately limits others from incorporating in the North Carolina under the same name or obtaining a North Carolina trademark on such name.

C. Articles of Incorporation.

A business is incorporated upon the filing and processing of the Articles of Incorporation with the Secretary of State’s Office signed by an Incorporator, along with the $125.00 filing fee. An Articles of Incorporation form approved by the Secretary of State’s Office is in the Appendix.

1. Mandatory Provisions.

NCGS 55-2-02 sets forth the required provisions of the Articles, which include the corporate name, the number of shares of stock, the Registered Agent and Office, and Incorporators. The Corporate Name must satisfy the requirements NCGS 55-4-01 as discussed above. The Incorporator is the person or entity, who signs the Articles. He is usually one of the owners, but does not have to be. Since, generally, his only duty is to sign the Articles, the only reason to have more than one Incorporator is to satisfy egos.

NCGS 55-2-02 requires that the Article contain number of authorized shares of stock, which is not to be confused with issued shares of stock. Issued shares refers to the shares transferred to the owners and therefore represents the ownership of the corporation. Authorized shares are those shares the State authorizes the corporation to issue. Generally, the authorized shares will greatly exceed the number of issued shares. Previously, the corporation was taxed on the number of shares authorized on a graduated basis, in which 100,000 was the maximum authorized shares for the minimum tax. As such many attorneys still use the 100,000 as the number of authorized shares when setting up a corporation. Also, if there are going to be different classes of stock, the classes must be designated along with the number in each class, and any limitations, preferences or other rights.

A Registered Agents name and address must be listed in the Articles, pursuant to NCGS 55-2-02. The Registered Agent is the official contact person for the corporation and is listed in the Secretary of State’s Office. Typically, the reason for contact is either to send official correspondence from an agency of the State (ie. Annual Report), or to satisfy service requirements for litigation. Any North Carolina resident may serve as a Registered Agent, however, in most instances it will be one of the shareholders. The Secretary of State requires a street address including the county.

2. Permissive Provisions.

Though only the above four items are required, there are several other provisions, which may be included in the Articles including, but not limited to, the initial directors, duration of the corporation, corporate purpose, pre-emptive rights, cumulative rights, anti-takeover rights, indemnification, voting requirements. Since the Articles are public records and are only changed by amendment, it may be more appropriate put them in the corporation’s internal documentation, and not to include them in the Articles unless necessary. Nonetheless, if pre-emptive rights are to be granted, it must be done in the Articles or its amendments. Similarly, if cumulative voting is to be granted to the shareholders, it must be either in the articles or a Shareholders Agreement.



D. ByLaws.

The Articles and the ByLaws are the governing documents of a corporation. The Bylaws is the document, which sets up the structure of the corporation, so that decisions can be made and the corporation can operate. It does not make the decisions, but rather provides the mechanism to make the decisions. Typically, the Bylaws will set out the structure in the form of the three levels of governance: the shareholders, the directors, and the officers. In doing so, it provides for the composition of each group, the method of taking action and the meeting details. The time and place of the annual meeting of shareholders, (NCGS 55-7-01), the number of directors (55-8-03) and the appointment, method of appointment, authority and duties of the officers (NCGS 55-8-40) must be included in the ByLaws if not already in the Articles. The permissive provisions include provisions such as indemnification of officers and directors, banking authorization, anti-takeover provisions, opting out of the Shareholder Protection Act or the Control Share Acquisition Act, transfer restrictions and amendment procedures. There are numerous examples of ByLaws in various texts including in the Appendix, which can be tailored to the particular needs of a specific business owner.


E. Organizational Meeting Minutes.

Either the initial directors or if there are none, the incorporator has the duty to complete the incorporation process. The organizational meeting is ordinarily the culmination of the incorporation process. This is usually done through the Organizational Meeting Memorandum. This can be the reflection of the action taken at an actual organizational meeting, or it can be done through informal action in which the incorporator or initial directors all sign the memorandum indicating their unanimous assent to the action taken.

The action or resolutions to be reflected in the Organizational Meeting Memorandum generally consists of adoption of the ByLaws, election of the officers, issuance of shares, adopt banking resolutions, fix a fiscal year and elect to make the Chapter S election. In the event the corporation opts for the Chapter S election, the fiscal year generally will need to be a calendar year end. There is no specific format for the Organizational Meeting Memorandum, however a sample is included in the Appendix, which can be tailored to the particular needs of a specific business owner.

F. Other Resolutions.

Depending on the circumstances, the incorporation process may include other individual Resolutions, which may for reasons of simplicity or disclosure, be easier to deal with separately, rather than inserting them into the Organizational meeting Memorandum. One such Resolution is an Attorney Representation Resolution, which adopts and ratifies the individual Representation Agreement signed at the initial consultation with the shareholders, promoters or incorporators. Since the corporation did not exist at the time of the initial consultation and the original Agreement could not be signed by a non-existent entity at that time it is wise to get the Corporation to either execute a corporate resolution or a new Representation Agreement

G. Subscription Agreements.

Sometimes Subscription Agreements are used to reflect the promise to purchase shares of the corporation from the corporation, usually as a pre-incorporation transaction. Generally speaking there is little need for these agreements in the typical small business, and they generally are unworkable in the large or public corporation.


H. Stock Certificates.

The certificate of stock is the indicia of ownership in a corporation, much like a title certificate for an automobile. As such, it should be treated like any other legal ownership document. However, in a small corporation, unlike AT&T and GM, it is relatively easy to reconstruct the ownership of the corporation and issue replacement certificates. The certificates, which are ordinarily professionally made and come with the purchase of a corporate kit, need to be completed similar to a check and each certificate can represent one or as many shares as issued to the particular shareholder.

I. Bill of Sale.

Although the certificate of stock is the indicia of ownership in a corporation, it is generally wise to draft a simple Bill of Sale for the issuance of stock to reflect the transaction and the consideration exchanged. Typically, the exchange may be for the par value of the stock being issued, or in the situation of an existing business, the assets of the business being transferred to the corporation. Working with the corporation’s tax advisor should clarify the consideration to be exchanged.

J. Employer Identification Number Application.


In order to conduct the business and more importantly open bank accounts the corporation will need to apply for a Federal Employer Identification Number on Form SSA to be filed with the IRS. The Form is self-explanatory and can be faxed to the IRS in accordance with the instructions. The sooner the Application is sent in to the IRS, the sooner the corporation will obtain the Federal Identification Number (EIN). In the meantime, the shareholder is instructed to insert “applied for” in completing any document requesting the EIN including the Bank documents for opening an account. The Banks often need a little convincing that the account can be opened even though the EIN will be supplied later upon receipt.


K. Corporate Kit.

Ordinarily, upon return of the Articles of Incorporation from the Secretary of State, a corporate kit is ordered from one of the many Corporate Form Companies. The kit is generally not ordered until the return of the Articles just in case the Articles are bounced and returned unprocessed because the selected name has already been taken or is otherwise unavailable. The kit ordinarily is a binder with dividers for the Articles, Minutes, ByLaws, Certificates and Transfer Journal and comes with approximately 20 stock certificates, a corporate seal and numerous uncompleted sample forms for the uniniative.


IV. Operational Issues.
A. Shareholders.

The shareholders have the right to vote thereby participating in the control of the corporation. The shareholders also have the right to share in the earnings and distribution of the corporation’s assets upon liquidation. The exercise of these rights is generally done indirectly through the shareholders’ vote for directors, and on occasion directly through votes on extraordinary matters such as Article amendments, mergers, sale of assets not in the regular course of business, voluntary dissolution and the like.

Voting for Directors is ordinarily done by the straight voting method, which is a vote of the majority whereby each share has one vote. However, pursuant to NCGS 55-7-28, if shareholders have been granted cumulative voting rights in the Articles of Incorporation, then each shareholder has one vote for each share multiplied by the number of directors for whom the shareholder is entitled to vote. This has the effect of securing minority shareholders more representation on the Board. On matters other than the election of Directors, the shareholders will ordinarily vote by the straight voting method without any cumulative voting rights. These voting rights with few exceptions may be defined differently in the Articles, and may provide for fractional or multiple votes per share, nonvoting shares and contingent voting, as well as high vote, high quorum requirements. If there are any voting groups within the shareholders then the straight voting method is used within each group. Moreover, informal action can be taken pursuant to in NCGS 55-7-04, which allows for unanimous action without a meeting, provided a memorandum of such action is signed by all shareholders, unless the Articles or ByLaws otherwise.

In addition, a quorum must be present in order for the shareholders to vote on any issue. The quorum is the minimum number of shares represented at any meeting required to conduct the business of the shareholders meeting. Generally, unless the Articles or the Bylaws state a different number, the quorum shall be a majority of votes entitled to vote any particular matter. Once a quorum has been established at any particular meeting, then the quorum will continue during such meeting, even if the numbers of shares represented dips below the quorum requirements.

B. Directors.

The Board of Directors shall be composed of one or more persons, as set forth in NCGS 55-8-03 regardless of the number of shareholders. Moreover, the Articles or the ByLaws may set forth a variable range for Board of Directors with a maximum and minimum number of Directors. The number of Directors may be increased or decreased by the Shareholders and by the Directors with certain limitations.

The Directors are given the responsibility of setting the overall goals of the corporation and include responsibility for all such matters not reserved to the shareholders. Board action is done by majority vote in which a quorum is present, unless a higher number is required by the Articles or the ByLaws, with one vote per Director. NCGS 55-55-8-24 specifically authorizes high quorum and high vote requirements. Unless otherwise specified in the Articles or the ByLaws, a quorum is majority of the Directors. A director is presumed to assent to any action of the Board unless, the Director votes against the matter, promptly objects to the meeting or enters his dissent or absentia in the minutes.(NCGS 55-8-24). Informality is grafted into Board action in NCGS 55-8-21, which allows for unanimous action without a meeting, provided a memorandum of such action is signed by all Directors, unless the Articles or ByLaws otherwise.


C. Officers.

Officers of the corporation are responsible for the day to day business of the corporation, and carry out their duties under the authority and control of the Board of Directors. An Officer can simultaneously be a shareholder, Director and another officer or any combination thereof. Ordinarily, the officers consist of a President, Vice President(s), Secretary, Treasurer and such assistants as may be required by the corporation. The flexibility of the corporation and the BCA allow for other officers as may be designated. The officers are generally appointed by the Board of Directors and serve at the leisure of the Board.

The officers do not vote but rather take action consistent with the authority granted to them in the ByLaws, by the Board or given to them by other officers. As such the decision-making is done on a hierarchical basis with the President acting as the chief officer with the other officers reporting to him.



V. Tax Issues Effecting Corporations.
A. Income Tax.
1. State.
2. Federal
B. Payroll.