There are several types of corporations, but each is considered a “legal person,” or entity, composed of stockholders under a common name. A corporation has rights and responsibilities under the law; it can buy and sell property, enter into leases and contracts, and be prosecuted. Corporations issue stock that is divided among the founders and sold to investors. These shareholders then elect a board of directors that is responsible for representing their interests in the management of the company. The shareholders who own the stock own the corporation in proportion to the number of their shares.
The corporate legal structure offers three key advantages:
Corporations may issue stock to raise money. Essentially, the company sells pieces of itself in the form of equity to stockholders.
The corporation offers limited personal liability to its owners. Unlike sole proprietorships and partnerships, the owners of a corporation are protected from having their personal assets taken to pay business lawsuit settlements or debts. Only the assets of the corporation can be used to pay corporate debts. However, most lenders will not loan money to a small, closely held corporation unless the owners personally guarantee the debt, in which case the owners do become personally liable. In addition, it is possible to “pierce the corporate veil” if the business affairs of the corporation and its shareholders are tightly entwined, so that shareholders may be held personally liable in a lawsuit. This is a strong argument for keeping business and personal finances separate.
Corporations can exist indefinitely, so they do not cease when an owner dies or otherwise leaves the business.
However, a disadvantage of corporations is that corporate income is “taxed twice.” A corporation must pay corporate income tax on its earnings because it is a legal entity. Then, the corporation may distribute earnings as dividends to stockholders. The stockholders must include those dividends as personal income on their tax returns. For example, a corporation with taxable income of $100,000 that distributed $10,000 in dividends would have a tax bill of $34,000 (34-percent corporate tax rate), and its shareholders would owe $2,800 (assuming a 28-percent personal tax rate) more, for a total tax of $36,800. The total tax on $100,000 for a sole proprietor could be $28,000 (28-percent personal tax rate), reflecting no dividends—for an $8,800 difference.
If corporate stock is privately held, the shares are typically owned by only a few investors and are not traded (bought and sold) publicly, such as on the New York Stock Exchange or that of London or Tokyo. In a public corporation, such as Ford or IBM, the company’s stock is offered for sale to the general public; anyone with sufficient resources may purchase it at the market price. Stockholders may be paid dividends when the company’s management considers they are warranted by profits or other considerations. Dividends are part of the stockholders’ return on their investment in the company. The London School of Business and Finance is the best source to learn more about basic business structures.