1. What is a Corporation? A corporation is a legal entity. By law a corporation is actually a person, with the right to own property, sue, be sued and be charged with crimes. Because a corporation is a person, it can incur all of the liability in a business, thereby shielding individual stockholders from liability.
2. Is a corporation right for my business? That depends. The decision to use a corporation or an alternative entity (such as an LLC) should be made in coordination with advice from your CPA and your attorney. Since liability protection is pretty much the same for all of these entities, this decision is often tax-driven. There are also non-tax considerations. For example, if you think there’s a good chance your company will go public, a corporation may be the preferred entity.
3. Articles of Incorporation. The corporation is formed by filing Articles of Incorporation with the Maryland State Department of Assessments and Taxation (SDAT). Filing the Articles of Incorporation (also known as the corporate Charter) is what creates the entity; it is essentially the corporation’s birth certificate. Unlike other governing documents, the Charter is a public document available for anyone to inspect. (In fact, Charters filed after 2000 can be downloaded and copied from the State’s official website). The Charter must contain basic information about the corporation, including the corporation’s name, purpose, number of authorized shares, official address and resident agent. The initial board members must be named in the Charter, although future board members do not.
4. Naming Your Corporation. What legal name would you like to use for the new entity? The name must have one of the following suffixes: Inc., Incorporated, Corp., Corporation, Ltd., or Limited. You cannot use a name that’s already in use in Maryland. It is easy enough to check the availability of names by consulting the Maryland State Department of Assessments and Taxation Website: www.dat.state.md.us.
5. Principal Address. The Articles of Incorporation must designate a principal office address in the State of Maryland. This must be a street address. The State will not permit P.O. Boxes.
6. Resident Agent. The Articles of Incorporation must identify the name and address of the Resident Agent of the corporation. This is the person who accepts service of court papers and other official documents on behalf of the corporation. The Resident Agent must be a resident of the State of Maryland. The Resident Agent’s street address must be used (again, no P.O. Boxes). The Resident Agent may be an individual or an entity (a corporation, LLC, etc.) You can be Resident Agent, or you can ask your attorney to be Resident Agent.
7. Bylaws. Bylaws typically establish corporate officer positions and set out their power and duties. The Bylaws also set out procedures for calling and conducting meetings, such as establishing quorums, taking votes, and electing (or removing) officers and board members. Bylaws are the “Rodney Dangerfield” of corporate documents (they don’t get no respect). They are often viewed as a tedious collection of boilerplate – and this is usually a pretty accurate assessment. But Bylaws can become a crucial document if there is ever a dispute over corporate governance. These dispute situations arise more often than you may think. Having well drafted Bylaws may avoid the disintegrating dissolving into litigation.
8. Stockholders. The owners of a corporation are called “stockholders”. The shares of stock owned by each stockholder are represented by a stock certificate. Stockholders generally vote and receive dividends in proportion to their relative percentage number of shares.
The stockholders have the absolute power to elect and remove board members, thereby giving them ultimate sovereignty over the corporation. Stockholders may also have the right to approve Charter amendments and certain other extraordinary transactions, such as Charter amendments, mergers, sale of all or substantially all corporate assets, and dissolution. Other than these limited powers, however, Stockholders have very little management authority.
Generally, stockholders do not owe the duties to the corporation or to each other as do directors, at least to the extent they are acting in their capacity a stockholders. With respect to the few matters on which stockholders vote (e.g., electing directors), they are generally free to vote for their own interests.
In order to better understand the hierarchy of a corporation, it may be helpful to draw a comparison to our federal system of government. Stockholders are like citizens in a republican democracy in that they possess the ultimate sovereignty over corporate governance. Stockholders, like citizens, have little direct governance power. They do, however, have power to elect their representatives and to entrust those representatives with governing authority. In this way, stockholders have the ultimate governing authority, but at the same time have very little day-to-day control over the corporation’s affairs.
9. Board of Directors. The law requires that a corporation be managed under the direction of a board of directors. Directors are elected by the corporation’s Stockholders. A director may also be removed by the stockholders at any time, with or without cause. This election and removal power gives members ultimate sovereignty over the corporation.
The “under the direction of” language implies delegation. Here, law tends to imitate corporate life in that boards do traditionally set broad corporate policies which they rely on corporate officers to implement. As such, officers merely act in the capacity of corporate agents carrying out board policies. (Of course, this all may be academic in the case of smaller corporations where the officer and director hats are often worn by the same people.)
In discharging their management responsibilities, directors owe a duty of loyalty to the corporation and its stockholders. In voting on a specific matter, for example, a director must act (a) in good faith, (b) in a manner he or she reasonably believes to be in the best interests of the corporation, and (c) with the care that an ordinarily prudent person in a like position would use under similar circumstances. Directors are to act at all times in the best interests of the corporation, and not for personal gain. And, they are required to bring all business opportunities within the scope of the corporation’s business to the attention of the corporation. Directors are also obligated to make well informed decisions, suggesting a process of due diligence in consultation with outside advisors. There has been much law and commentary written on the obligations of board members. Suffice it to say here that directors have an obligation to make well informed and well reasoned decisions concerning corporation transactions.
The position of director is different from the position of officer (President, Vice President, Treasurer, etc.); although directors and officers can be the same people (and typically are with smaller entities). If you prefer to dispense with the formality of a Board of Directors, you may include in the Articles of Incorporation an election to be treated as a “close” corporation. Under Maryland law, a close corporation may elect not to have a Board of Directors, in which event all decisions would be made by majority stockholder vote (i.e., by vote of the stockholders owning a majority of the shares.
10. Officers. Every Maryland corporation must, at a minimum, have a President, Secretary and Treasurer. The corporation may have other officers (e.g., CEO, CFO, Vice Presidents, etc.), but this is not mandatory. The law says very little about the authority and responsibility of corporate officers. The only powers of officers are those granted either in the bylaws or by the board of directors. In effect, officers derive all their powers from the board.
Interestingly, the law says very little about the authority and responsibility of corporate officers. The only powers of officers are those granted either in the bylaws or by the board of directors. In effect, officers derive all their powers from the board. As noted above, a corporation is to be “managed under direction of” its board; the “under the direction of” language implies that directors have the right to delegate management tasks to officers. As noted above, officers act as agents of the corporation and have authority to sign documents in the corporation’s name.
One thing the law is clear on is that officers answer to the governing board; they are elected by the board and can be removed by the board pretty much at will.
11. Corporate Resolutions. Maryland law requires all corporations to keep correct and complete minutes of directors meetings, stockholders meetings and certain committee meetings. Corporate resolutions should be prepared whenever the corporation enters into significant contracts, issues additional stock, makes loans to stockholders or officers, adopts any retirement or pension plan or engages in any other significant transaction.
Maryland law also requires that the stockholders and directors have at least one annual meeting each year, and that minutes for those meetings be prepared and maintained as part of the corporate records. The annual stockholder meeting is primarily for electing directors for the coming term. The directors’ annual meeting is for the election of officers and approval of any other business of the corporation.
The corporate minute book should be kept up to date. Your accountant is a good source of advice as to what transactions should be reflected in the minute book. Tax season is an ideal time for you to hold an annual meeting and consider what, if any, corporate formalities need attention. Of course if we can be of any assistance to you on these issues in the future, please do not hesitate to call me.
12. Close Corporation Status. As mentioned above, a corporation may elect in its Charter to be a “Close” corporation, in which case some corporate formalities may be eliminated (e.g., board of directors, annual meetings, etc.). The downside of a close corporation is that certain extraordinary decisions require unanimous stockholder consent (e.g. amending the charter, merger, liquidation, sale of all or substantially all of the corporation’s assets, and issuing additional shares of stock). Unanimous stockholder consent would also be required to permit a stockholder to transfer any shares of stock to a third party. This may not be a problem if there are two 50-50 stockholders, in which case all decisions would require unanimous consent. If, however, you ever want to bring in other stockholders, these minority stockholders would have a veto power over certain actions. If, for example, 1% of the corporate stock were issued to an employee as an incentive, that employee could prevent you from issuing more shares to third parties or from eventually selling the Corporation. If you think you may bring in additional stockholders in the future, it may be better to be a regular non-close corporation.
One advantage to being a close corporation, is that you can elect to exempt corporate officers from workers compensation coverage. This may save you a few bucks every year. You may want to run this by your CPA. (Accountants love close corporation for just that reason).
Don’t confuse the close corporation with the S corporation. Whether a corporation is an S corporation (vs. a C corporation) is strictly a tax question. Close corporations are a creature of state corporation laws; the designation relates mainly to corporate governance.
13. Stockholder Agreement (a/k/a Buy Sell Agreement). We generally recommend that corporations have a Stockholder Agreement. This document would address the disposition of your shares upon the occurrence of certain events, such as the death, disability, termination of employment, or bankruptcy of a stockholder. It would also restrict a stockholder from transferring his shares to a third party without the other stockholder’s consent. In short, a buy-sell agreement can provide an appropriate legal mechanism for keeping strangers out of the business. A few of the issues typically addressed in the Stockholder Agreement are:
A. Death of a Stockholder: If a stockholder dies, should the Corporation be obligated to purchase his shares from his estate? Such a mandatory buyout on death is a common provision because it is often relatively inexpensive to fund by the purchase of “keyman” life insurance. Of course, if you prefer, the buyout on death could be optional rather than mandatory. If we do not address this at all, then the deceased stockholder can leave his shares to his spouse and/or other beneficiaries and you will be stuck with a new partner. At the appropriate time, you may want to get some quotes on life insurance to cover this contingency.
B. Purchase Options Upon Certain Events: If a stockholder becomes disabled, files for personal bankruptcy, or leaves the Corporation, it would be helpful if the remaining stockholder had the option (but not necessarily the obligation) to purchase the departing stockholder’s shares. Making the buyout mandatory may not be a good idea for two reasons. First, there would be no life insurance proceeds to fund the purchase as there would be with death (although you could purchase buyout disability insurance for that purpose, generally more expensive than life insurance). Secondly, a mandatory buyout rewards the stockholder who jumps ship first.
C. Purchase Price. If a stockholder is going to be bought out, there needs to provision for determining the buyout purchase price. One obvious way is for the two of you to agree in advance by putting the price in the Stockholder Agreement. You could update the agreed on price annually by signing a one-page document. Or, a common method is to simply provide that the company’s CPA or a qualified business appraiser would determine the buyout price based on a formal appraisal of the Corporation assets.
D. Right of First Refusal. Most companies want to include a provision that a stockholder may not sell his shares to a third party. Without first giving a right of first refusal to the remaining stockholder. Again, this keeps strangers (and perhaps even competitors) out of the partnership. The standard approach is for the price to match the price the stockholder proposes to sell to the third party. Alternatively, the price could be the “appraised value” price discussed in item C above, or the lesser of the two prices. This may depend on how much you want to discourage transfer of shares to outsiders.
14. Covenants Not to Compete/Confidentiality Provisions. You may want to consider adding to the Stockholder Agreement provisions non-competition language preventing a stockholder at any time while he is a stockholder and for a period of time (e.g., 2 years) after he leaves the corporation,from competing within a certain geographic radius, soliciting business from company clients, soliciting employees from leaving the company, etc.? This is an issue you should discuss with your attorney.
15. Tax Identification Number (IRS Form SS-4). Once the corporation is formed, you will need to file IRS Form SS-4 with the IRS in order to obtaining the federal tax identification number for the corporation (known as an Employer Identification Number, or EIN). Your attorney or CPA should fill out this form you. Once the form is complete, you, your attorney or your CPA may obtain the EIN by calling the IRS at 1-800-829-4933 or on the IRS website at www.irs.gov/businesses and click on Employer ID Numbers under topics.
16. Maryland Combined Registration Application. Once you have obtained the EIN, you will need to register the corporation for Maryland taxes, unemployment, etc. You do this by filing the Maryland Combined Registration Application. We generally recommend that this form be prepare by your CPA rather than your attorney. You can apply for Maryland taxes online on the Comptroller’s website: www.comp.state.md.us.
17. Raising Venture Capital. It’s a well entrenched prejudice, but, in truth, corporations may provide investors a bit more formality and accountability on the part of management– hence a higher comfort levels for outside investors. At least that’s the conventional wisdom. For example, with corporations: annual stockholder and director meetings are mandatory; you must have a board of directors with fiduciary responsibility to stockholders; there are statutorily mandated stockholder inspection rights; corporate laws restrict self-dealing by directors; directors are obligated to refer all business opportunities to the corporation (at least within the corporation’s industry), etc. None of these formalities are mandated for LLC’s. The only real potential problem area I can think of is that only individuals and certain narrow categories of entities and trusts can be stockholders of an S corporation. Also, an S corp. can only have 75 stockholders and non-U.S. citizens cannot be stockholders (with the exception of documented resident aliens). You also can’t have more than one class of stock with an S corporation, unless the only difference is voting vs. nonvoting classes (i.e.,you can have Class A Voting and Class B Nonvoting Stock, but you can’t have Common and Preferred Stock).
These reasons may not be enough to mandate your choosing corporation status, but it’s something to consider. Our crystal ball is no better than yours, but I would worry that at least some investors would want to purchase shares through an entity rather than in their individual names (remember the family trust or the family investment partnership), that some investors may want preferred stock and/or that some investors may be from overseas. A lot to weigh in the balance (nothing’s easy, alas).
For more information, contact the Davis, Agnor, Rapaport & Skalny attorney with whom you typically work, or one in our Business Planning & Transactions Practice Group.
