An S corporation is a hybrid corporation that is organized as any regular corporation under state laws, but is treated, for federal tax purposes, as a pass-through entity.
Owners of an S corporation are known as shareholders or stockholders. Owners of a S corporation will be shielded from being personally liable for corporations’ debts and liabilities. However, an S corporation cannot have more than 100 shareholders, though a husband and wife are automatically treated as one shareholder. Also, one family can elect to be treated as one shareholder as well. Shareholders have to be natural persons – exceptions to this rule include certain trusts, estates, and tax-exempt nonprofit organizations. In addition, shareholders of an S corporation have to be US citizens or US residents for federal tax purposes. Ownership of an S corporation is easily transferrable through a stock sale. One possible restriction to transfer is that many small businesses will include a right of first refusal in the shareholder agreement, to allow the company to have the first chance to buy the stocks back if the shareholder wants to sell them. The easy transferability of S corporation stock is different from interests in an LLC or partnership, where transfer of more than 50% of the interest may cause termination of the entity.
In terms of control of the business, the default rule benefits the majority shareholder. The majority shareholder elects the board of directors, which makes decisions on nearly all major business operation issues. Some states require a supermajority vote on certain types of corporate actions, such as the sale of all or of the majority of the assets of the business, or in mergers and acquisitions; but in most situations, a majority vote is all is needed. However, these default rules can be changed by using a special agreement at the time of incorporation.
There can only be one class of stock in an S corporation. However, S corporations can issue non-voting and voting common stocks, as long as the only difference in these stocks is in voting power. Stocks entitle shareholders of the company to a share of the profits of the corporation through dividends and capital appreciation. Stockholders are usually also entitled to voting rights proportionate to the number of shares they own. They often enjoy preemptive rights, which means if the company were to issue new stocks, stockholders who enjoys preemptive rights would have the first choice in purchasing the new stocks to maintain the proportional ownership/voting rights of the company.
Even though the owners of the corporation are the shareholders, they are not responsible for overseeing the activities of the corporation. A body named the “board of directors”, elected by shareholders, is responsible for the governance of the corporation, and is the highest management authority. The scope of the board’s authority, responsibilities, and duties is usually specified in the bylaws.
Some of the most common board duties include appointing executives and officers for the corporation, issuing dividends, deciding policies regarding the management of the corporation, determining the mission of the corporation and making sure that the corporation stays on task. Board members owe fiduciary duties to the shareholders. The board’s ultimate goal is to protect and enhance the shareholders’ investment in the corporation.
Board members usually also enjoy limited liabilities and will be protected from personal liabilities in connection with their duties on the board. This is usually done by putting an indemnification provision in the bylaws of the corporation, stating that the members will be reimbursed for any liability expenses occurred while they are performing their roles as board members. This protection can even extend to cover personal liabilities incurred by lawsuits filed by shareholders of the company. However, the indemnification provision usually doesn’t cover behavior that is bad faith, intentional or fraudulent.
S corporations enjoy pass-through taxation. The corporation’s income is taxed when it is paid in dividends to its owners under the personal income tax, not at the corporate level. This means that both the income and tax loss of the corporation can be “passed through” to the corporation’s owners. In addition, the S corporation enjoys a once-a-year tax filing requirement, in contrast to the quarterly tax filing requirement for a C corporation.
The incorporation process of an S corporation is the same as that of a C corporation. Rules vary from state to state. The first thing business owners need to decide is which state they want the business to be established in. Usually the process involves filing with the appropriate state authorities, paying the required amount of incorporation fees, and providing the required organizational documents.
S corporation status is obtained by simply checking the box on IRS Form 2553, which subjects the corporation to Subchapter S of the Internal Revenue Code. Form 2553 must be signed by all of the corporation’s shareholders. This means all shareholders of the corporation must agree to the decision. One person’s objection will make incorporation unsuccessful.
Some of the key organizational documents – some of them mandated by statutes, some of them conventional – include:
Articles of Incorporation: This document establishes the existence of the corporation when it is filed and recorded. It usually contains information such as the name of the corporation, the registered agent, the registered office, the nature and purpose of the business, the shares of stock the corporation is authorized to issue, the types of stocks the corporation is authorized to issue, the initial officers or directors, and the signatures of the incorporators.
Bylaw: A by-law is a set of rules established by the corporation itself to regulate the day-to-day operation and management of the corporation. Some of the key provisions include the roles and duties of the shareholders, the qualifications of board members, the election and removal of a director, the size of the board, the terms of office of board members, the procedures for calling and holding meetings and their annual meeting time and location, the election of a fiscal year, key contracts approval, indemnification provisions, share transfer restrictions, tax elections and the procedures to amend the bylaws.
Directors’ Resolutions: This documents a corporate action, as it is approved or authorized by the board of directors. Some directors’ resolutions are important to the start-up of a business, such as the approval of the articles of incorporation, the adoption of bylaws, the election of officers, the authorization of the issuance of stocks, and the ratification of pre-incorporation business transactions, etc. A resolution can consist of either a written consent, signed by all members, or minutes of a meeting where the board members agreed upon the resolutions.
Stock Certificate: This is a legal document issued to the shareholders that certifies ownership of a specified amount of shares of the corporation. It includes information such as when and to whom the certificate was issued. A physical copy of a stock certificate is no longer required in the US – electronic registration is sufficient.
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