• Identify the defining characteristics of a corporation

 

Corporations have a number of distinguishing characteristics. The most significant of these are:

• Separate Legal Existence
• Continuous Life
• Ability to Acquire Capital
• Transferability
• Limited Liability
• Government Regulations
• Taxation
• Governance and Management

Let’s look at each of these in turn.

Separate Legal Existence

In 1819, Chief Justice John Marshall defined a corporation as “an artificial being, invisible, intangible, and existing only in contemplation of law.” This definition is the foundation for the prevailing legal interpretation that a corporation is an entity separate and distinct from the people who own it.

Continuous Life

The life of a corporation is stated in the charter granted by the state, and most modern corporations elect a perpetual life. Since a corporation is a separate legal entity, its continuance as a going concern is not affected by the withdrawal, death, or incapacity of a stockholder, employee, or officer.

Ability to Acquire Capital

It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Also, numerous individuals can become stockholders by investing relatively small amounts of money.

Transferability

Shares of capital stock give ownership in a corporation. These shares are transferable units. Stockholders may dispose of part or all of their interest in a corporation simply by selling their stock. In a partnership, the transfer of an ownership interest requires the consent of each owner. In contrast, the transfer of stock is entirely at the discretion of the stockholder. It does not require the approval of either the corporation or other stockholders.

The transfer of ownership rights among stockholders normally has no effect on the daily operating activities of the corporation, nor does it affect the corporation’s assets, liabilities, and total ownership equity. The transfer of these ownership rights is a transaction between individual owners. The company does not participate in the transfer of these ownership rights after the original sale of the capital stock.

Limited Liability

Since a corporation is a separate legal entity, creditors have recourse only to corporate assets to satisfy their claims. In most circumstances, creditors have no legal claim on the personal assets of the owners. Even in the event of bankruptcy, stockholders’ losses are generally limited to their capital investment in the corporation. In other words, if you buy stock and the price of the stock drops to zero, that’s the extent of your loss.

Government Regulations

A corporation is subject to numerous state and federal regulations. For example, state laws usually prescribe the requirements for issuing stock, the distributions of earnings permitted to stockholders, and the acceptable methods for buying back and retiring stock. Federal securities laws govern the sale of capital stock to the general public. Also, most publicly held corporations are required to make extensive disclosure of their financial affairs to the Securities and Exchange Commission (SEC) through quarterly and annual reports (Forms 10Q and 10K). In addition, when a corporation lists its stock on organized securities exchanges, it must comply with the reporting requirements of these exchanges.

Taxation

As a legal person, corporations pay federal and state income taxes on earnings. In addition, stockholders must pay taxes on cash dividends (pro rata distributions of net income). In contrast, sole proprietors, partners, and members of an LLC that has elected to be taxed as a partnership report their share of earnings on their personal income tax returns.

Corporate income is taxed at the corporate level, and then the remaining earnings after tax that are distributed to owners are taxed again as dividends; therefore, corporate earnings are said to be subject to “double taxation.”

Governance and Management

Stockholders do not have the right to participate actively in the management of the business unless they serve as directors and/or officers. However, stockholders do have certain basic rights, including the right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets in case of liquidation, and (5) participate in management indirectly by voting at the stockholders’ meeting. Stockholders get one vote for every share of stock.

Management of the corporation is through the delegation of authority from the stockholders to the directors to the officers. The stockholders elect the board of directors. The board of directors formulates the broad policies of the company and selects the principal officers who execute the policies.

The board’s more specific duties include: (1) authorizing contracts, (2) declaring dividends, (3) establishing executive salaries, and (4) granting authorization to borrow money. The decisions of the board are recorded in the minutes of its meetings. The minutes are an important source of information to an independent auditor, since they may serve as notice to record transactions (such as a dividend declaration) or to identify certain future transactions (such as a large loan).

Normally, companies hold stockholders’ meetings annually. At the annual stockholders’ meeting, stockholders vote on such issues as changing the charter, increasing the number of authorized shares of stock to be issued, approving pension plans, selecting the independent auditor, and other related matters. Stockholders who do not personally attend the stockholders’ meeting may vote by proxy. A proxy is a legal document, signed by a stockholder, that gives a designated person the authority to vote the stockholder’s shares at a stockholders’ meeting.

A corporation’s bylaws usually specify the titles and duties of the officers of a corporation. The number of officers and their exact titles vary from corporation to corporation, but most have a president (who may also be the chief executive officer or CEO), several vice presidents, a secretary, a treasurer, and a controller. Beyond that, a typical corporation will have multiple vice presidents, such as the vice president of marketing, the vice president of finance or chief financial officer (CFO), the vice president of operations, and the vice president of human resources. The treasurer and controller usually report to the vice president of finance or chief financial officer, and department heads report to their respective vice presidents, and so on, down to the line workers (like the people you see on the floor of Home Depot helping customers and stocking shelves.)

The president/chief executive officer (CEO) of the corporation is empowered by the bylaws to hire all necessary employees except those appointed by the board of directors.

The corporate secretary maintains the official records of the company and records the proceedings of meetings of stockholders and directors. The treasurer is accountable for corporate funds and may supervise the accounting function within the company. A controller carries out the accounting function. The controller usually reports to the treasurer of the corporation.

The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management often reduces an owner’s ability to actively manage the company. In addition, as became evident in the Enron scandal, managers are often compensated based on the performance of the firm and may own stock as well. They thus may be tempted to exaggerate firm performance by inflating income figures.

As a result of the Sarbanes-Oxley Act, the board is now required to monitor management’s actions more closely. Many feel the failures of Enron, WorldCom, and more recently MF Global could have been avoided by more diligent boards.

Summary

As you have learned, a corporation is a legal entity separate and distinct from its owners, so the corporation acts under its own name rather than in the name of its stockholders. Home Depot, Inc. may buy, own, and sell property. It may borrow money, and it may enter into legally binding contracts in its own name. It may also sue or be sued, and it pays its own taxes, just like a real person.

In a partnership, the acts of the owners (partners) bind the partnership. In contrast, the acts of its owners (stockholders) do not bind the corporation unless such owners are agents of the corporation. For example, if you owned shares of Home Depot, you would not have the right to purchase inventory for the company unless you were designated as an agent of the corporation.