Corporate Structure and the Rights of the Shareholder in Accounting

Chapter 3:  Corporation Issues (Part 1)

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Overview

Chapter Description

This is the first chapter on corporations in this course.  Upon completion of this chapter students will be able to discuss the corporate structure and summarize the rights of shareholders in the corporation.  The application of the tax laws and required tax forms will then be explained.  Selection of an accounting period and use of various accounting methods will be discussed and summarized.  Finally, the tax treatment of capital contributions to the corporation by shareholders and non-shareholders will be explained.

Learning Objectives

1. Discuss the corporate structure.
2. Summarize the rights and liabilities of shareholders.
3. Explain the tax laws as they apply to corporations.
4. Discuss selection of an accounting period.
5. Summarize various accounting methods which may be used and their applicability to various situations.
6. Explain the tax treatment of capital contributions from shareholders and non-shareholders.

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Key Terms

• Accounting Period
• Articles of Incorporation
• Basis
• Board of Directors
• Capital stock
• Dividends
• Fiduciary
• Shareholder

Objective #1: Corporate Structure

This chapter will cover the general tax laws for domestic corporations.  The legal issues involved in forming a corporation, such as the duties and rights of directors and stockholders, are explained.  Issues specific to the Form 1120, U.S. Corporation Income Tax Return or the Form 1120S, U.S. Income Tax Return for an S Corporation will be discussed in subsequent chapters.

A corporation is an entity that is separate and distinct from its owners.  Legally, a corporation is considered to be a person formed for the purpose of carrying on a business.  As a separate entity, the corporation can sue or be sued.  Unlike a partnership the corporation retains liability for damages or debts.  This liability is normally limited to the assets of the corporation and does not pass down to the owners as in a partnership.  As a result, the owners (stockholders) are protected from personal claims.  The rules used to determine whether an entity should be taxed as a corporation changed in 1996. A business formed before 1997 and taxed as a corporation continued to be taxed as a corporation after the new rules took effect.

Corporate Operations

The purpose and authority of a corporation are derived from state corporate statutes, and bylaws.  Most state corporate statutes require a set of corporate bylaws for each corporation.  This document is prepared during the formation of the corporation and are occasionally modified as the corporation develops to maturity.  This document is the blueprint for internal operations of the corporation.  Modifications may be proposed by the Board of Directors but must be approved by the stockholders.  Each set of corporate bylaws will be customized to the particular corporation for which it was prepared in order to reflect that corporation’s situation.  The bylaws will be a blueprint for operation of a corporation.  Powers and rights of various parties (stockholders, officers, and directors) will be included along with the process of nominating and electing those who will be in charge.  Dispute resolution and place and time of meetings of officers and the board of directors will also be included, as well as any provisions which are considered necessary.   The bylaws work together with the Articles of Incorporation (see next paragraph) to constitute the legal framework of the company.

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State corporate statutes usually state that the corporation may engage in all legitimate business activities.  The Corporate Charter or Articles of Incorporation will normally be filed with the applicable state or regulatory agency for the state in which the corporation chooses to incorporate.  This document will usually be drafted broadly and grants the corporation express powers such as the ability to borrow money, buy real estate, and conduct a specific business.  If a corporation acts outside of the boundaries of its stated purpose it is said to be acting “ultra vires” (beyond its powers).  It also has the implied powers necessary to carry out the things it is expressly authorized to perform.  The corporation has the implied authority to make bylaws to implement its Articles and conduct the affairs of the corporation.  The express authority to make bylaws resides with the stockholders unless the corporate statute or charter delegates this authority to the board of directors.  Bylaws cannot conflict with the Articles or corporate statute.

The initial board of directors is elected by the incorporators.  The bylaws of the corporation contain the authority for setting up the board and will detail the size of the board.  In addition, the responsibilities, powers, and duties of the board will be detailed in the bylaws.  Successor directors are elected by the shareholders at the expiration of the terms of the initial board members.  Directors are elected to a specified term of service specified in the bylaws.  It is common practice for the terms of board members to be staggered in order to maintain the stability of the board.  For example, Director A’s term ends in year 2, B’s term ends in year 3, and C’s term ends in year 4.  Each board will normally have “inside” directors and “outside” directors.”  Inside directors are also officers or managers of the corporation.  As a result, they will have a certain special knowledge of the inner workings of the company, its financial position, and its competitive position.  Outside directors are not otherwise employed by the corporation.  These directors will often be president of some company in another industry.  Outside directors are often thought to be more objective and are often thought of as a check on potential excesses of inside directors.  Although outside directors may not be as knowledgeable of specific issues relating to the company, they bring an outside perspective and may be more objective than the inside directors.  Such independence may allow an outside director to be useful in resolving disputes between shareholders and the board or between inside directors.

The board of directors is the ultimate authority in the management of the corporation and is responsible for the management functions of the corporation.  The directors establish company policies and elect and supervise the corporate officers.  The officers are authorized by the board to act as agents for the corporation.  The board defines the duties and responsibilities of each officer.

A single director does not have the authority to act for the board.  Board actions must be collectively authorized at a meeting at which a quorum (majority) of the board members is present.  A required quorum is defined in the corporate documents and will constitute the minimum number of members that may be present in order to conduct any business. The document may establish the same quorum for all board actions or require a simple majority for some actions and possibly a 2/3 majority for others.  The board may decide to delegate some of its management functions to an executive committee.  Executive committees often include the president, vice president and treasurer of the corporation.

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Dividends must be declared by the board of directors.  This is a distribution to a class of shareholders from the company, usually from earnings, and is normally in cash.  The board’s decision to declare a dividend cannot be questioned unless the stockholders can establish an abuse of discretion by the board.  Board members are not compensated unless authorized in the corporate articles, bylaws or by a vote of the stockholders.  The board is not authorized to make fundamental changes to the corporation.  Changes to the purpose of the corporation or creating new classes of stock must not be made by the board of directors.  The authority to make such changes is vested in the shareholders.

Liability of Directors

The board of directors is responsible to the shareholders of the corporation.  A board of directors has certain responsibilities and, if a breach of any duty to the corporation could result in personal liability. board members are required to exercise:

1. Duty of care—directors must act as a reasonably prudent man would act when managing his own affairs.  Directors are not responsible for mere judgment errors or failure to act prudently unless there is clear evidence of negligence.
2. Duty of loyalty—directors owe a fiduciary duty to the corporation.  This means that a director should always be acting in the best interests of the corporation.  Directors may be held liable to the corporation in some situations such as:
   1. Corporate opportunity—a director may not take advantage of an opportunity that is discovered in his capacity as a director.  Such an opportunity rightfully belongs to the corporation.
   2. Dealings with the corporation—directors must conduct any dealings with the corporation in the open and in good faith.  A transaction that required the vote of a board member who could personally benefit from the action may be voided by the corporation.  Example:  John is one of five directors.  The board signed a rental contract with John.  The contract may be voided by the corporation.  Failure to disclose all material facts in such a transaction would be cause for nullification of the contract as well.
3. Statutory liability—directors may be personally liable for authorizing the following acts:
   1. Loans to stockholders—loans to stockholders are generally prohibited by corporate statute.
   2. Unlawful dividends—payment of dividends when the corporation does not have a profit or surplus.
   3. Acquisition of treasury stock—if in violation of the corporate statute.  Acquiring treasury stock can’t impair capital of corporation.  Must be acquired with surplus funds.
   4. Corporate waste—this generally involves preferential transfers of assets.

Duties of Officers

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Officers may bind the corporation by individual acts within the scope of his/her authority.  For example, the treasurer would have the apparent authority to borrow funds for the corporation.  The express authority of each officer should be stated in the corporate bylaws.  Officers are entitled to compensation.  If the salary is not stated in corporate documents the law implies that an officer may receive reasonable compensation for his services.  Each officer has a fiduciary duty to the corporation.  The corporate actions of each officer are covered under the laws of agency which gives them the authority to act in place of the corporation.

Capital Stock

Capital stock in a corporation represents an ownership stake in the business.   It can consist of common shares and/or preferred shares (see below).  If the corporation is publicly-held, then it has a large number of shares held by the general public which are freely traded on a stock exchange or a somewhat less supervised over-the-counter market.  A privately held company is one which does not offer or trade its stock to the general public.  An ownership stake in a privately held company can only be obtained through a private trade or exchange with an existing shareholder since the company’s stock is not publicly traded.

Capital is the total amount of the par value of stock with a stated par value and the cash received or to be received for no par shares outstanding.  Any amounts received over the par value are recorded as capital surplus or additional paid-in capital.

Authorized stock is the maximum amount of stock the corporation is authorized to issue by the corporate charter.  The amount of authorized shares may be increased later if authorized by the shareholders.  This is often done if a company has additional capital needs at some point after its formation.  Issued stock is the portion of authorized shares of stock for which certificates have been issued by the corporation.  Outstanding stock is issued stock being held by shareholders.  Treasury stock is authorized, issued but not outstanding stock.  This stock was reacquired by the corporation.  Treasury stock is not entitled to dividends and may not be voted by the corporation.  The corporation can resell Treasury stock.

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Classes of Stock

• Common Stock—common stockholders are entitled to one vote per share of stock owned (unless the stock is designated as nonvoting stock).  Common stockholders are entitled to dividends when they have been declared by the board.
• Preferred Stock—preferred stockholders generally have the same voting rights as common stockholders (unless the charter provides otherwise).  Preferred stock is always granted some advantage over other classes of stock.

1. Cumulative preferred stock means that if the corporation has not paid a fixed dividend to these stockholders it will accumulate until it is paid.  Common stockholders are not entitled to a dividend payment until all the accumulated dividends have been paid to preferred shareholders.
2. Non-cumulative preferred—dividend obligations do not accrue if not paid.
3. Participating preferred—preferred stockholders receive a fixed dividend and participate with common shareholders in dividends in excess of the fixed amount.
4. Convertible—convertible preferred shares may be exchanged for shares of common stock.
5. Redeemable—these shares may be called by the corporation for a fixed price.

Stock subscriptions are contracts to purchase a certain number of shares of capital stock.  They are considered an offer to purchase and may be withdrawn at any time prior to acceptance by the corporation.  The acceptance officially occurs when the corporation comes into existence and approves subscriptions.