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QUESTIONS 4. When should I seek further legal advice with respect to operating "my" corporation? 6. How will my "C" corporation be taxed?
ANSWERS 1. It is difficult for us to actually hold shareholder meetings so we generally authorize corporate actions by preparing "consents in lieu of a meeting" signed by all the shareholders. Is there a way to use "consents" but only need signatures of a "majority" of the shareholders to approve actions? Yes. The 2001 Oregon Legislature amended the Business Corporation Act (ORS Chapter 60) to permit corporations to take shareholder actions without a meeting with less than unanimous consent. Previously, all "consents" in lieu of a meeting had to be signed by all the shareholders to be effective. To make this option available, you will need to revise the articles of incorporation and add the operative language to the corporation’s bylaws as well. Please note that the existing provisions under Oregon Law that allow a corporation’s board of directors or shareholders to take action without a meeting with unanimous consent have not been changed. The next annual shareholder meeting would be the perfect opportunity to address this statutory change. 2. I have heard that in some cases, the owners of a corporation can be held personally liable for debts of the corporation? Is this possible? Yes – the "piercing the corporate veil theory" is applicable in Oregon depending on the facts and circumstances. One important reason to incorporate your business is to impose a shield against personal liability. However, to successfully insulate the shareholders from personal liability, the corporation must be adequately capitalized, insured and observe corporate formalities. In a recent Oregon case, the corporate veil was pierced and the corporation’s sole shareholder held personally liable on an employment contract when the corporation was under capitalized at the time the employment contract was executed and in light of the plaintiff’s salary and bonus and the operating costs of the business. Vuylsteke v. Broan, 172 Or. App. 74 (2001). To avoid personal liability, all corporate documents must be signed by an authorized officer in his or her representative capacity (showing your title). This means the company name must be shown and you sign: [name of company] By: [your signature], [title, e.g. President]. At a minimum, the corporate formalities should include the annual meeting of shareholders to elect directors and officers. Further, any corporate loans and/or borrowing must be authorized. It is always a good idea for the board to authorize officer compensation as well, especially relating any bonuses to performance. 3. Now that I have "incorporated" my business, what "formalities" do I need to observe to properly operate as a corporation? Now that the corporation is organized and ready to function, certain basic procedures should be observed in the proper operation of the corporation. In order to preserve the limited personal liability and tax benefits of doing business in the corporate form, you must comply with the requirements of corporate law. (a) Corporate Formalities. The benefits of the corporate form derive from the legal recognition of the corporation as an entity separate from its shareholders, directors, and officers. To enjoy these benefits, not only must you be incorporated, you must act as a corporation. The term "piercing the corporate veil," refers to losing the limited liability protection inherent to a corporation. As a general rule, shareholders are not responsible for the debts of a corporation in excess of their capital contributions. However, upon losing such protection (i.e., having the "veil pierced"), the shareholders may become personally liable. (1) Maintain Corporate Entity. Generally, a corporation is treated by law as a separate "person" or "entity" from its owner(s) (the shareholders). Recognizing and adhering to this distinction will help keep the corporate veil from being pierced. To do so, it is essential that corporate and personal affairs be kept separate. Never mix or co-mingle corporate and personal funds, assets, or accounts. You should not use corporate funds or assets to pay personal obligations or for any other personal or non-corporate purpose, even though there may be offsetting balances or accounts that might seem to justify such use. To maintain this separation of personal and corporation funds, you must open a corporate account under the Employer Identification Number ("EIN") assigned to the corporation. Any money paid to the corporation should go directly into this account. Any compensation paid to you or others should be properly recorded. As a general rule it is best to avoid personal loans from the corporation. Loans should be accompanied by property documentation such as a promissory note. All financial transactions should be authorized as required in the bylaws. Failure to keep a record of such transactions will not only expose the parties to disputes within the corporation and create income tax liability but may also aid any third party in an attempt to pierce the corporate veil. (2) Use Corporate Name. Corporate business should be done in the corporate name. When acting for the corporation, avoid any indication that you are dealing in a personal capacity. Use the corporate name on all agreements, contracts, leases, orders, accounts, checks, correspondence, letterheads, business cards, directory listings, advertisements, signs, and products. (3) Act in Representative Capacity. When signing documents, always make clear that you are acting on behalf of the corporation. For example, the signature block on agreements should include the corporate name, the capacity in which you are acting, and the word "By:" preceding the signature, similar to the following form: [name of Company] By: [your name], President If you are also required to obligate yourself personally, you should add an additional signature as follows: and [your name], personally. (4) Individual Roles. The formalities of corporate operation provide the mechanism by which the corporation governs itself, makes decisions, and takes action. To better understand the proper conduct of corporate business, you should become familiar with the different capacities in which you will be acting from time to time. (i) Shareholders. As shareholder(s), you own the corporation. Shareholders do not own the business; the corporation owns the business, including all of its assets. Shareholder control of the corporation extends only to the election and removal of directors, adoption of certain amendments to the articles of incorporation, and approval of a few other major actions such as loans to directors, sale of all corporate assets, merger, and dissolution. These actions will be valid only if authorized by the shareholders acting properly as shareholders. (ii) Directors. As director(s), you direct the management of the corporation. You establish policy. You make all major business decisions such as election and removal of officers, compensation of employees, issuance of stock, payment of dividends, approval of important contracts, loaning or borrowing money, initiation of new ventures, and purchase of new equipment and property. These actions are expressed in the form of resolutions adopted by the board of directors and recorded in the corporate minutes. The authority of the board of directors is limited by law, by the articles of incorporation and by the bylaws, but the board may amend the bylaws and certain portions of the articles without the necessity of shareholder approval. Within those areas over which directors have control, only those acts authorized by resolution will be considered acts of the corporation. (iii) Officers. As an officer (you can be both president and secretary – the two required officers under Oregon corporation law), you are an employee of the corporation. You conduct the everyday business of the corporation under the direction of the board of directors. Your acts are the acts of the corporation as long as you act within the authority given by the articles of incorporation, the bylaws, and the resolutions of the board of directors. (5) Formalities Protect You. In closely held corporations such as yours, where the same people act in more than one capacity, it is particularly important to be mindful of keeping the roles straight and acting with proper authority. Courts consider observance of corporate formalities to be an important factor in deciding whether the corporation has been operated as a separate entity. If the corporation is not operated as an entity separate from you, a creditor of or claimant against the corporation is much more likely to be able to hold you personally responsible for the liabilities of the corporation. The formalities are the source of authority for those who act on behalf of the corporation. Officers, directors, and employees who act without authority (that is, without necessary approval of the shareholders or directors, properly made and recorded in the corporate minutes) act at their own risk. (6) Minutes, Meetings, and Manner of Acting. Properly held and documented meetings of shareholders and directors are the keys to formal operation of the corporation. Failure to authorize an act in advance can sometimes be corrected by later ratification of actions already taken. The better practice, however, is for the board to act regularly and in advance of actions requiring its authorization. (i) Meetings. The date for the annual meeting of shareholders is typically set under the corporation’s bylaws. The shareholders should elect directors at the annual meeting, and may take such other action as is appropriate. A meeting of the board of directors should follow the annual shareholders' meeting in order to elect officers and to take such other action as may be proper. The bylaws also set forth the procedure for holding special shareholders' meetings and regular and special meetings of the board of directors. A meeting that does not comply with the bylaws is legally ineffective. Action attempted at a meeting improperly called or conducted will not accomplish its purpose. For this reason, you should become familiar with the bylaws provisions governing shareholders' and directors' meetings. As a practical matter (as discussed further below), you can observe the necessary corporate formalities by having consents to corporate action prepared and signed (which operate to approve actions without actually holding the meetings). (ii) Minutes. A written record that shows that a meeting was properly held and that recites actions taken must be prepared. This is the function of the corporate minutes. The minutes must show that proper notice was given and that a quorum was present. The minutes must contain the substance of resolutions adopted and a list of the names of directors voting against any resolution adopted by the board. (iii) Waiver of Notice. Timing and other technical problems of giving proper notice of meetings can be avoided by obtaining a waiver of notice signed by each affected shareholder or director, as appropriate. (iv) Consent Resolutions. There is a substitute for the meeting process, which you will probably use extensively. Unanimous written consent of all directors or shareholders, as the case may be, will serve as the legal equivalent of a meeting. This is the most logical way to act for corporations owned by a single shareholder or boards made up of a sole director. Due to its convenience, this method of acting may become the one you use most commonly. Just as the minutes of actual meetings, of course, such unanimous consent resolutions should be recorded in the minute book. The Oregon Business Corporation Act (ORS Chapter 60) now permits shareholders to amend the articles of incorporation and bylaws to permit consent resolutions to be adopted if signed by a majority of the shareholders. (b) Directors' Duties and Standards. Directors are held to certain standards of conduct and are responsible for certain duties under the law. A director must act in good faith and with care in protecting the interests of the corporation. The following is a discussion of some of the duties and standards that govern director conduct. (1) Duty of Loyalty. Directors are held to a fiduciary standard of loyalty to the corporation. Both as a director and as an individual, the director must act in the best interest of the corporation. Any conflict between the director's personal interest and the corporation's interest must be resolved in favor of the corporation. For example, a director may not pursue a business opportunity outside of the corporation if the opportunity could be pursued by the corporation and is within the corporation's line of business. Similarly, a director cannot be involved in a business that competes with the corporation. (2) Self-Dealing. All dealings between a director and the corporation should be approved, after full disclosure, by an independent vote of a majority of the other directors. Do not enter into any agreement with the corporation, sell to or buy from, rent to or rent from, or otherwise deal with the corporation, without first obtaining legal advice. (3) Loans. The corporation may make loans to directors only with the formal approval of the independent shareholders, or approval of the independent members of the board of directors together with a determination by the board that the loan benefits the corporation. Directors and shareholders may make loans to the corporation, but these loans may, in some circumstances, be found to constitute capital contributions for tax purposes. Again, we suggest you consult an attorney before any loan is made between the corporation and a shareholder or director. (4) Taxes and Tax Returns. Directors are responsible for the timely filing of all tax returns and other required reports (federal, state and local). Failure to file tax returns and to pay the taxes due may render directors personally liable. Officers directly responsible for seeing that corporate taxes are paid may also be personally liable if they remain unpaid. You should work closely with your accountant in establishing a system to assure proper reporting and payment of taxes. You may also need to obtain a city or county business license. (5) Prohibited Acts. Certain acts are specifically prohibited by law, and violation of them will result in personal liability for directors. Included among these prohibited acts are the following: (i) Voting to pay dividends in violation of the articles of incorporation or applicable law; (ii) Voting to purchase the corporation's own shares beyond amounts authorized by law; (iii) Voting to distribute assets without proper allowance for indebtedness; and (iv) Voting to make a corporate loan to a director without appropriate approval of the shareholders or directors. (6) Manner of Dissent. Any director present at a meeting where a vote is taken on a prohibited act will be treated as having voted in favor of the action unless: (i) The director objects at the beginning of the meeting, or promptly upon arrival, to holding the meeting or transacting business at the meeting; (ii) A dissent or abstention from the action is entered in the minutes; (iii) A written dissent or abstention is delivered to the presiding officer of the meeting before adjournment; or (iv) A written dissent or abstention is delivered to the corporation immediately after adjournment. 4. When should I seek further legal advice with respect to operating "my" corporation? You should seek additional legal advice whenever you are considering major corporate business matters such as: (a) Issuing new stock or debt instruments; (b) Purchasing stock from a shareholder; (c) Doing business in other states or countries; (d) Amending the articles of incorporation; (e) Selling the majority of the corporation's assets outside of the ordinary course of business; or (f) Merging or dissolving the corporation. 5. As the majority shareholders, can we operate the corporation as we please, without treating minority shareholders fairly? No. Oregon law imposes a fiduciary duty on the majority shareholders to minority shareholders. For example, in Cooke v. Fresh Exp. Foods, Corp., Inc., 169 Or. App. 101 (2000) the appellate court found that the majority shareholders had engaged in a course of oppressive conduct and breached their fiduciary duties to the minority shareholder by freezing him out of all participation in the corporation thus depriving him of the benefits of his stock ownership. The court held that an appropriate remedy was to require the majority shareholders to purchase the minority shareholder’s shares at a price that was based on the stock’s "fair value" without any adjustment for either minority or lack of marketability discount. Further, the court determined that it was appropriate to increase the price of his shares by the amount of unpaid wages that he did not receive following termination. Similarly, in Hayes v. Olmstead & Associates, Inc., 173 Or. App. 259 (2001), the court found that because of oppression by the majority shareholders, the appropriate fair value of the minority shareholder’s stock was the pro rata value of the going concern value of the corporation without adjustments for minority or lack of marketability discounts. 6. How will my "C" corporation be taxed? Corporations are generally subject to the graduated income tax imposed under IRC §11 at rates ranging from 15% (on taxable income up to $50,000) up to 39% of taxable income. Even if the corporation has no income, or no tax is due, a corporation must file an income tax return. The Form 1120, "U.S. Corporation Income Tax Return," must be filed on or before the 15th day of the third month that follows the close of its tax year. Form 1120-A, "U.S. Corporation Short Form Income Tax Return," may be filed by a corporation that has gross receipts of less than $500,000 and meets certain other requirements. Corporations doing business in Oregon or with income from an Oregon source must file an annual tax return with the Oregon Department of Revenue ("ODR"). Corporations doing business in Oregon must file Form 20 and pay corporation excise tax. Corporations not doing business in Oregon, but with income from one or more Oregon sources, must pay income tax and file Form 20-I. "Doing business," means being engaged in any profit-seeking activity in Oregon. A taxpayer having one or more of the following in Oregon is clearly doing business in Oregon:
"Doing business" also includes providing services to customers as the primary business activity or incidental to the sale of tangible or intangible personal property. What is income from an Oregon source? Oregon source income is income derived from: (i) tangible or intangible property located in Oregon; or (ii) any activity carried on in Oregon, whether intrastate, interstate, or foreign commerce. Oregon returns are due on or before the 15th day of the month following the due date of your corporation’s federal return. In addition, there are certain other local payroll tax returns due such as Transit District Payroll tax returns for TriMet Transit (Multnomah, Washington and Clackamas Counties) and Lane Transit (Lane County). The current corporate tax rate is 6.6%. The tax year of a "C" corporation may be a calendar year or a fiscal year; however the return may not cover a period of more than a year (except that a corporation may elect to use an annual filing period that fluctuates between 52 and 53 weeks). If a corporation is not in existence for the entire tax year, a return is still required for the short period during which it was in existence. If a corporation adopts a resolution to dissolve or liquidate, it must file Form 966, "Corporate Dissolution or Liquidation" in addition to its regular income tax return. The due date for payment of a corporation’s income taxes corresponds with the due date for filing its return; however, estimated payments are required when the corporation’s tax liability is expected to be at least $500 for the tax year. To do so, Form 8109, "Federal Tax Deposit Coupon," is used to make federal tax payments and Form 20ES is used for estimated payments to the ODR. For a calendar-year corporation, installments of estimated tax are due on April 15, June 15, September 15 and December 15. For fiscal-year corporations, installments of estimated tax are due on the 15th day of the fourth, sixth, ninth, and twelfth months of the tax year. Certain penalties together with interest are imposed on underpayment of a required installment of estimated tax. The entire area of corporate taxation is quite complex and all specific questions must be addressed to your tax advisor. Further, proposed tax law legislation may significantly change the so-called "double" taxation of dividends (that is, first income is taxable to the corporation, then again, to the shareholders when distributed). Generally, any distribution by a corporation to its shareholders is taxable to them as a dividend, to the extent it is paid out of corporate earnings and profits. Any distribution in excess of available earnings is treated as a return of capital and therefore, not taxable except to the extent it exceeds the shareholder’s basis in the stock. It is then subject to taxation under the capital gain rules. Corporations may accumulate income if there is a reasonable need for it and a definite plan for its use. Otherwise, the accumulated earnings tax may apply. 7. My golf buddy told me that there are advantages from electing to be taxable as "S corporation." What is an "S corporation" and why would I want to operate my business as one?" At the present time, nearly all new small businesses that adopt a formal structure are organized as either a limited liability company ("LLC") or as an S corporation. This is because the other forms of doing business (e.g. a sole proprietorship, general partnership or limited partnership (with respect to the general partner) require "someone" to be liable for the debts and obligations of the entity. By comparison, with a LLC or corporation, the members (in the case of a LLC) or shareholders (in the case of a corporation) are liable only to the extent of their investment in the company. Although a C corporation offers limited liability, the current income tax treatment of C corporations generally makes them unsuitable for use by start-up businesses, except for certain service businesses. The tax treatment for LLCs and S corporations provides for "pass-through" treatment of tax items, which generally benefits owners of businesses that may incur losses in the start-up years. There are certain limitations however, imposed on S corporations that may limit their use in a particular situation. If all the shareholders of an "eligible" corporation agree, the corporation may elect subchapter S corporation status. This is done by filing Form 2553, "Election by a Small Business Corporation by the 16th day of the 3rd month if the tax year (if filed during the tax year the election is to take effect). An election made after the 15th day of the 3rd month but before the end of the tax year is effective for the next year. Once the election is made, it stays in effect until it is terminated. If the election is terminated, IRS consent is generally required for another election by the corporation (or a successor corporation) for any tax year before the fifth tax year after the first tax year in which the termination took effect. If a shareholder terminates his or her S corporation interest, and all "affected" shareholders consent to the termination, the tax year can be treated as two tax years, the first of which ends of the date of termination. The term "affected shareholders" includes the shareholder whose interest is terminated and all shareholders to whom that shareholder has transferred shares during the tax year. A corporation may elect to be an S corporation only if it meets all of the following tests: (a) It is a domestic corporation; (b) It has no more than 75 shareholders - - a husband and wife (and their estates) are treated as one shareholder for purposes of this requirement. (c) All shareholder must be individuals, decedents’ estates, certain trusts, bankruptcy estates, qualified plan trusts, or tax-exempt IRC §501(c)(3) organizations. (d) It can only have only class of stock (disregarding differences in voting rights). Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation’s stock provide for identical rights to distribution and liquidation proceeds. (e) It has no nonresident alien shareholders (or shareholders married to a nonresident alien who has a current ownership interest in his stock under local law - - unless the spouses elect to be taxed as U.S. residents), and (f) It is not one of the types of ineligible corporations including banks, building and loan associations, DISCs and former DISCs, and insurance companies, among other organizations. The following types of trusts may be S corporation shareholders:
(a) Grantor trusts. The grantor, not the trust, is treated as the shareholder. Following the death of the grantor, the trust may continue as the shareholder for two years. (b) Section 678 (nongrantor) trusts. If someone other than the grantor is considered as the substantial owner of the trust during the time period the trust holds the S corporation stock, the deemed owner is treated as the shareholder. (c) Testamentary trusts. Testamentary trusts may be shareholders of an S corporation for two years beginning with the day the stock was transferred to the trust under the testator’s will. (d) Voting trusts. Each beneficiary is counted as a separate shareholder. (e) Electing small business trusts. An "electing trust" can be an S corporation shareholder. In an electing trust, a beneficiary must be an individual, an estate, or a charitable organization. However, any portion of the trust that consists of S corporation stock is taxed at the highest tax rate for trusts and estates - - 39.6% on ordinary income and 28% on capital gains. Charitable remainder unitrusts and charitable remainder annuity trusts cannot qualify as electing small business trusts. (f) Qualified subchapter S trusts. A qualified subchapter S trust also may be an S corporation shareholder. The individual trust beneficiary, or legal representative, must elect to be treated as the owner of the portion of the trust that consists of S corporation stock for purposes of the non-grantor trust rules. The election may be revoked only with IRS consent. A parent S corporation can elect to treat an eligible wholly owned subsidiary as a qualified subchapter S subsidiary (QSub). If the election is made (on Form 8869, "Qualified Subchapter S Subsidiary Election"), the assets, liabilities, and items of income, deduction and credit of the QSub are treated as those of the parent. Because an S corporation is a pass through entity, it does not generally incur federal income taxes. The election permits the income of the S corporation to be taxed to its shareholders whether distributed or not. However, the S corporation may be liable for certain corporate-level taxes, including:
Each shareholder of an S corporation separately accounts for his or her pro rata share of corporate income, deduction, loss, and credit in his or her own tax year in which the corporation’s tax year ends. These items must be separately stated whenever they can affect the shareholder’s individual tax liability. If shares are sold during a tax year, a shareholder’s share of each item is computed on a daily basis according to the number of shares held on each day of the corporation’s tax year. However, the shareholder’s currently deductible share of the corporation’s losses (and deductions) is limited to the total of the shareholder’s basis in his or her stock and any debt the corporation may owe the shareholder. Losses and deductions that are disallowed due to insufficient basis may be carried forward to any later tax year in which the shareholder restores or increases basis in the stock or debt. Whether distributions of cash or property are taxable to the shareholder depends on whether the S corporation has "earnings and profits." An S corporation is deemed to have no earnings and profits unless attributable to tax years prior to making the "S election" or to S corporation years prior to 1983. If an S corporation has no earnings or profits, distributions are treated first as a nontaxable return of capital to the extent of the shareholder’s basis in his or her stock, then as a gain from the sale or exchange of property (thus, capital gain rules apply). However with respect to earnings and profits, distributions are treated as follows:
Before these rules are applied, the shareholder’s stock basis and AAA are adjusted for the corporate items passed through from the corporation’s tax year during which the distribution is made. |
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