When you see the term stockholders’ equity, you should instantly think of a corporation. That is because corporations are the only type of entity that have stockholders. Partnerships have partners. Sole proprietorships have a proprietor. Corporations have shareholders.
A corporation is an entity structure that offers a number of characteristics that make it unique. Some of these characteristics are advantages and some are disadvantages. The important characteristics of a corporation are:
When you create a corporation, it is like giving birth to a child. The corporation is a being separate from the owner. It has many of the rights and privileges that a person would have, things like free speech and the ability to establish credit. It is because of this principle that a number of the other characteristics exist.
Unlimited Life and Continuous Existence
Because a corporation is an entity separate from the owner, even if shareholder were to pass away, the corporation still exists. A corporation can continue to exist until it is dissolved, either because the owners agree to do so or because it is forced into bankruptcy and forcibly dissolved.
Easy Transfer of Ownership
If you watch the stock market, you know how easy it is to buy and sell stock. Every time a stock transaction takes place, partial ownership of the company changes hands. Due to the fact that a corporation is a separate entity from its owners, owners can easily dispose of their ownership stake by simply selling their stock. As long as there is a willing buyer, ownership transfers can take place.
Limited Liability for Shareholders
A corporation can establish credit and enter into business transactions with third-parties. Shareholders are not liable for the actions of the corporation unless a shareholder personally guarantees a debt (which is often required when small corporations are establishing credit). Therefore, shareholders have limited liability against personal losses.
If a corporation gets sued, the shareholders cannot be sued with it. If a corporation goes bankrupt, the shareholders cannot be held liable for the debt (unless personally guaranteed). A shareholder’s liability is limited to the amount of the investment made by the shareholder. For example, if you invest $10,000 in a corporation and that corporation does bankrupt, you will most likely lose your $10,000 investment because the stock will become worthless. You cannot lose more than the investment in the company.
Separation of Ownership and Management
Corporations allow for the separation of ownership and management. That means that owners do not need to be managers and managers do not need to be owners. It is often the case that someone is both, like the case of Mark Zuckerberg at Facebook. In most small corporations, the owners typically manage the company but it is not necessary that owners run the company or are even involved in the day-to-day operations of the company.
In some cases, this is considered an advantage, but if you are a shareholder/manager, you could also lose control of the company you started.
Corporate Taxation and Double Taxation
Unlike sole proprietorships and partnerships, corporations pay taxes at the entity level. According to KPMG (one of the Big 4 Accounting Firms), the U.S. corporate tax rate is approximately 40%. This applies to the profit that the corporation makes. If the company decides to pay out dividends to its shareholders, those dividends are also taxed. The tax on the dividends is collected from the shareholders. The maximum dividend tax rate is 23.9%.
Imagine a corporation has a profit of $1 million and decides to pay out all of the after-tax profit to the shareholders. How much money would the shareholders have after taxes?
One million dollars of corporate profit could be taxed as high as 54.34% leaving $456,600 to the shareholders after all taxes are paid. This is certainly a disadvantage for U.S. corporations.
It is important to be aware of the characteristics of corporations in order to decide how to form a new business venture. It is also important to know these characteristics when working with corporations.