When you create a new corporation in the United States or Canada and prepare your Articles of Incorporation, you'll have to set up shares and share classes. This article explains three share series that may be used when setting up a new corporation - common voting shares, common non-voting shares and preferred shares - and explains when and why you might want to use each share class.
Defining Share, Shareholder and Share Class
Before we delve into the different kinds of share classes you can set up, it's important to understand shares and shareholders.
A share is one unit of ownership in a company. So when you buy a share in Company X, you own part of that company. If you own ten out of 100 shares, then you own 10% of the company. If you have 1 share out of one million, then you own 0.0001% of Company X. Issuing shares helps corporations in many ways, including access to capital for future investments or projects.
When you own a share, you become a shareholder. But a shareholder isn't limited to an actual individual. In fact, shareholders can also be an institution such as a mutual fund company. These companies can buy shares in a company and package them into funds and sell them to their clients.
A share class is a specific kind of security held by the owner. It determines what rights the shareholder has in the company. More on this below.
Single Share Class (Common Voting Shares)
Setting up share classes for a new corporation doesn't have to be complicated. You have to have one class of shares since corporations are owned by shareholders.
Legally, that's all a small, non-reporting corporation (a company that doesn't have to file financial reports) has to have – one share class of common voting shares. These are distributed among every shareholders, who then have the right to vote at any shareholder meeting. This may include any decisions on how the company is run, the company leadership, major purchases or acquisitions, or even a sale of the company.
They can also receive dividends and the remaining property of the corporation on dissolution after all the corporation's creditors are paid.
Keep in mind, a non-reporting corporation cannot be listed on a stock exchange. Reporting corporations (those that are required to publish financial reports) can list their shares on an exchange. But in order to do so, they must undergo a higher level of regulatory compliance and issue a prospectus to potential purchasers.
It is entirely possible to have a single shareholder. In this case, the person setting up the new corporation creates a single share class so that he or she has 100% of the shares. Remember when it comes to shares, it's the percentage of shares that determines ownership — not the number. One hundred percent of the shares may mean 1 share or 100,000 shares, depending on how many shares the corporate owners decide to issue when the corporation is set up.
When one member of a married couple sets up a corporation, it is quite common for shares to be split between them so the other member can receive company dividends.
Multiple Share Classes (Non-Voting Common Shares)
So if one share class is all you need to have when you set up a new corporation, why would have more?
You may grant people shareholder status but don’t want to give them the right to vote. For example, you may assign non-voting shares to your children. Or you may use these shares to get employees more vested in your company without giving them the power to determine company policy.
This is why it can be an advantage to set up at least one other share class when you're setting up a new corporation — non-voting common shares. These are normally (but not always) designated as Class B shares. Class B shareholders would be entitled to receive dividends and have a place in line if your corporation dissolves, but would not be able to vote.
Various permutations of share classes and voting rights are possible, for example Facebook has Class A shares which trade publicly and Class B shares which do not. Class B shares have 10 votes per share vs 1 vote per share for the Class A shares. Because Mark Zuckerberg owns 28% of the Class B shares he controls the voting rights.
You may also wish to set up a certain number of share under the preferred class. Preferred shares are just that — they offer shareholders advantages over shareholders that only hold common shares. They can be voting or non-voting, but the preferences are specified when the share class is created.
For instance, when you are creating your new corporation, you might set up a Class C of shares which are preferred shares and are non-voting, but give those shareholders the right to collect dividends at a set amount and to be first in line (after creditors) if the corporation is dissolved.
Any number of preferred share classes can be set up — each with distinct rights attached. This is why preferred shares are often used to try and entice people to invest and raise money for the corporation. In return for investing in a business, most angel investors and venture capitalists receive preferred shares which give them specific rights and privileges over those of the common shareholders.
So when you set up share classes for your new corporation, consider who you want to participate in the corporation and what that participation will entail.
Issue Extra Shares for Future Use
One last point about setting up share classes. For future flexibility, it's a good idea not to issue all the shares in your corporation but to keep some in your treasury. This makes it much easier to have new shareholders join the corporation in the future. It also gets into things such as fractional shares — shares that are less than a full share.
For the same reason, originally issuing a larger number of shares than a smaller number often turns out to be more convenient. For instance, if there are two shareholders in your new corporation and you issue only two shares — one each — you have none to sell to anyone else.
Tax Changes to Reduce Income Splitting
While hiring family members and/or distributing shares to family members (and paying dividends) can be an effective income splitting mechanism, there are limits. You cannot pay your spouse and children an unreasonably high salary, and in the U.S. gifts of stock or dividends (unearned income) to children above a certain level are subject to the "kiddie tax". As of 2018, the kiddie tax applies to unearned income in excess of $2100 according to the following rate structure:
- $0 - $2100 - no tax
- $2101 - $4650 is taxed at 10%
- $4651 - $11250 is taxed at 24%
- $11251 - $14600 is taxed at 35%
- > $14600 is taxed at 37%
Beginning in the 2018 tax year, the Canadian government introduced a number of changes to the tax code to curb income splitting (also referred to as "income sprinkling"). The changes involve a so-called "reasonableness test" which requires shareholders receiving dividends from a family business to be actively engaged in the business. To qualify for the lower tax rate a family member must:
- Be a spouse over age 65
- Be over 18 and make a "substantial labor contribution" of at least 20 hours per week. You can keep timesheets or logbooks of hours worked in case these are required by the CRA.
- Be over 25 and own 10% or more of a business earning less than 90% of its income from the "provision of services."
Those who do not meet the requirements are subject to taxation at the marginal rate of the primary owner. Note this does not apply to salaried employees — salaries are always deductible by the corporation.