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Advantages and Disadvantages To Forming A Corporation
©2024, Melissa C. Marsh.
Written: 5/31/2006  
By: Melissa C. Marsh

Incorporate A Business.
Although it is not necessary to employ the services of an attorney to form your corporation, incorporation is a complex process that involves handling a lot of issues that have legal implications beyond the mere filing of "Articles of Incorporation." First, choosing the proper organizational structure for a business is one of the most important decisions a business owner must make. The structure will determine how the business handles tax matters and whether there is protection against personal liability. A business owner should consider several factors, such as: the number of individuals involved, the type of business, the likelihood of initial profitability or loss, the need for capital, and insurance. If you elect to form a corporation after carefully considering the below-mentioned advantages and disadvantages, strongly consider using an attorney. Paralegal services and legal service companies are renowned for filing your "Articles of Incorporation" and then, with good reason, giving you a corporate kit along with a letter that suggests you seek the advice of an attorney. Often these legal service companies are unable to file all of the documents necessary to property organize your corporation beyond the mere filing of the Articles, they are unable to include important provisions in your Articles to help limit your personal liability (because that would constitute "practicing law without a license"), and such failures often lead to the loss of the personal liability protection sought, and in some cases the imposition of severe penalties.

The remainder of this article will provide a brief overview of the various advantages and disadvantages of incorporation.

Main Advantages To Incorporation.
The main advantages to incorporation, which are more fully explained below, include: (1) limited personal liability protection for the shareholders (owners); (2) perpetual existence independent of its shareholders; (3) corporate tax treatment; (4) ease of capital investment; and (5) ease of transferability of ownership; and (6) centralized management.

1. Limited Personal Liability.
One of the key reasons for forming a corporation is the limited personal liability protection provided to its owners (shareholders). A corporation is considered a separate legal entity, and as such the shareholders generally will not be held personally responsible for the corporation's debts. In other words, the personal assets of shareholders are not up for grabs by creditors seeking to satisfy corporate debts or liabilities. This limited personal liability protection, however, is only afforded to those corporations properly formed, funded, and maintained. If the owners of the corporation fail to incorporate fully and properly, or fail to follow the required formalities, the corporation will be deemed to be an "alter-ego" of the shareholders who in turn may be held personally responsible for the corporate debts and obligations.

2. Perpetual Existance.
A corporation is a separate legal entity, apart from its business owners. As a separate legal entity, the corporation continues to exist, regardless of what happens to its owners, until it is legally dissolved or merged with another company. The owner(s) of a corporation are known as shareholders. The shareholders elect directors to set the policies of the corporation and represent their interests. The directors appoint the officers of the corporation to manage day-to-day operations of the business.

3. Corporate Tax Treatment.
Since a corporation is a separate legal entity, it pays taxes separate and apart from its owners (at least in the typical C corporation). Owners of a corporation only pay taxes on corporate profits paid to them in the form of salaries, bonuses, and dividends. The corporation pays taxes, at the corporate rate, on any profits it retains and does not pass-through to its shareholders. A shareholder (owner) who works for the corporation may become an employee and in turn eligible for reimbursement or deduction of many types of expenses, including health and life insurance.

4. Ease Of Capital Investment.
The built-in stock structure of a corporation makes it attractive to investors. The stock structure also allows corporations to attract key and talented employees they may not be able to otherwise hire by offering an ownership interest in the form of stock options or stock.

5. Freely Transferable Shares.
Shares of corporations are generally freely transferable because as a separate entity, the existence of a corporation is not dependent upon who the owners or investors are at any given time. A corporation continues to exist as a separate entity and is not terminated or dissolved even when shareholders dies or sell their shares. Shares of corporations are freely transferable unless the corporation has a by-law restriction, or the shareholders have executed a "buy-sell" agreement, limiting when and to whom shares may be sold or transferred.

6. Centralized Management.
Corporations have a set management structure. Shareholders are the owners of a corporation, who elect a Board of Directors, which then elects the officers to run the day-to-day operations of the business. Other than the election of directors, shareholders do not typically participate in the operations of the corporation. The Board of Directors is responsible for the management of and exercising the rights and responsibilities of a corporation. The Board sets corporate policy and the strategy for the corporation much of which must be documented in the corporate minute book. The Board elects officers, usually a CEO, vice president, treasurer and secretary, to follow the policies set by the Board and to manage the corporation's day-to-day operations. In a small corporation, the lines between the shareholders, Board of Directors, and officers tends to blur because the same people may serve multiple functions.

The main disadvantages of incorporation include: (1) the fees and costs; (2) adherence to the corporate formalities and paperwork; and (3) adverse tax consequences for the unwary.

1. Fees and Costs.
It costs money to incorporate. There are typically four types of fees, including: a filing fee to file the Articles of Incorporation with the Secretary of State ($115 in California); an annual minimum franchise tax ($800 in California); miscellaneous fees for other required governmental filings with various state and local governmental agencies ($50 to $250 in California); and attorney fees ($1000 to $5000). But every year tens of thousands of businesses foolishly choose to incorporate online without the use of an attorney, because such services often require less than $500. Unfortunately, these incorporations often lead to huge penalties and other problems that later lead to drastically increased attorney fees to repair the problems created by these legal service firms. If you can't afford to do it right, just don't do it.

2. Adherence To Corporate Formalities.
Corporations are legally required to follow more formalities than any of the other entities. If the proper corporate formalities of organizing and running the corporation are not followed, the shareholders may lose many of the primary benefits of being a corporation (e.g., the limited personal liability protection they originally sought). Corporations are legally required to hold at the very least annual meetings of the shareholders and directors, and to seek board approval of most significant acts by the corporation. For example, even if one person is the sole shareholder/director/officer of the corporation, that person cannot just take corporate funds for him/herself without holding a meeting of the directors and/or shareholders, documenting the reason, and entering a board resolution into the corporate minute book. In addition, various filings and tax returns must be compiled and filed annually in a timely fashion. Moreover, business bank accounts, corporate credit cards, and records must be maintained and kept separate from personal accounts, personal credit cards, and individual assets.

3. Adverse Tax Consequences For The Unwary.
When a corporation is formed, it is always a C corporation. Once the corporation is formed, the corporation may elect S- Corporation status. C corporations have the potential to incur double tax consequences—first when the company makes its profit, and a second time when dividends are paid to shareholders. S corporations can mitigate this tax issue.

The corporation business structure while popular, is a complicated model to form and operate. If not formed and operated properly, the business can run into problems from not only its local and state government but also the IRS. In addition, if not properly formed and organized, the shareholders risk losing the personal limited liability protection they sought when incorporating. We strongly suggest you seek the expertise of a local attorney to form your corporation and assist you in its annual maintenance.

© Copyright 1999-2024 Melissa C. Marsh. All Rights Reserved. All Information on this website is subject to a Disclaimer and Use Agreement. This information is provided as general information only and should not be construed as legal advice. We advise you to seek the advice of competent legal counsel to address your own specific questions, facts and circumstances.

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