It is true that operating as a corporation has its share of drawbacks in certain situations. For example, as a business owner, you would be responsible for additional record keeping requirements and administrative details. More important, in some cases, operating as a corporation can create an additional tax burden. This is the last thing a business owner needs, especially in the early stages of operation.
You do not have to incorporate to be in business. You can be in business just by being paid for a service or a product. You are then a sole proprietor as well as a self-employed freelancer. But there are certain pros that you and your business can benefit from incorporating.
Advantages of Incorporating
Founders of startup companies often wait to incorporate a company until they are confident that their concept is viable or fundable. At some point, however, an entrepreneur will need to formally incorporate a company.
Aside from tax reasons, the most common motivation for incurring the cost of setting up a corporation is the recognition that the shareholder is not legally liable for the actions of the corporation. This is because the corporation has its own separate existence wholly apart from those who run it. However, there are four other reasons why the corporation proves to be an attractive vehicle for carrying on a business.
- Unlimited life. Unlike proprietorships and partnerships, the life of the corporation is not dependent on the life of a particular individual or individuals. It can continue indefinitely until it accomplishes its objective, merges with another business, or goes bankrupt. Unless stated otherwise, it could go on indefinitely.
- Transferability of shares. It is always nice to know that the ownership interest you have in a business can be readily sold, transferred, or given away to another family member. The process of divesting yourself of ownership in proprietorships and partnerships can be cumbersome and costly. Property has to be retitled, new deeds drawn, and other administrative steps are taken any time the slightest change of ownership occurs. With corporations, all of the individual owners’ rights and privileges are represented by the shares of stock they hold. The key to a quick and efficient transfer of ownership of the business is found on the back of each stock certificate, where there is usually a place indicated for the shareholder to endorse and sign over any shares that are to be sold or otherwise disposed of.
- Ability to raise investment capital. It is usually much easier to attract new investors into a corporate entity because of limited liability and the easy transferability of shares. Shares of stock can be transferred directly to new investors, or when larger offerings to the public are involved, the services of brokerage firms and stock exchanges are called upon.
- Limited Liability. The main advantage of incorporating is the limited liability of the incorporated company. Unlike the sole proprietorship, where the business owner assumes all the liability of the company when a business becomes incorporated, an individual shareholder’s liability is limited to the amount he or she has invested in the company.
Owners of a corporation may only be liable for business losses and obligations up to their investment in the company. As explained on the Entrepreneur website, the shareholder’s personal assets may not be taken to cover the liabilities of the corporation. However, shareholders of an incorporated business may be liable for the company’s debts if they sign a personal guarantee on a corporate loan. In addition, shareholders that engage in criminal activities will be individually held responsible for their acts.
If you’re a sole proprietor, your personal assets, such as your house and car can be seized to pay the debts of your business; as a shareholder in a corporation, you can’t be held responsible for the debts of the corporation unless you’ve given a personal guarantee.
On the other hand, a corporation has the same rights as an individual; a corporation can own property, carry on business, incur liabilities and sue or be sued.
Disadvantages of Incorporating
Incorporating a business can seem like a good idea, but the process and requirements of incorporation can actually hinder an organization’s growth and success, especially for smaller start-up companies. Incorporating a business provides some benefits, but the corporation definitely pays the price for these benefits in fees and legal hurdles. The main reasons not to incorporate include a sizeable initial investment, tax disadvantages, increased complexity in bookkeeping and public disclosure mandates.
- Corporations require annual meetings and require owners and directors to observe certain formalities. Corporations are more expensive to set up than partnerships and sole proprietorships. The process costs money. You can do it on your own, technically, but it’s more advisable to get the help of a lawyer and an accountant. It also requires periodic filings with the state and annual fees. Incorporating later in the life of a business is always an option but a little more expensive, depending on the complexity involved in transferring business assets into the corporation and registering the accompanying tax elections.
- No Personal Tax Credits and Less Tax Flexibility. Another disadvantage of incorporating is that being incorporated may actually be a tax disadvantage for your business. Corporations are not eligible for personal tax credits. Every dollar a corporation earned is taxed. As a sole proprietor, you may be able to claim tax credits a corporation could not. A corporation doesn’t have the same flexibility in handling business losses as a sole proprietorship or a partnership. As a sole proprietor, if your business experiences operating losses, you could use the loss to reduce other types of personal income in the year the losses occur. In a corporation, however, these losses can only be carried forward or back to reduce the corporation’s income from other years.
- Ongoing fees. You must file articles of incorporation with the state, plus applicable fees. Many states impose ongoing fees—which are steeper for a corporation than for a sole proprietorship or general partnership.
- More record keeping. Corporations must follow initial and annual record-keeping requirements—which sole proprietorships, general partnerships and limited liability companies (LLCs) avoid. There is a lot more paperwork involved in maintaining a corporation than a sole proprietorship or partnership. Corporations, for example, must maintain a minute book containing the corporate bylaws and minutes from corporate meetings. Other corporate documents, that must be kept up to date at all times, including the register of directors, the share register and the transfer register.
- Liability May Not Be as Limited as You Think. The prime advantage of incorporating, limited liability, may be undercut by personal guarantees and/or credit agreements. The corporation’s much-vaunted limited liability is irrelevant if no one will give the corporation credit. When a corporation has what lending institutions consider to be insufficient assets to secure debt financing, they often insist on personal guarantees from the business owner(s). So although technically the corporation has limited liability, the owner still ends up being personally liable if the corporation can’t meet its repayment obligations.
- Added Requirements. Another reason to avoid incorporation is the increased complexity of organizations operating under a corporate shield. Besides the financial and document requirements, corporations are forced to operate with a formal organizational structure of stockholders, a board of directors and officers; these members are required to conduct annual, timed meetings. The last disadvantage of corporations is the amount of information that must be made public. Corporations are publicly traded companies, therefore requiring more business information to be disclosed for the benefit of investors. Besides being required to make accounting records public, the organization must also identify all directors and officers publicly.
Process of Incorporating
To start the process of incorporating, you can contact your attorney or CPA. If you wish to do it yourself then contact the secretary of state or the state office that is responsible for registering corporations in your state. Ask for instructions, forms and fee schedules on business incorporation. It is possible to file for incorporation without the help of an attorney by using books and software to guide you along. Your expense will be the cost of these resources, the filing fees, and other costs associated with incorporating in your state.
If you do file for incorporation yourself, you’ll save the expense of using a lawyer, which can cost from $500 to $1,000. The disadvantage of going this route is that the process may take you some time to accomplish. There’s also a chance you could miss some small but important detail in your state’s law. You may also choose to use an incorporation service company to prepare and file the documents with the state.
One of the first steps you must take in the incorporation process is to prepare a certificate or articles of incorporation. Some states will provide you with a printed form for this, which either you or your attorney can complete. The information requested includes the proposed name of the corporation, the purpose of the corporation, the names and addresses of the parties incorporating, and the location of the principal office of the corporation.
You’re not required to incorporate in the state where your business operates; you can choose from any one of the 50 states or the District of Columbia.
Note that simply transacting business via mail order or the Internet typically does not an equal transacting business; however, the determination is made on a case-by-case basis. Again, consult your attorney for specifics, as this list is not intended to be comprehensive.
The corporation will also need a set of bylaws that describe in greater detail than the articles how the corporation will run, including the responsibilities of the shareholders, directors, and officers; when stockholder meetings will be held; and other details important to running the company. Once your articles of incorporation are accepted, the secretary of state’s office will send you a certificate of incorporation.
After You’ve Incorporated
Once you’re incorporated, be sure to follow the rules of incorporation. If you don’t, a court can pierce the corporate veil and hold you and the other owners personally liable for the business’s debts.
To make sure your corporation stays on the right side of the law, practice these exercises:
Get Documents and Records in Order
After incorporating a business, you’ll need to prepare bylaws that describe how your new corporation will operate. A few states also require you to publish a newspaper notice of your incorporation.
You should set up a corporate minute book and a file or binder where you will keep important corporate documents such as your certificate of incorporation, bylaws, shareholder information, and resolutions. Some states require you to file an initial report after incorporation and you will generally need to hold shareholder and director meetings at least once a year.
- Get an Employer Identification Number
An employer identification number, or EIN, is a number that the Internal Revenue Service uses to identify businesses—sort of like the business version of a Social Security number. Most businesses need an EIN, though solo business owners who don’t have employees or pay excise taxes can use their Social Security Number instead.
- Open a Business Bank Account
A business bank account will help you keep your business finances separate from your personal finances. This makes record-keeping and tax preparation easier and helps preserve your business’s separate identity.
For most businesses, the question is not if, but when, to incorporate. There are many pros and cons of incorporating a small business, depending a lot on individual situations. But too many businesses fail to revisit the question of whether to incorporate. As your business matures, and the realities of your legal and tax situations change, asking the question again may bring a different answer. A business with anticipated losses and little legal risk can likely start as a sole proprietorship, but increasing risk and more significant earnings will favor incorporating later on.
Deciding whether or not to incorporate is much more than just understanding the disadvantages of incorporation; the decision also requires knowledge about the advantages and disadvantages of other legal business formation options, such as sole proprietorships, partnerships, and limited liability companies.
You should definitely discuss your personal situation with your accountant and lawyer before you decide. He or she will be able to give you a much more exact picture of how incorporation could benefit your business, and help you see whether or not the trouble and expense of incorporation will be worth it to you.