Learn about the benefits and drawbacks of becoming a corporation to decide if incorporating is right for you.
- The most common types of corporations are C-corps (double taxed) and S-corps (not double taxed).
- Advantages of a corporation include personal liability protection, business security and continuity, and easier access to capital.
- Disadvantages of a corporation include it being time-consuming and subject to double taxation, as well as having rigid formalities and protocols to follow.
- This article is for entrepreneurs who are trying to determine their business structure and whether a corporation makes sense for them.
Small business owners have a variety of options when establishing the legal structure. One option is to structure as a corporation. Although there are several reasons why incorporating can be advantageous to your business, there are a few disadvantages to be aware of as well. To help you determine if a corporation is the best legal structure for your business, we spoke with legal experts to break down the different types of corporations, and the benefits and drawbacks of incorporating.
What is a corporation?
A corporation is a business recognized by the state as a legal entity separate from its owners (also known as shareholders). A corporation can be owned by individuals and/or other entities, and ownership is easily transferable via the buying and selling of stock. Since a corporation is its own legal entity, it can enter litigation on its own, protecting its owners from personal liability in the event of legal action.
"This entity type is often chosen by entrepreneurs who wish to have a more formal business structure than that of an entity such as a limited liability company (LLC) and may eventually consider taking the business global or establishing an IPO [initial public offering]," Deborah Sweeney, CEO of MyCorporation, told Business News Daily.
You must follow your state's legal requirements to become a corporation. For many businesses, these requirements include creating corporate bylaws and filing articles of incorporation with the secretary of state. Preparing all the information to file your articles of incorporation can take weeks or even months, but as soon as you've successfully filed them with your secretary of state, your business is officially recognized as a corporation.
It's wise to seek guidance from an attorney and a tax advisor before you decide to become a corporation. These experts can help you determine if it is the best legal structure for you – and help you file if it is.
Key takeaway: A corporation is recognized as a separate entity by the state and protects its owners from personal liability for the business's debts or legal trouble.
How do corporations work?
A corporation is a separate legal entity from its owners, offering liability protection for each owner's personal assets. According to Shannon Almes, attorney at Feldman & Feldman, corporations can generally conduct any lawful business as well as the actions necessary to conduct the business, like entering into contracts, owning assets, borrowing money, hiring employees, suing and being sued. Corporations are generally governed by a board of directors elected by the shareholders.
"Each shareholder typically gets one vote per share in electing the directors," said Almes. "The board of directors oversees the management of the daily operations of the corporation, and often do so by hiring a management team."
Each owner of the corporation generally owns a percentage of the company based on the number of shares they hold. Since corporation shares are easy to buy or sell, ownership of a corporation is easily transferable. This is especially helpful for business continuity and longevity.
Did you know? A corporation is owned by one or more shareholders, and the percentage of each one's ownership directly correlates to the number of shares they own.
What are the advantages of forming a corporation?
There are several advantages to becoming a corporation, including the limited personal liability, easy transfer of ownership, business continuity, better access to capital and (depending on the corporation structure) occasional tax benefits. The legal structure of your corporation and the benefits you receive from it will depend on the specific setup of your business.
Personal liability protection
A corporation provides more personal asset liability protection to its owners than any other entity type. For example, if a corporation is sued, the shareholders are not personally responsible for corporate debts or legal obligations – even if the corporation doesn't have enough money in assets for repayment. Personal liability protection is one of the main reasons businesses choose to incorporate.
Business security and perpetuity
Corporation ownership is based on percentage of stock ownership, which offers much more flexibility than other entity types in terms of transferring ownership and perpetuating the business for the long term.
Although specific details regarding transfer of ownership depend on the governing agreement in the bylaws and articles of incorporation, ownership of this entity type is often easy to buy and sell. For example, if an owner wants to leave a company, they can simply sell off their stocks. Similarly, if an owner dies, their ownership stocks can easily transfer to someone else.
Access to capital
Since most corporations sell ownership through publicly traded stock, they can easily raise funds by selling stock. This access to funding is a luxury that other entity types don't have. It is great not only for growing a business, but also for saving a corporation from going bankrupt in times of need.
Although some corporations (C corporations) are subject to double taxation, other corporation structures (S corporations) have tax benefits, depending on how their income is distributed. For example, S corporations have the luxury of splitting their income between the business and shareholders, allowing it to be taxed at different rates. Any income designated as owner salary will be subject to self-employment tax, whereas the remainder of the business dividends will be taxed at its own level (no self-employment tax).
What are the disadvantages of forming a corporation?
A corporation is not for everyone, and it could end up costing you more time and money than it's worth. Before becoming a corporation, you should be aware of these potential disadvantages: There is a lengthy application process, you must follow rigid formalities and protocols, it can be expensive, and you may be double taxed (depending on your corporation structure).
Lengthy application process
Filing your articles of incorporation with your secretary of state can be quick, but the overall process of incorporating is often a long one. You will likely have to go through extensive paperwork to properly determine and document the details of the organization and its ownership. For example, Sweeney said you need to draft and maintain corporate bylaws, appoint a board of directors, create a shareholders ownership change agreement, issue stock certificates, and take minutes during meetings.
Rigid formalities, protocols and structure
Alongside the lengthy application process is the amount of time and energy necessary to properly maintain a corporation and adhere to legal requirements. You have to follow many formalities and heavy regulations to maintain your corporation status. For example, you need to follow your bylaws, maintain a board of directors, hold annual meetings, keep board minutes and create annual reports. There are also restrictions on certain corporation types (for example, S-corps can only have up to 100 shareholders, who must all be U.S. citizens).
Most corporations (like C-corps) face double taxation, which means that the business income is taxed at the entity level as well as the shareholder level (based on their percentage of profits earned). The only way around this is to operate as an S corporation. S-corps eliminate this problem by only taxing each shareholder on their individual income, not at the entity level. However, the IRS has been known to pay closer attention to S-corps and even tax them as C-corps if their records fail to meet the legal requirements.
Corporations are expensive to form and operate. It might be easy for established corporations to raise capital by selling shares, but forming and maintaining a corporation can be costly. You will likely need a lot of startup capital to get a corporation running, in addition to paying the filing charges, ongoing fees and larger taxes. When weighing the pros and cons to determine whether a corporation is the right legal structure for your business, consult an attorney and an accountant who are well versed in the implications of creating a corporation.
What types of corporations are there?
There are several types of corporations, including C corporations, S corporations, B corporations, closed corporations and nonprofit corporations. Each has it benefits and disadvantages. Some alternatives to corporations are sole proprietorships, partnerships, LLCs and cooperatives.
As one of the most common types of corporations, a C corporation (C-corp) can have an unlimited number of shareholders and is taxed on its income as a separate entity. C-corp shareholders are also taxed on the dividends they receive from the company, and they receive personal liability protection from business debts and litigation. Ownership for this type of corporation is divided based on stocks, which can be easily bought or sold. A C-corp can raise capital by selling shares of stock, making this a common business entity type for large companies.
S corporations (S-corps) are similar to C-corps in that the owners have limited personal liability; however, they avoid the issue of double taxation. An S-corp is considered a pass-through entity, meaning its income, losses, credits, and deductions can be passed on to the shareholders to be reported and taxed on their individual tax returns instead of the company being taxed as a separate entity. All S-corp shareholders must be U.S. citizens.
"In order to qualify as an S corporation, the corporation must meet several requirements, including not having partnerships, nonresident aliens, or other corporations as shareholders; having no more than 100 shareholders; and only having one class of stock," said Almes.
A certified benefit corporation, also known as a B corporation or B-corp, is a for-profit business structured to benefit society. This relatively new type of corporation is essentially a seal of approval for S corporations and C corporations, certifying that they are dedicated (and legally committed) to improving the environment and society. To become a B corporation, you need to meet rigorous criteria, like scoring an 80 or above on the B Impact Assessment, publicly reporting your scores on BCorporation.net, and making a legal commitment to consider your organization's stakeholders. As a B-corp, you will still maintain your C-corp or S-corp tax status.
A closed corporation – also known as a private company, family corporation or incorporated partnership – is a privately held company owned by a few shareholders. Shares for these corporations are not publicly traded, which can make it difficult to raise capital for them; however, the owners still have the benefit of limited personal liability.
Business owners can form a nonprofit corporation for religious, charitable, political, educational, literary, scientific, social or benevolent purposes. Certain states may have stricter requirements for nonprofit corporations. Almes said the main characteristic of a nonprofit corporation is that it is prohibited from distributing profits to members, directors or officers; however, this does not preclude nonprofit corporations from paying wages or reasonable compensation for services rendered.
Nonprofits have specific tax advantages, including the ability to file for nonprofit tax-exempt status with the state and federal governments.
"Typically, most nonprofit corporations choose 501(c)(3) tax-exempt status, which exempts qualifying nonprofit corporations from having to pay federal and state taxes because the nonprofit corporation is pursuing a nonprofit mission," said Sweeney.