The Pros and Cons of Incorporating
You are starting a small business – congratulations! Now, how best to structure your business? You will have to choose among sole proprietorship, partnership, LLC, or corporation, or any variant of these available in your state. Which you choose will depend upon what type of business you have, what level of personal risk and liability you can tolerate, whether there are multiple owners of the business and whether you intend to make a public offering in the future.
This post will explain the pros and cons of incorporating. Please keep in mind that the laws governing corporations vary from state-to-state, so be sure to check the laws in the state where the business will be registered for specifics.
What is a Corporation?
A corporation is a business entity that is separate from its owners with regard to both taxes and liability. Shares in the corporation can be held by a few individuals, or “publicly held” if offered for sale to the public. In the case of a closely-held corporation, there might not be stocks at all. Corporations can be for-profit, not-for-profit, or non-profit.
Incorporating involved a bit more paperwork than forming other business entities, as “articles of incorporation” must be filed with the state in which the corporation is based. A “board of directors” runs a corporation according to its articles of incorporations and federal, state, and local rules and regulations. Shareholders – who might also be on the board of directors and/or a corporate executive – receive dividends from profit in proportion to the number of shares they own. Corporate executives run the day-to-day operations of the business and are paid employees.
Types of Corporations Explained
For-profit corporations are set up to distribute profits in the form of dividends to the owners, or shareholders.
Also called “NPOs”, non-profit corporations cannot be organized for private gain and profits must go back to the corporation. If a non-profit dissolves, a non-profit corporation must distribute its assets to another non-profit.
Not-for-profit corporations are a type of NPO commonly called a “501(c)” corporation and they must be organized for one of the 28 categories listed in section 501(c) of the tax code. A 501(c) corporation must file an application and a filing fee with the IRS, and receive IRS approval, for tax-exempt status.
Tax Treatment of Corporations
Corporations are taxed apart from the shareholders as the corporate tax rate. This means that corporations’ profits are taxed twice – once at the corporate tax rate, then again when shareholders must pay tax on dividends received – unless the corporation elects to be taxed as a “Subchapter S” corporation where only shareholders are taxed.
Personal Liability of Shareholders
A corporation’s liabilities and debts are separate from its owners. This is often called the “corporate shield” or the “corporate veil”. If a corporation is sued for any reason, it is common practice for a plaintiff to attempt to “pierce the corporate veil” and if successful, the owners are liable. Plaintiffs are commonly successful at piercing the corporate veil when the corporation is found to have been set up for fraudulent purposes, or if owners or officers engage in egregious behavior and cause some public harm in the pursuit of private gain.
Evidence that often results in piercing the corporate veil includes:
- Failure to keep personal and business funds separate;
- Putting business expenses on a personal credit card, and vice versa;
- Contracts signed personally, not on behalf of the corporation
- If an owner gives a personal guarantee or uses personal collateral, such as real property, for a business loan
When the corporate veil is pierced, the owner(s) of the corporation may be held personally liable for:
- Payment of payroll taxes;
- Payment of business expenses paid with a personal credit card;
- Payment of business loans personally signed or personally guaranteed;
- Payment of any fines or restitution for negligence or criminal acts.
The Pros of Incorporating
- Owners are shielded from liability for corporate acts;
- Owners are shielded from financial liability for corporate debts and other contractual obligations;
- If the owners elect to form an S-corp., the profits are only taxed once, to the owners’ dividends;
- Corporations may be for-profit, not-for-profit, or non-profit.
The Cons of Incorporating
- The corporate shield can be pierced under certain circumstances, rendering owners liable for business obligations and behavior;
- If not electing to be taxed as an S-Corp or not eligible to do so, the profits of the corporation are taxed twice, first at the corporate rate, then the owners pay tax on dividends;
- There is a burdensome filing package that must be submitted to incorporate;
- There are complicated rules and procedures that a corporation, the board of directors, and the corporate executives must follow.
Hopefully, this overview will help you decide whether incorporating is right for your business.
About the Author
Vanessa Baxter is a blogger and legal assistant living and working in the great city of Philadelphia. She frequently works for Philadelphia appeals attorney Todd Mosser, Esq.