The decision to form a corporation comes with many advantages and disadvantages. Breaking the process down into its separate parts will ideally show if this is the right choice for you at this time.
Incorporating is a phrase we often hear in the business world, yet many still are unsure exactly what it implies. When small business owners decide what legal structure to use for their business, they are faced with many choices, and one of these is whether or not to structure the company as a corporation. While there are numerous benefits to incorporation, there are also some disadvantages, and this is never an easy decision. Here, we will go over the different kinds of corporations and the inherent advantages and disadvantages of incorporating your business.
We will cover everything an entrepreneur needs to know about corporations and business structures, from detailing the common corporation types, such as C corps and S corps, to discussing the benefits of personal liability protection and the drawbacks of double taxation. Stay tuned.
Brad Nakase, Attorney
A Corporation, Defined
Essentially, when a company is recognized as a legal entity by the state and is separate from its owners or shareholders, then it is known as a corporation. This new corporation can be owned by individuals or other entities, and ownership can be transferred seamlessly through the buying/selling of stocks. A corporation can also enter into litigation by itself, which serves to protect shareholders from personal liability if legal action such as a lawsuit occurs.
Generally, entrepreneurs choose corporations because they are seeking a more formal structure than an LLC. Perhaps they plan to take the company onto the global stage or form an IPO. Whatever their plans, structuring the company as a corporation can be helpful for entrepreneurs, but it is vital that they do the research and choose carefully.
When entrepreneurs decide that forming a corporation is the right fit for them, they need to pay attention to the specific requirements dictated by their state. For some companies, these rules stipulate how to create corporate bylaws and file articles of incorporation. If this sounds like a lot of paperwork, it is, and it can be challenging, so it makes sense to navigate these guidelines carefully and take one’s time. Once all the correct forms and documents are completed and filed, the business will be universally recognized as a corporation and can move forward. Before deciding to create a corporation and as entrepreneurs move through this complex process, it makes sense to get in touch with a qualified attorney. For California corporations, Nakase Wade can provide licensed expertise along with free consultations.
Essential Tip: When it is recognized by the state, a corporation becomes a separate business entity. Notably, the entity then protects its owners from any personal liability incurred due to debts of the business or legal troubles pertaining to the company or shareholders.
Advantages of A Corporation
We have established that a corporation is a legal entity that is recognized as separate from its owners. Therefore, the corporation offers protection of liabilities over the owner’s personal assets. In fact, corporations have a unique freedom to conduct various business activities once they are established, as long as the actions are lawful. These include hiring additional employees, buying and owning assets, signing contracts, borrowing money, and more. All of these actions and the moves and decisions made by the business are seen after by the board of directors, and the board is elected by the shareholders. So, corporations have a cohesive, organized structure that helps entrepreneurs get things done.
In terms of the ownership of a corporation, each owner is usually responsible for a percentage of the business, which is derived from the number of shares held. Corporations always must be owned by shareholders (one or more), and the amount of each shareholder’s ownership directly relates to the number of shares owned.
The Different Types of Corporations
From C corporations to B corporations, the structural choices that exist are numerous and can be overwhelming. Each different business structure has its own specific benefits and drawbacks, so before you commit to one, it is helpful to compare, for example, a closed corporation to a nonprofit so you remain informed and can make the right decision. Additionally, some entrepreneurs decide that rather than a corporation, it makes sense to form a different type of business, such as an LLC, a partnership, a solo venture such as a sole proprietorship, or even a cooperative. Here, we will tell you a little more about each structure and let you debate the finer points.
S Corps
Many choose to create an S corp because although they offer limited personal liability to owners, they manage to avoid double taxation. Why? S corps are considered flow-through entities. This means that deductions, losses, credits, and all other income can be reported on the owners’ individual tax returns instead of the business paying taxes as a separate entity. Clearly, not being taxed twice is desirable. Another notable detail that pertains to S corps is this: all S corp shareholders need to be citizens of the US.
C Corps
C corporations are popular and commonly used, and here are a few of the reasons why. A C corp features an unrestricted number of owners/shareholders, and this structure is also taxed by its income but as a separate entity. Shareholders of a C corp must pay taxes on the dividends they receive, but they do get the protection of personal liabilities from both litigation and business obligations. C corp ownership is based on the division of stocks, and these stocks and is sold or bought as owners see fit. Revenue can be raised by selling stock, which makes the C corp structure an intelligent choice for larger companies.
B Corps
B corps are otherwise known as certified benefit corporations. This for-profit system is intended to help benefit our society as we know it, and it is one of the newer business structures we will take a look at. For S corps and C corps, being certified as a B Corp is a note of approval that shows the business world that the company’s primary concern is the welfare of the environment and our society. B corps legally pledge to improve the world, and it is not an easy status to attain. The criteria, such as scoring well on the B Impact Assessment test, are stringent, but it is the right fit for entrepreneurs who have their hearts in the right place and plan to create a company that works for the public good. B corps enjoy the tax status of a C corp or S corp, depending on what structure they utilized beforehand. Contact a business attorney for more information about B corps, such as the necessary legal commitments to the company’s owners.
Nonprofit Corporations
You have surely heard of nonprofit organizations that are more or less dedicated to purposes of religious, political, educational, scientific, or otherwise benevolent. These corporations are very similar to B corps in their pursuit of the greater good, and they are also sometimes dictated by the state in which they are formed. Since nonprofits are unable to distribute profits to their officers, directors, or members, this makes them easier to run. However, nonprofits are still able to pay out employee earnings and offer compensation. With these complications come some tax advantages, such as the chance to file for tax-exempt status with federal and state governments. In fact, many nonprofit corps decide to file what is called 501(c)(3), which is a tax-exempt status that is enjoyed because the company is dedicated to pursuing a nonprofit mission.
Closed Corporations
When a company is considered “closed,” it means that the business is privately held. You may have heard of this being called a family corporation, a private company, or even an incorporated partnership. Still, the result is the same: the company is only owned by a few shareholders and on private terms. So what does this mean in terms of the way the company works? First, the company’s shares cannot be publicly traded. While this can make it challenging to raise the capital of the claims, the owners will still assume the benefits of personal liability that is more limited than within other structures.
Corporations : The Benefits
When corporations are formed, they bring with them multiple advantages for the shareholders and the business itself. Now, the specific benefits of corporations depend on the setup and nature of the company, but we can easily explore the finer points of these advantages as you decide if a corporation is suitable for you.
Taxes
Tax benefits are a plus side for corporations. While C corps are subject to double taxation, other structures, such as S corps, provide tax advantages that depend on income distribution. Here is an example: S corps are able to split income among the business and owners, therefore letting income be taxed at different and more favorable rates. Owners’ salaries must be charged self-employment tax, but the rest of the amount can be taxed without self-employment tax. Clearly, this is a tax advantage for corporation owners.
Liability Protection
When owners form a corporation, they are afforded more excellent liability protection over their personal assets than with any other business entity. This is one of the reasons that forming a corporation is a popular choice for entrepreneurs. How does this work? When a corporation faces a lawsuit, the owners are not personally responsible for the legal responsibilities or corporate expenses or debts. This is true even if the company does not possess enough funding for repayment of these debts. This sense of protection is one of the main advantages that businesses cite when they decide to try incorporating.
Security of the Company
Ownership of stocks is what dictates corporation ownership. This immediately creates a sense of flexibility for the business instead of other entity types. From being able to transfer ownership to considering the business’s long-term prospects, flexibility is a crucial trait for companies and one that makes the corporation structure even more desirable. It is important to note that specifics relating to the transfer of ownership rest on the articles of incorporation and the bylaws that were first conceived when the business was started. However, it is usually easy to sell and buy ownership of a corporation. When a shareholder wants to leave, he or she can sell their stocks and be instantly detached from the company. If a shareholder retires or dies, he or she can also have their stocks transferred to another person.
Capital Access
Corporations have another advantage: they can conveniently raise their assets by selling off stock. This is an advantage that other business entities simply do not have access to and can be very helpful in growing a business and providing a safe way to prevent bankruptcy and increase value.
Disadvantages of A Corporation
Although we have taken a look at some of the top advantages offered by corporations, they are definitely not ideal for every entrepreneur or every business entity. In fact, a corporation can prove to be an expensive, time-consuming endeavor. Therefore, as you debate the next step in your business career, it is essential to stay aware of the drawbacks that corporations can have and how these disadvantages can impact you. Forming a corporation can be quite a grind, from extra expenses to strict protocols to possible problematic taxation.
Doubling Your Taxes
Many corporations deal with the prospect of “double taxation,” which sounds daunting but is a relatively simple concept. This term implies that the corporation faces two tax hurdles on its company income: one at the level of the entity, and one at the level of the shareholders, depending, of course, on the amount of earned profits. However, there is a way to avoid this: to run the company as an S corp. This is because S corps are only taxed based on the individual incomes of shareholders, not at the level of the business entity. However, this loophole is becoming smaller and smaller as the Internal Revenue Services has begun to focus on S corporations, sometimes even taxing them as C corps depending on their records. So, if you are worried about double taxation, perhaps a corporation is simply not suitable for you at this time.
A Long Application Process
This may seem less consequential than paying more taxes, but it is worth stating that incorporating a business can be both arduous and tenuous. Indeed, filing the correct incorporation articles can often be an easy process, but the rest of the documentation and paperwork can be significant pain. Owners need to figure out and detail the critical aspects of the new entity and identify the owners. These tasks can consist of but are not limited to: taking the minutes during meetings, forming ownership change agreements, drafting and preserving bylaws, appointing a directors’ board, and more. While it is true that starting a new business always necessitates a lot of time-consuming busy work, it is worth considering that corporations, especially at first, may require even more.
Strict formalities, Systems, and Structures
Going along with the often time-consuming application process requires adhering to strict legal requirements while keeping the corporation running smoothly. This, too, can be complex and demanding. Business owners are forced to follow strict regulations and understand the nature of the rules and regulations that must be maintained in order to keep the business open. From annual reports to annual meetings, every function of the company must be kept up to date. For example, bylaws must be relied upon at all times by an active board of directors. Also, specific corporation types must satisfy particular restrictions, and these must be kept up to date as well, such as the fact that an S corp may not have more than 100 shareholders. They all must be certified US citizens.
The Cost of Corporations
Here is one of the top disadvantages and a deciding point for many individuals who are debating creating a corporation. Corporations can indeed become quickly expensive to operate. Companies that are already established can generate revenue through selling shares, but the act of forming a corporation and making sure it is not only off to a strong start but being run correctly can place a drain on capital. First, a solid amount of startup capital is needed to get the corporation off the ground. Next, there are many different fees to pay, such as taxes, ongoing fees, and even filing charges that begin right at the start of the life of the business. Therefore, it is vital to have a clear sense of what you can afford before you start and to be honest with yourself about your goals and whether you can afford the costs of a corporation. As you debate the costs vs. the rewards, it may help to contact an accountant and a business lawyer. Both of these parties can help weigh in on the decision.
Consulting Legal Experts When Deciding Whether to Incorporate
Just as we often consult tax experts during tax season, it makes perfect sense to contact a business lawyer when deciding whether or not to incorporate your business. We hope this article serves to outline some of the details, advantages, and disadvantages, but if you have additional questions, please bring them to our attention. Our experienced corporate attorneys can offer advice regarding incorporation and help with everything from articles of incorporation, other pertinent documents, and taxes and fees. If you are having trouble sizing up the advantages and disadvantages that may come with forming a corporation, get in touch with the skilled, licensed legal professionals at Nakase Wade today. Your California corporation will thank you.