Whether you are just starting your business or you have already been operating as a sole proprietorship or general partnership, you may be wondering about the benefits of forming your business as a corporation.
That’s a question that growing numbers of Americans are facing as entrepreneurship levels stay strong in early 2023. In fact, despite labor shortages, high inflation and supply chain challenges, the number of businesses started last year exceeded 5 million for the second year in a row. 2023 is looking like another banner year.
An early decision you will face in your entrepreneurial journey is the incorporation question. Often, business owners think that incorporation is too costly or too time-consuming, and neither is the case.
The benefits entrepreneurs gain by forming their business as a corporation typically outweigh any perceived disadvantages. These benefits are, in many cases, unavailable to sole proprietorships and general partnerships.
Incorporation benefits include:
- Limited Liability – Corporations provide limited liability protection to their owners (who are called shareholders). Typically, the owners are not personally responsible for the debts and liabilities of the business; thus, creditors cannot pursue owners’ personal assets, such as a house or car, to pay business debts. Conversely, in a sole proprietorship or general partnership, owners and the business are legally considered the same and personal assets can be used to pay business debts.
- Tax Advantages – Corporations often gain tax advantages, such as the deductibility of health insurance premiums paid on behalf of an owner-employee; savings on self-employment taxes, as corporate income is not subject to Social Security, Workers Compensation and Medicare taxes; and the deductibility of other expenses such as life insurance. For information on the types of tax advantages your business may gain by forming as a corporation, consult an accountant or tax advisor.
- Establishing Credibility – Incorporating may help a new business establish credibility with potential customers, employees, vendors and partners.
- Unlimited Life – A corporation’s life is not dependent upon its owners. A corporation possesses the feature of unlimited life, meaning if an owner dies or wishes to sell his or her interest, the corporation will continue to exist and do business.
- Transferability of Ownership – Ownership in a corporation is typically easily transferable. (However, there are restrictions on S corporation ownership).
- Raising Capital – Capital can be raised more easily through the sale of stock. Additionally, many banks, when providing a small business loan, want the borrower to be an incorporated business.
- Retirement plans – Retirement funds and qualified retirements plans, such as a 401(k), may be established more easily.
Corporations do not come without perceived potential disadvantages.
Potential disadvantages of a corporation include:
- Double Taxation – C corporations are subject to double taxation of corporate profits when corporate income is distributed to the owners in the form of dividends. The double tax is created when tax is first paid at the corporate level. If corporate profit is then distributed to owners as dividends, the owners pay tax at the individual level on that income. The double tax can be avoided by electing S corporation tax status with the Internal Revenue Service.
- Formation and Ongoing Expenses – To form a corporation, articles of incorporation must be filed with the state and the applicable state filing fees paid. Many states impose ongoing fees on corporations, such as annual report and/or franchise tax fees. While these fees often are not very expensive for small businesses, formation of a corporation is more expensive than for a sole proprietorship or general partnership, both of which are not required to file formation documents with the state.
- Corporate formalities – Corporations are required to follow both initial and annual record-keeping tasks, such as holding and properly documenting initial and annual meetings of directors and shareholders, adopting and maintaining bylaws and issuing shares of stock to the owners. Sole proprietorships, general partnerships and even LLCs do not incur the formalities imposed on corporations.
For specific questions on whether the corporation is the best structure for your business, it is best to seek the advice of an attorney or accountant.
Originally published Sept. 14, 2019.