Pros and Cons: Why Form a Corporation?
Starting a business means making key decisions, with choosing the right business entity being a significant one. For many entrepreneurs, forming a corporation, particularly a C corporation, is a top choice.
Deciding whether to incorporate is an important choice to make when starting your new business. Other types of business legal structures include sole proprietorships, partnerships, and limited liability companies. As with any legal structure, corporations have certain advantages and disadvantages. Whether you decide to incorporate should be based on these factors and a careful analysis of the nature and needs of your business.
This article will provide insights into what it means to form a corporation, its benefits, and its potential drawbacks.
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Forming a Corporation: General Overview
When you form a corporation, you're creating a legal entity that stands apart from its owners. There are several types of corporations, with the C corporation (C corp) and nonprofit corporations being some of the most common. Each type has its unique advantages, tax implications, and requirements.
To establish a corporation, you file specific paperwork, called the Articles of Incorporation, with the state. The Internal Revenue Service (IRS) views corporations as individual entities. This means they have their tax rates and return obligations. Additionally, corporations need an employer identification number (EIN) from the federal tax body. Corporations must be diligent in their record keeping. You can use your EIN to open a business bank account.
You may also need to get a business license from the state, depending on the type of business you operate. You will also need to draft corporate bylaws and appoint a board of directors. Before making the decision to incorporate, however, you should understand the pros and cons of forming a corporation.
Pros of Forming a Corporation
There are several advantages of forming a corporation that attracts business owners, including:
- Liability Protection: This is a significant advantage of a corporation. The personal assets of the business owners remain safe, such as homes and cars. Should the business face business debts, only the corporation's assets are in jeopardy. This is unlike liability with a sole proprietorship or general partnership, where personal assets are fair game.
- Tax Benefits: Corporations encounter corporate tax. Sometimes, the tax on their profits is lower than personal income tax. Plus, business owners can dodge certain self-employment taxes. These taxes relate to federal benefits like social security.
- Credibility: A business name with “corp" or “inc." tends to appear more professional to customers. This also helps show clients and partners that the business has undergone formal processes. It also shows they adhere to state regulations. This can enhance the corporation's trustworthiness.
- Separate Legal Entity: The corporation can continue its operations even if the owners retire or pass away. The corporation can enter into contracts and acquire assets. They can face liabilities independently. This allows for continuity and stability even amidst changes in ownership or management.
- Capital Raising: Corporations can generate funds by selling their shares of stock. The corporation's ability to issue stock is a strong selling point to those willing to invest capital in a business venture.
- Power Structure: The corporate business form has an established power and management structure. This structure consists of directors, officers, and shareholders. Each group has its own set of clearly defined roles and responsibilities within the corporate framework. See Corporate Structure: Directors to Shareholders for more details.
- Stock and Stock Options for Employees: The corporate business structure offers an appealing opportunity to potential employees, like stock benefits and stock options, which are the employee's right to buy stock at a locked-in price.
Cons of Forming a Corporation
There are also some disadvantages to incorporating your business. You should consider the following:
- Complexity: The incorporation process can be expensive and time-consuming. Many documents must be prepared. This includes the new corporation's articles of incorporation and bylaws. You also have to pay a filing fee to your state's Secretary of State office or a similar business filing agency.
- Cost: Incorporating generally requires more funds upfront. Some states charge corporations an annual franchise tax.
- Double Taxation for C Corps: The profits of a c corp can be taxed both as corporate income and again as personal income when given to shareholders. This occurs most often in larger corporations. It may not be an issue for stockholders and owners of smaller corporations, who often work for the business itself and receive salaries. These salaries are tax-deductible for the corporation rather than dividends. One solution to the double-taxation problem is electing "S" corporation tax status.
- Corporate Formalities: All corporations must observe several corporate formalities. These are rules that ensure the corporation is operating as a separate entity independent of the business's owners. These steps include holding regular meetings with the board of directors and keeping records of corporate activity. Business owners should also maintain the corporation's financial independence. See The Basics of Small Business Incorporation to learn more.
- Less Control: Decision-making often rests with the board of directors. This can make some small business owners feel they have relinquished too much control.
Still Unsure About Whether To Incorporate? Talk to an Attorney
The type of legal structure you choose for your business will play a huge role in your success or failure, so it pays to do your homework before deciding. Ultimately, you and any business associates will have to make that decision for yourselves. A skilled business attorney can help you make an informed decision.
Then, work with your lawyer or our simple-to-use business formation service to set up your business following your state's laws.
You Don’t Have To Solve This on Your Own – Get a Lawyer’s Help
Meeting with a lawyer can help you understand your options and how to best protect your rights. Visit our attorney directory to find a lawyer near you who can help.