It is important to realize that changes may occur in this area of law. This information is not intended to be legal advice regarding your particular problem, and it is not intended to replace the work of an attorney.
Business owners often consider whether they should incorporate their business. There are a number of factors that should be considered.
Liability
A primary reason given to incorporate is to limit liability. A corporation
is a separate and distinct entity from its owners and has the same
rights and obligations as an individual. It can own property, carry
on business, incur liability and sue or be sued. A shareholder’s
liability is limited generally to the value of the cash or other property
contributed to the corporation in exchange for stock. Therefore, as
a general rule, the shareholder’s assets not invested in the
corporation are safe from the corporation’s creditors, and a
shareholder is not personally liable for the debts of the corporation.
However, there are two primary exceptions to this general rule. The first is if the shareholder provides a personal guaranty. A personal guaranty is often required by lenders, vendors and landlords or other key creditors. The second primary exception is for tort liability. For instance, if an owner of a corporation is negligent and causes damage then the owner is personally liable for the damage even if the owner has incorporated its business. Because an owner of a small corporation is actively involved in the business the tort liability exception is a large exception. Nevertheless, if the business has outside employees then to shield the owner from the negligent acts of the employees it is necessary to incorporate. Accordingly, if a business has employees then it is generally a good idea to incorporate (or form a limited liability company).
In addition to the two primary exceptions to limited liability, a shareholder may become personally liable for corporate debts if the corporation is not formed in compliance with or operates in violation of applicable statutes, or if the corporation is operated as a mere front for its shareholders rather than for corporate purposes. Under some circumstances, corporate officers may be held personally responsible for the corporation’s failure to pay state and federal income tax withholdings.
Control
The business affairs of a corporation are managed by its board of directors
and its officers. The directors are elected by the shareholders. While
shareholders have the ultimate control of a corporation because of
their stock ownership, the day-to-day management lies with the board
of directors through its officers.
When a corporation has a large number of shareholders, such day-to-day
centralized management by the board of directors can be an advantage.
This division of responsibility and possible conflicts of interest
between the shareholders and directors can also create the risk of
dissension. However, in small corporations the shareholders, directors
and officers are often the same person or persons.
Transferability of ownership interest
A corporation can have a perpetual
existence, unaffected by the death, withdrawal or entry of shareholders,
officers or directors. The corporation can simply continue its business
uninterrupted by such events, and only the ownership of the shares
of stock in the corporation is involved. The ease of transferring
of shares of corporate stock may facilitate family estate planning,
gifts to children, intra-family sales, transfers between shareholders,
and compensation of key employees. Shareholders can enter into an
agreement limiting the transferability of shares of stock and providing
for the sale and purchase of the stock on death, disability, withdrawal
from the corporation or other such circumstances. This ease of transferring
shares of stock also facilitates the financing of the corporation
through the issuance of stock to the general public. (Public offerings
of stock are subject to numerous federal and state requirements and
generally require the assistance of counsel familiar with these requirements.)
Taxes
Corporations may enjoy certain tax advantages and are subject to certain
tax disadvantages. Because of the complexities involved, anyone considering
incorporation should consult with a qualified tax adviser prior to
incorporation.
The corporation or a non-corporate business entity can adopt a pension or profit-sharing plan for the benefit of the employees. If certain requirements are met, contributions of cash or other property by a corporation to such a plan will be deductible by the corporation for federal income tax purposes, the earnings derived from contributions to such a plan will not currently be subject to tax, and the employees will not be taxed on their share of the funds until it is distributed to them. Under current tax law, there is very little difference between the types of plans that a corporation may adopt compared to a non-corporate business entity. The corporation may be able to provide for its employees tax free: 1) group term life insurance benefits; 2) medical and dental insurance benefits; 3) so-called cafeteria plans and 4) death benefits. While a non-corporate business entity can provide these same benefits, if the shareholder is also an employee, the shareholder becomes eligible to receive these benefits. (Note: Those benefits may be treated differently for shareholders in an “S” corporation.)
The corporation pays income tax on the profits that are not distributed to the shareholders-employees as salary or in some other form deductible by the corporation for federal income tax purposes, and the shareholders-employees also pay a tax on that same money when it is later distributed to them as a dividend. This disadvantage can be avoided if distributions are made to the shareholders-employees in a form that is deductible to the corporation for federal income tax purposes, such as salary.
Operating losses of corporations cannot be deducted by the shareholders unless the corporation has made an “S” election.
If the shareholder is an employee, the shareholder’s compensation is subject to state and federal payroll withholding requirements.
Legitimacy
Fair or not, often businesses that are incorporated maybe perceived
as being more legitimate than a business that is not incorporated.
If you incorporate then you can use “Company, “Inc.,” “ltd” or
similar identification of a corporation in your business name. Such
ability to be identified as a company may lead to an enhanced image
to the general public.
It is important to keep in mind that the factors that have been discussed are the principal considerations to be evaluated in determining whether a business should be organized as a corporation. However, they are not the only considerations. You should consult with an attorney and tax professional to discuss the advantages and disadvantages of incorporating in your particular case.
Legal editor: Anthony J. Motschenbacher, June 2008